Executives
Chris Blessington – Director Marketing & Communications
Sujal M. Patel – President, Chief Executive Officer & Director
William D. Richter – Vice President Finance & Interim Chief Financial Officer
Analysts
Katie Huberty – Morgan Stanley
Glenn Hanus – Needham & Company
Amit Daryanani – RBC Capital Markets
Isilon Systems, Inc. (ISLN) Q4 2008 Earnings Call February 5, 2009 5:00 PM ET
Operator
Welcome to the Isilon Systems 2008 fourth quarter and full year financial results conference call. My name is Michelle and I will be your coordinator for today. At this time all participants are in listen only mode. We will be facilitating a question and answer session towards the end of today’s conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today’s conference Mr. Chris Blessington, Director of Marketing and Corporate Communications.
Chris Blessington
The speakers on our call today will be Isilon’s CEO, Sujal Patel and Vice President of Finance and Interim CFO, Bill Richter. Before I turn the call over to Sujal there’s important information I will share with you. On this conference call we’ll be referencing both GAAP and non-GAAP financial measures. When we review gross margin, operating expenses, operating loss and net loss we may be speaking in non-GAAP terms which excludes stock-based compensation.
We believe that excluding these expenses gives our management and investors a better indication of our operating results. We provide GAAP and non-GAAP reconciliation information in the press release we issued today announcing Q4 and year-end results. The press release is available on the home page of the investor relations section of our website at www.Isilon.com/company.
A webcast of this call will be archived in the same location. In addition, a recording of this conference call will be available later this evening through Midnight Eastern Time on February 19th. Details on the playback are included in the press release mentioned earlier.
During this conference call we will make forward-looking statements about our business and expectations for the future. These forