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

Websense, Inc. (NASDAQ:WBSN)

Q4 2008 Earnings Call

January 27, 2009 5:00 pm ET

Executives

Kate Patterson – Vice President, Investor Relations

Dudley Mendenhall – Chief Financial Officer

Douglas Wride – President and Chief Operating Officer

Gene Hodges – Chief Executive Officer

Analysts

Samuel Wilson – JMP Securities

Philip Winslow - Credit Suisse

Daniel Ives - Friedman, Billings, Ramsey & Co.

Todd Raker - Deutsche Bank Securities

Eric Martinuzzi - Craig-Hallum Capital

Walter Pritchard – Cowan & Co.

Rob Owens - Pacific Crest Securities

Philip Rueppel - Wachovia Capital Markets

Bud Leedom - California Equity Research

Erik Suppiger - Signal Hill

Operator

Welcome to this Websense conference call. (Operator Instructions) And now at this time for opening remarks and introductions I would like to turn the conference over to Websense’s Vice President of Corporate Communications and Investor Relations, Ms. Kate Patterson.

Kate Patterson

Good afternoon everyone and thank you for joining us to discuss our fourth quarter financial results. With me on the call today are Gene Hodges, Websense CEO; Dudley Mendenhall, our Chief Financial Officer; Doug Wride, our President and COO; and [Abilina Ebara], Investor Relations Manager.

Before we begin a review of the financial results, let me outline our conference calendar for the first quarter of 2009. Management will present at the Deutsche Bank Small and Mid Cap Conference in Naples, Florida, on February 12; the Pacific Crest Emerging Technologies Summit in San Francisco on February 26; and the Morgan Stanley Technology Conference the first week of March.

Before turning the call over to Dudley, let me remind you that during this conference call, management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties and other factors that may cause the company's actual results to be materially different from historical results or any other results expressed or implied during the call. The potential risks and uncertainties which contribute to the uncertain nature of the statements include, among others, risks associated with integrating acquired businesses and launching new product offerings, customer acceptance of the company's services, products, fee structures in a changing market, the success of Websense brand development effort, the volatile and competitive nature of the Internet and security industries, changes in domestic and international market conditions, the volatility in currency exchange rates, risks relating to the required use of cash for debt services, the risks of ongoing compliance through the covenants of the senior credit facility, risks related to changes in accounting interpretation, and other risks and uncertainties described in Websense's public filings with the Securities and Exchange Commission. The information in this call related to financial results, projections and other forward-looking statements is based on current expectations and we expressly disclaim any responsibility to update forward-looking statements should circumstances change.

Our discussion also includes financial measures that are numerical measures that can't be calculated in accordance with generally accepted accounting principles. The company believes the non-GAAP financial measures enhance investors' ability to evaluate the company's operating results and compare current operating results with historical operating results. For more information, please consult the press release that was issued this afternoon and which is also posted on the investor relations portion of the company's web site.

I will now turn the call over to our Chief Financial Officer, Dudley Mendenhall.

Dudley Mendenhall

Let me start by saying that our business remains strong and we believe our performance was excellent given the overall environment. Billings for the fourth quarter came in at $105.9 million, down 3% compared to the combined billings of $108.6 million for SurfControl and Websense in Q4 a year ago. The small year-over-year decline was driven by several factors: a shortening of average contract duration to 22.5 months from 23.4 months a year ago, which reduced total billings by about $4.0 million; a change in the valuation of the dollar compared to a year ago, relative to the Euro, British pound, and Australian dollar that resulted in lower billings in U.S. dollars of about $6.4 million; and finally a decline of $1.3 million in billing to discontinued non-core products from the SurfControl acquisition.

Despite this modest decline, the fundamental indicators of the [health bug] served as a positive. Billings of core products were up 4.3% in constant dollars, using the same exchange rates of a year ago. In fact, billings in North America increased for the second sequential quarter, even and the economy in North America continued to weaken. We were successful at continuing to retain customers and seats under subscription increased by 600,000 to approximately 43.9 million.

Historically we have provided you with customer retention rates and our retention rates in 2008 continued to trend in a historical of 75% to 85%. We are now introducing two new billings metrics related to renewals, which are most closely aligned with how we manage our business.

The first metric is the percentage of our historical billings that we obtain for renewals and historically that average has been in the range of 75% to 80%, coincidentally the same as the customer retention rate.

The second metric is the percentage of billings for renewals divided by expiring subscriptions in any given period and historically that metric has been at or above 100%.

In Q4 2008 our billings from renewals was at the high end of our historical average of 75% to 80% and our renewal yield exceeded 100% and benefited from migrations of SurfControl customers to the Websense product suite and from existing purchasing our new Web Security Gateway.

Renewals are a key driver of our business model and both of these customer retention metrics demonstrate the soundness of our fundamental business despite the volatility of the global economy.

Further, we continue to have growth opportunities from SurfControl migrations and in 2008 54% of SurfControl renewals upgraded.

For the full year Websense billings were down slightly at $343.0 million compared to $356.0 million in 2007 with the $13.0 million decrease accounted for by a decrease in billings of discontinued products of $6.3 million and a decrease in the average contract duration for all contracts booked during the year to an average of 21.9 months from approximately 23.4 months in 2007.

As we witnessed in the fourth quarter, 2008 full year results benefited from our subscription model with billings from renewals of $275.0 million, or about 80% of the total billings for the year, at the high end of our historical average.

The income statement in the fourth quarter benefitted from higher revenues combined with lower than forecast expenses due principally to currency translation resulting in non-GAAP earnings per share of $0.31, which above the high end of our guidance range.

Our revenue performance in Q4 once again exceeded our expectations as it has every quarter this year, principally due to shorter billings duration which result in a stronger revenue yield. Further, revenue does not fluctuate as much from short-term changes in the exchange rate since we convert billings immediately to U.S. dollar denominated deferred revenue at the time of the billings and not when the revenue is actually recognized.

Non-GAAP revenue was $86.1 million prior to the Q4 impact of a non-cash write-down of SurfControl’s deferred revenue in the amount of $6.8 million as required by purchase accounting rules.

Our operating margin for Q4 was 27.2% and annually for 2008 it was 30.3%, within our long-term target range of 28% to 32%. The decrease in margin relative to Q3 was due principally to higher sales commissions and our seasonally higher largest billing quarter. Recall that we front-end load our expenses because we pay commissions on billings in the current quarter even though we recognize revenue over time.

For the full year 2008 our non-GAAP EPS of $1.38 is up 45% over 2007’s results of $0.95, reflecting the success of the SurfControl acquisition, including disciplined expense management during the integration combined with underlying growth in Websense core business.

Q4 cash flow as strong with GAAP cash flow from operations of approximately $24.1 million compared to approximately $16.0 million in the fourth quarter of 2007. The pro forma cash flow is $27.1 million for the quarter if we exclude $3.0 million of one-time outflows associated with the SurfControl acquisition.

For the full year we generated GAAP cash flow from operations of $67.4 million compared to $53.6 million in 2007. The pro forma cash flow from operations in 2008 is $85.0 million, excluding approximately $18.0 million of one-time outflows associated with the acquisition.

The 2008 full year pro forma cash flow from operations of nearly $85.0 million greatly exceeds our updated guidance of $75.0 million.

On the balance sheet, we finished the quarter with $67.0 million in cash, above our target range of $60.0 million.

Accounts receivable were $82.00 million at the end of 2008 and days outstanding were 70 days versus 67 days in the third quarter of 2008 and 66 days in the fourth quarter of 2007. We had strong collections in the first week of January and days outstanding are now below 66 days.

In the quarter we made prepayments of our credit facility of $15.0 million, resulting in a debt balance at quarter end of $125.0 million, which is down $85.0 million since closing the transaction in the fourth quarter of 2007.

Consistent with previous quarters, we also repurchased approximately 289,000 shares of stock for approximately $5.0 million.

In 2008 we made $65.0 million in principal pay downs on our credit facility and repurchased $20.0 million worth of common stock for a total outflow of $85.0 million.

Turning to 2009 guidance, the strength of our subscription model coupled with the expectations that billings renewals will contribute 75% to 80% of our 2009 billings forecast makes us cautiously optimistic that our growth projections for 2009 are not overly aggressive.

Although new business growth could be more challenging in a difficult economic environment, expansion of our product suite and sales force will provide us with more opportunities to grow new business.

Our guidance is for growth in 2009 billings over 2008 of about 8% at the midpoint and assumes that contract duration will continue to trend in the low-20 month range.

Our forecast is for billings growth to follow the seasonal patterns of our renewal base with low single-digit growth in Q1 and Q2, mid-single-digit growth in Q3, and mid-teens growth in Q4.

We are also assuming with this guidance that the major foreign exchange rates will remain in the current ranges. However, every 10% change in the exchange rate between the U.S. dollar and the Euro and British pound can generate volatility of approximately $8.0 million to $10.0 million annually in billings. As you know, we have seen volatility as high as 25% in Euro currencies in the past three months.

Further, although we price mostly in U.S. dollars in markets besides Europe and Australia, a general strengthening of the dollar can also negatively impact billings growth in those markets as local clients must buy dollars through their local banks in order to pay us in dollars.

For 2009 our non-GAAP revenue guidance for the year is $342.0 million to $350.0 million, about flat with 2008 results at the midpoint, even though we are forecasting growth in billings. This is one of the anomalies of a subscription base model. It takes three to four quarters for a change in the growth rate in billings to show up in the revenue growth rate.

In addition, we are starting 2009 with non-GAAP deferred revenue of approximately $353.0 million, which is $5.7 million less than at the start of 2008 due to the billings declines that we discussed earlier. These two factors combine to make it difficult for us to generate growth in 2009.

In order to achieve our billings growth objectives in 2009 we are expanding and upgrading our sales force, growing our product development budget in line with billings, and holding our remaining expenses flat year-over-year.

In view of our new expanded product offerings and our larger customer base, we feel that it is prudent for us to add to our sales force to capitalize on the market opportunity and to continue to invest in our products. Gene will speak about the investments in a few minutes.

Overall our expenses are forecast to increase 6% to 7% in 2009. Consequently, flat revenue, despite growth and billings will result in lower margins and lower non-GAAP earnings per share due to the increase in forecasted expenses in 2009.

Simply put, we will be recognizing all growth and sales expenses in 2009 as they are incurred but the growth in billings will not result in a growth in revenues until 2010. We are, therefore, anticipating a modest decline in operating margins by about 200 basis points compared to our Q4 operating margin in the 25% to 28% range to reflect the higher sales cost associated with the growth in billings and product development.

While below our historical rates due to the anomaly of our revenue recognition model this year, even at 25% to 28% we continue to perform in the top tier of software companies.

We will continue to see interest expense decline as we pay down debt and forecast total interest expense to be about $5.0 million to $6.0 million for the year compared to $10.8 million in 2008.

Our estimate of the non-GAAP tax rate remains at 34% to 35% in 2009.

The net is non-GAAP earnings per share for 2009 of $1.20 to $1.30.

Cash flow is driven by billings and not revenues and our forecast is for GAAP cash flow from operations to exceed $80.0 million in 2009 from $67.4 million in 2008. Since we do not anticipate any future one-time cash outlays associated with the SurfControl acquisition, we plan to report cash flow on a GAAP basis going forward. As we accumulate excess cash above our target level, we anticipate a continuation of our 10b-5 one share repurchase program for which the Board has authorized an increase in 2009.

We also anticipate that we will continue to make significant discretionary prepayments on our bank debt.

As previously stated, for the first quarter of 2009 we are forecasting low, single-digit growth in billings year-over-year and a very small sequential decline in revenues. While these trend lines will continue in the second quarter, we anticipate that revenue will begin to grow sequentially in the third and fourth quarter and billings growth will accelerate. We also anticipate that strong renewals will continue to drive billings in 2009.

It is useful at this time for us to provide forward guidance to 2010 since our forecasted growth in billings in 2009 will result in a more normal revenue run rate. Therefore, assuming that we generate 2009 billings in our guidance range, and assuming expenses grow as planned, in the range of 6% to 7% annually in 2009 and 2010, we have the potential to generate substantial growth in non-GAAP earnings per share in 2010 of more than $1.50 per share.

To summarize, we had an outstanding year and as we look beyond the one-year acquisition of our acquisition of SurfControl, we are in great shape financially. The acquisition was much more successful than we anticipated at the time of the closing and we have significantly exceeded the financial metrics that we guided to in late 2007.

Although we are selectively increasing our spending in 2009, which may appear contrarian in an uncertain economic outlook, we will continue to monitor our billings trends closely and have significant flexibility to adjust expenses accordingly.

I would again reiterate that the foundation of our financial strength and stability is our subscription model and billings renewals yields.

I will now turn the call over to Doug Wride.

Douglas Wride

As Chief Operating Officer I want to assure you we are not managing our business with disregard for what’s going on in the global economy. We see the same headlines and market declines that you do and we are not making these investments in our business in a vacuum. While we don’t think we are completely immune to an economic downturn we believe, and our performance in the last recession supports this belief, that we are more resistant than most.

Additionally, we have a very nimble business model and like most software companies, the majority of our expenses are headcount-driven. Should our business outlook change materially, we are prepared to make the necessary changes to balance our business investment with a solid financial return.

In fact, we have already taken several precautionary steps. All salaries for Websense officers have been frozen, with no merit increases in 2009. Headcount growth, outside of sales and engineering has been halted and even replacement requisitions are undergoing executive committee review. Non-headcount variable costs and cash outlays have been, and will continue to be, scrutinized. Examples of these are travel, employee benefits, outsourced services, and discretionary IT upgrades. Additionally, we recently asked our functional department leads to trim additional amounts from their 2009 operating budgets, which were approved early last month.

These are purely precautionary measures, which I am communicating to you so that you know how we are reacting to the global economic realities that we must all deal with today. I believe that the characteristics of our business and our subscription model place us in a very good position to not only weather this financial downturn but prosper.

Let me outline what gives me confidence that we are in better shape than most. We are entrenched within IT infrastructures as a must-have. Few of our customers would go naked, as demonstrated in 2008, by renewals from financial institutions that had declared bankruptcy, and the stable seat count, even as unemployment rose.

Additionally, Websense software is typically not a high-ticket item relative to other IT expenditures. Our recurring revenue model and consistently high renewal yields mean we do not start from zero every quarter as do enterprise license software business models. As Dudley mentioned, we begin this year with a large portion of our 2009 revenue already on our balance sheet and the highest ever dollar amount of contracts up for renewal in the current year.

Because we collect cash up front our cash flows are consistently well ahead of our net income and our cash balances are solid. In 2008, as Dudley said, we generated $67.4 million in GAAP cash flow from operations and we expect to exceed $80.0 million in 2009. The cash generating characteristics of our business allowed us to pay down our debt by $85.0 million in five quarters ended December 2008 and to repurchase the $20.0 million worth of our common stock last year while maintaining adequate operating balances of cash. Both of these actions are accretive to our financial performance. As a result, our balance sheet remains very solid.

We recognize that the last significant recession in the 2001/2002 time frame was different than what we are experiencing today. However, that time is our most recent benchmark for comparison. During that period we outperformed by balancing our growth with maximizing our cash flow. We grew our business, gained market share and emerged stronger than ever.

Yes, average contract duration was a little shorter, about 20 months on average, and DSOs a little higher, but we retained our customers and focused on new products. In 2003 we introduced v5 of our core Web Security product, just as IT bending was starting to turn. This time, we have our new Web Security Gateway, our DLP products, hosted services, and much more.

I believe that our performance during this time will be similarly strong and we are actually in a better position since our new products are already shipping.

In summary, we remain conservatively managed and focused on cash flow. The investments we are making, which have the impact of decreasing our operating margins somewhat, are entirely consistent with this philosophy. I am as confident as I’ve ever been that Websense will be successful in the years to come.

A final note on our acquisition strategy. The acquisition of Defensio that we announced today is exactly the type of acquisition that we have said over the past year that we are interested in: small, technology tuck-in companies that complement and extend our current technologies and have no immediate material impact on our financial model. At this time we have no plans to pursue anything of material size, and as you know the covenants of our credit facility restrict us from doing large acquisitions.

With that I will turn the call over to Gene.

Gene Hodges

Thank you for taking your time this afternoon. Q4 was another strong quarter of execution across Websense in spite of the weak economic conditions. As you heard from Dudley and Doug, we certainly felt the impact from the recession more strongly in Q4 than we had before. Foreign exchange changes and a one-month shortening of average contract length cost us about $10.0 million with Q4 billings.

The good news is that customers are still buying. Our renewal rats continue to be strong and price points have held up well. We were also successful in finding customers for our newer offerings, with 146 orders for just under $7.0 million total in our Web Security Gateway and $3.0 million for our data loss prevention products.

This performance in DLP included our largest DLP order ever, which came from a North American financial services company. Our win rate in DLP continues to improve against Symantec, our primary competitor, and year-over-year growth for the DLP product line in Q4 was 63% with 73% growth 2008 over 2007.

One of the strongest indicators of the breadth of demand for both our WSG and DLP product lines is the geographical penetration we are seeing. In 2008 we won DLP orders in 26 countries, with Europe coming on line big time. And in Q4 we sold WSG into 20 countries during the first quarter of general availability.

Today, in fact, we are releasing our international language versions of the Web Security Gateway adding German, Chinese, Spanish, Portuguese, and Japanese localized offerings.

Price points for our Web Security Gateway orders were very strong. In Q4 we saw a typical uplift of about 35%, slightly over our expectation of a 30% uplift.

SurfControl customers continue to upgrade to Websense products. In Q4, as Dudley mentioned, 54% of the SurfControl customers who renewed chose this upgrade. And the price points for these upgrades were solid, with a 25% uplift.

We also saw progress selling our software-as-a-service offerings, specifically Web Security. Q4 saw our first large deal for software-as-a-service Web Security from a large global hospitality company. We also signed a deal with a large ISP for a supply of software-as-a-service e-mail capabilities to the federal government. This contract will only generate billings as new users are registered but it could be significant in 2009 and beyond.

Even in this tough climate we are still able to find new-name customers, either in white space in emerging markets or from competitive wins in developed markets. In Q4 we sold $12.0 million of Web Security web filtering and e-mail security to such new-name customers. Given solid performance in both renewals and generation of incremental business, we grew 5% in North America and 10% in Asia. We shrank in Europe and Latin America, which had been both strong growth contributors earlier in 2008 but shrank because of foreign exchange rate changes.

The two quarters of growth we’ve achieved in North America in the second half of 2008 is, we believe, an important indicator that we can grow even in challenging economic conditions.

The most important non-financial information from Q4 is what we learned about the competitiveness and market demand for our new products. We spoke with hundreds of prospects in Q4. The selling cycle for most of our new products is six to twelve months so most of these discussions were about 2009 opportunities.

What we heard from our customers and partners says the investments we have made in product acquisition, integration, and in total development over the last two years are starting to pay off. The feedback was uniformly strong. Customers and partners see our competiveness improved against all of our major competitors. Customers have interest in our new products in spite of tightening budgets. The effectiveness and performance of our real-time Web Security capabilities is seen as a game changer in our core market.

Our availability to deliver both software-as-a-service and on-premise deployment options for our Web Security capabilities offers large distributed enterprises unmatched flexibility. Our tightly integrated DLP Endpoint and Gateway solution is the best in the industry for helping customers to stop data losses accurately and effectively.

The opportunities that these new products bring frame our strategy for 2009. The economy is horrible and will probably get worse before it gets better. We certainly felt the impact in Q4 and can feel it even more in 2009 but we have many more opportunities in 2009 than we did in 2008 and we believe that growth can offset the economic impact.

This upside is why we are planning to spend $10.0 million more in sales in 2009 than in 2008. 75% of the hiring for this investment has already been completed as we brought on new sales reps at the start of the year. Almost all the remaining hiring will be completed within the next 30 days.

The quality of these new hires is excellent. Many of these new hires were strong performers at security companies that have recently been acquired by larger competitors. The bulk of the hiring focused on our medium-to-large enterprise target segments. We have increased the enterprise sales staff in the U.S. and in the international markets which show good growth prospects for 2009.

We also released enterprise reps who had not been successful in selling our new products. About 15% of our former enterprise reps were released and their seats refilled with new, stronger players in the fourth quarter.

We are also adding sales capacity to new-name business teams in small-to-medium business. You may remember, we attempted to drive SMB new business growth through distribution in 2007 and this approach did not work. We de-invested and we made a smaller investment in 2008 in an in-house team that worked directly with our partners. This investment has been producing a good stream of new-name business, which is very profitable in spite of the economic climate.

We will also be hiring additional specialists in our software-as-a-service e-mail to look for new customers in that growth segment.

The productivity of our continuing sales force and being able to find new business opportunities is also improving. For the first time in my memory, our opportunity pipeline for new business and upgrades, exiting Q4, was larger than going in. This was a marked improvement over Q4 2007 where the transitioning of the SurfControl sales force and customer base resulted in a very low pipeline and low new business and upgrade billings in the first half of 2008.

The majority of this pipeline increase has been, as you would expect, in our Web Security Gateway opportunity. Given the economy holds, this is a trend we think we can continue through the first half of 2009 at least.

A strongly improved product set with an expanded and strengthened sales team will open up many opportunities for Websense in 2009. Simultaneously, shortening of contract length, and further strengthening of the dollar could challenge the yield from our renewal base. We still see growth, as our guidance shows. The investments in sales are EPS-dilutive in 2009, which should be cash accretive.

We enter 2009 with a much improved offense, define new customers and upgrade our current install base. Simultaneously, as you heard from Doug, we are ready to take defensive action, if it’s needed, to take costs out of the business if our sales investments don’t pay off. So far, as Dudley showed, our renewal business shows we have good sustainability in this economic crisis. It is a tough management challenge but the approach we are on is one we believe can yield the best results in 2009 and will really pay off whenever the economy starts to recover.

And now I will the call over to questions and answers.

Question-and-Answer Session

Operator

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

Samuel Wilson – JMP Securities

Dudley, what was headcount?

Dudley Mendenhall

About 1,250.

Samuel Wilson – JMP Securities

And do you have capex for the quarter?

Dudley Mendenhall

$2.5 million.

Samuel Wilson – JMP Securities

Can you give us the non-GAAP R&D sales and marketing in G&A?

Dudley Mendenhall

R&D is running right at 14% of billings. We tend to track it to billings because of the revenue anomaly. And then sales and marketing is running about 36% to 37%.

Samuel Wilson – JMP Securities

What was G&A?

Dudley Mendenhall

9%.

Samuel Wilson – JMP Securities

Can you give us some sense on promotional activity? In the last quarter you talked about increasing promotional activity. What did you do in the December quarter and what are your thoughts here on the first part of 2009?

Dudley Mendenhall

Q4 was pretty typical promotional activities, nothing extremely aggressive. We will definitely look towards being fairly aggressive on product bundling promotions, specifically targeted at lengthening contract lengths for those few customers who might be willing to go from one to three years, in the first half of 2009 but don’t expect to see anything unusual outside of that.

Samuel Wilson – JMP Securities

Gene, this is not meant to be in your face. It’s one of those things where I’m doing it across the phone. But it has been three years you’ve been at the company. The quarter you came to the company it was growing and had 35% operating margins. Today you are looking at flat revenue for 2009 and 25% to 28% operating margins. Can you just take us and sort of grade how you see the company has performed over the last three years?

Gene Hodges

Yes, the major measure that I’m looking at is cash flow. I think that is how we are best valued. And SurfControl certainly increased the revenue base. We dropped a couple of margin points but when you look at the cash the company generates, it’s up significantly. And the EPS last year, pro forma basis, increased 40%.

So I would say the first year was focusing to get ready to execute the strategy, 2008 was a year where we finished pulling all those pieces together. And I think we saw significant improvements in both cash flow and earnings and a big non-organic jump on the top line, which gives us scale to compete against a completely different set of competitors. And you know, I would like to see any other CEO stand up against that.

Samuel Wilson – JMP Securities

On Defensio, did you put out a purchase price?

Dudley Mendenhall

No, but it’s really small.

Samuel Wilson – JMP Securities

Really small, five, ten, twenty.

Dudley Mendenhall

Below seven figures.

Operator

Your next question comes from Philip Winslow - Credit Suisse.

Philip Winslow - Credit Suisse

On the headcount side, what are your expectations for headcount over the course of the year? And obviously you talked about some focus in sales and marketing, but I’m actually thinking about the trends of the other product lines.

And what do you think from a competitive standpoint, the secure computing deal just closed with McAfee during the fourth quarter, anything from the competitive landscape from that transaction?

Douglas Wride

I think when you net the increases in sales and in engineering, we are probably through the year, ballpark, 100 people more. Not a large increase. I would also say that there is some balancing there with continued, the majority or our engineering expansion in Asia as opposed to in the United States.

Gene Hodges

We haven’t seen any significant uptick in competitive activity from McAfee. I think they have a fairly strong integration challenge on their hand. We have seen some good people that we have been able to hire because of that and we are happy to have them.

Operator

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

Daniel Ives - Friedman, Billings, Ramsey & Co.

Given the climate, can you just walk us through a non-specific deal, whether it’s large or smaller, what are you doing differently in terms of just sales force methodology or is it through the channel? Can you just walk us through, in this environment, anecdotally, like how things change and what you’re doing as a company to make sure renewal rates continue to be healthy?

Gene Hodges

It’s actually a fairly big change. We felt very much sales-capacity constrained in our mid—market and enterprise accounts in 2008 and the manpower additions and some modifications of our coverage model are going to allow us to go much deeper into our customer base.

I think historically we have been a very good transactional sales force focusing on this quarter’s subscription renewals and trying to sell upgrades in combination with this quarter’s renewals. As we have deepened the coverage model, we are going to go through our entire install base and then into our customers’ install bases leading with the Web Security Gateway and with DLP. So it’s going to be a very big change and how much we touch of the medium-to-large enterprise customers, and we think that’s also very important to understand problems we might have and the renewal base, such as customers going from three year to one year. If that’s going to happen sometime in the fourth quarter with an account, we would like to know about it and start working on it well before hand. So it’s a pretty big change.

Operator

Your next question comes from Todd Raker - Deutsche Bank Securities.

Todd Raker - Deutsche Bank Securities

Dudley, on the FX side can you give us a sequential impact on billings, not just the year-over-year?

Dudley Mendenhall

FX rates of the pound deteriorated principally in the fourth quarter. Held fairly stable then became coming down in the late third and fourth quarter. So we saw most of that, given the linearity in the December month of the fourth quarter. We saw most of that hit us at the very end.

The euro, started the year a bit weak, went up and was stable in the second and third quarter and then began deteriorating as well.

So the real volatility that we saw, and remember the first quarter is a fairly small billings quarter, second and third quarters is where we saw a relative FX stability. So it was really the fourth quarter that we saw the real downward spike.

And again, given the fact that December is our biggest month by far in the fourth quarter, we really felt the pain of that FX drop-off in the fourth quarter.

Todd Raker - Deutsche Bank Securities

So you would say sequentially you should be close to the $6.0 million impact you saw annually?

Dudley Mendenhall

Again, if I understand your question, there wasn’t that much volatility, given the size of billings in the first quarter, when there was some FX movement. Second and third were relatively stable from an FX standpoint. So I think your question is, is the bulk of the volatility we saw in the fourth quarter for all of 2008 and that is the case.

Todd Raker - Deutsche Bank Securities

I’m just trying to understand when you guided at the end of Q3, what the impact relative to that guidance would have been, not on an annual basis. But I can circle back offline.

Gene Hodges

I think let’s get that question out of the way. If you look at our guidance at the end of Q3 there are two planning assumptions for 2009 that are different. The first is our planning assumption on contract duration was reduced one month, given that’s what we saw in Q4. And the second was we went to current foreign exchange rates. And the difference between 8% and 10% growth rates falls completely out of just the duration assumption.

Todd Raker - Deutsche Bank Securities

And that’s a good segue because if I look at the 2009 guidance, clearly you are forecasting renewal rates to remain robust. But what is the risk you see the seat count come down? So you have an account renew but the magnitude of the seats really comes down, given all the headcount reductions we’re seeing here.

Gene Hodges

It’s tough for us to call. And the way we’re doing guidance is kind of a Denny the Dunce approach of here are today’s conditions, if they remain the same, here’s how we will perform.

In a bat, I think it’s transparency so if you want to make some assumptions about duration one way or the other or about FX, you can tune your models that way. But I think we can of either go down a Microsoft path and just say the world is volatile, we don’t know. We can play junior macro economist and try to tell you—we’re just going to forecast based on current conditions.

Todd Raker - Deutsche Bank Securities

If I look at the 2010 guidance, given that you have said 6% to 7% expense growth this year and then the next year, 2010, to get to the $1.50 would imply that I have to see kind of mid-teens growth in 2010. Is that the right conclusion?

Dudley Mendenhall

No, it’s really the math from revenue recognition. You know, you begin to build deferred revenue this year with the billings growth and then you begin to see a normalized yield flow. But that doesn’t require that type of billings growth assumption, to get to the $1.50. It really is a mid-to-low mid-single-digit billings growth assumption in 2010.

Todd Raker - Deutsche Bank Securities

But let me make sure. You are saying expenses in 2010 should climb another 6% to 7% off the 2009 level.

Dudley Mendenhall

Correct.

Todd Raker - Deutsche Bank Securities

So to see the outperformance on the EPS side we should see revenue grown faster than that, right?

Dudley Mendenhall

Correct, which it will as we build deferred revenue this year. But billings assumptions are 7% to 8% as they are this year.

Operator

Your next question comes from Eric Martinuzzi - Craig-Hallum Capital.

Eric Martinuzzi - Craig-Hallum Capital

The R&D direction that you’ve talked about, there’s nothing big on the horizon and here we’ve seen the announcement of Defensio. What is it, beyond the current product line, or maybe within the current product line, that you are spending those R&D dollars on?

Gene Hodges

We are spending heavily to build our lead in Web Security. And that will come through extensions in our real-time characterization capability and the ability to integrate and policy manage our Web Security products through a single console that will give our customers more flexibility, improvements in our software-as-a-service capabilities to incorporate the real-time, and to feed our knowledge of the Web into our e-mail services.

Eric Martinuzzi - Craig-Hallum Capital

So kind of evolutionary within the current as opposed to adding a next-door neighbor type of technology.

Gene Hodges

Yes. In 2009 it’s staying well ahead of some large competitors.

Eric Martinuzzi - Craig-Hallum Capital

On the cash flow for 2009, you talked about cash from ops greater than $80.0 million. What is the capex assumption for 2009?

Dudley Mendenhall

About $10.0 million run rate for 2009.

Operator

Your next question comes from Walter Pritchard – Cowan & Co.

Walter Pritchard – Cowan & Co.

You talked about the 15% reduction on the sales force side. Can you just give us a sense of how many people you are bringing on and how many people are exiting and where that leaves you in terms of number of sales people?

Gene Hodges

I would rather not do that. I don’t want to give that information to competitors.

Walter Pritchard – Cowan & Co.

I hear pretty consistently on this Web Security Gateway side, when you are competing up against the blue coats of the world, some would like to see you have an appliance. And I know you have historically not been in that market, or not been doing that yourself, you have relied on partners to some degree. I’m just wondering if given the focus there and given what seems to be a move in the market, pretty squarely towards appliances, in the proxy space, if that’s something you are revisiting at this time?

Gene Hodges

Yes, we will ship our first appliance in April. It will be a Websense branded appliance that we will run through our books. Product impact and billings impact is included in guidance and we would rather not disclose additional details until April so that we don’t play our hand to competition.

Operator

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

Rob Owens - Pacific Crest Securities

With the aggressive growth in sales headcount do you anticipate any change in channel strategy? And can you remind us how much you take direct and how much goes to the channel currently?

Gene Hodges

We don’t anticipate any change in channel strategy. I think that this will allow us to team sell with our channel partners more effectively, which is pretty much the only way we work, and I think we were like 95% through the channel in the fourth quarter and will remain that or higher.

Rob Owens - Pacific Crest Securities

And on the Web Security Gateway, what was the number that you gave?

Gene Hodges

It’s about $7.0 million in billings.

Rob Owens - Pacific Crest Securities

That was for the quarter?

Gene Hodges

Yes, for the fourth quarter.

Rob Owens - Pacific Crest Securities

And the $7.0 million, does that cannibalize filtering or is that in addition to?

Gene Hodges

It’s an upgrade to filtering.

Rob Owens - Pacific Crest Securities

So it’s $7.0 million in upgrade revenue relative to WSG.

Gene Hodges

It is $7.0 million in WSG orders and typically about 35% of that is incremental.

Rob Owens - Pacific Crest Securities

With regard to seat compression, can you help us understand a little bit why you are not seeing it at this point? Why your customers are either opting for the same amount of seats on renewal or is the higher pricing that is helping in terms of that billings number, at 100% plus?

Gene Hodges

It’s a little bit of both. We obviously did see some pretty onerous seat compression because we had customers who went bankrupt, just like many of you did. And those are the big swings. But we were able to win new-name customers and keep the renewal base very, very strong with these upgrades.

Operator

Your next question comes from Philip Rueppel - Wachovia Capital Markets.

Philip Rueppel - Wachovia Capital Markets

You talked about you front-end loaded the new sales force expense in hiring. Do you expect the same ramp to productivity as you have in the past or given the expertise you have been able to hire, will that happen sooner. How long will it take for you to know if this sales investment is paying off? Is it a couple of quarters or do we have to wait until the second half of the year?

Gene Hodges

I think we will have a good idea by the end of the first quarter in terms of the pipeline we are able to generate.

To go back to the first part of your question, it will take most of the year since these are mostly enterprise sales people, for them to ramp to full productivity. It’s pretty complex, we have designed our territories so they will handle a few more renewals in the beginning of the year and then they have to bring in that incremental business and they will spend the first part of the year trying to find that incremental business for the second half of the year.

Philip Rueppel - Wachovia Capital Markets

Just digging a little bit behind the contract length decline, do you attribute that to just overall macroeconomic issues? Was it broad-based or was it the result of the mean of a handful of large customers that may have gone out of business, or is there any ancillary effects of the SurfControl customers as they upgrade? Could you give a little bit of color there?

Gene Hodges

It was broad-based but it was much more severe in areas where there were fairly significant currency fluctuations in the quarter. And we don’t quite understand that, but if you look at Latin America, for example, which had the strongest currency fluctuations in the quarter, it was much more severely impacted than anywhere else in the world, in duration. And we saw some pretty big hits in the U.K. and Europe. The U.S., on the other hand, had less than half a month’s decline.

So, it’s a little unusual for those countries where we sell in local currency. I think you can understand it more in the countries where we sell in dollars because basically we were just asking for a much bigger pile of dollars and going to a shorter contract length would be a way to address that.

Operator

Your next question comes from Bud Leedom - California Equity Research.

Bud Leedom - California Equity Research

Speaking specifically to billings and your financial vertical, which I believe you mentioned was around 6% of overall billings, what are you seeing currently there and what trends might we expect in 2009, just as it pertains to retention and maybe new opportunities?

Gene Hodges

The financial vertical in Q4 was fairly stable for us. We got a couple of orders from bankrupt institutions and we got [inaudible]. I think obviously consolidation in the industry will have some impact over time, but we did see DLP purchases in that vertical, in the healthier institutions, in both the U.S. and in Europe. And by and large no onerous impact in Web Security.

Bud Leedom - California Equity Research

How would you characterize seat count within that vertical?

Gene Hodges

I don’t think we’ve done a seat count by vertical analysis.

Bud Leedom - California Equity Research

Did you have a DLP billings number for the fourth quarter?

Dudley Mendenhall

3.7.

Operator

Your last question comes from Erik Suppiger - Signal Hill.

Erik Suppiger - Signal Hill

Can you give us any color in terms of what kind of growth we could anticipate for the WSG in 2009? Any metrics that we can use to measure you by?

Gene Hodges

I would rather not break it out product line by product line, but it will be the bulk of our incremental business growth in the year.

Operator

There are no further questions.

Kate Patterson

Thank you for joining us. We will be available tonight and tomorrow if you have further questions.

Operator

This concludes today’s conference call.

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

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

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

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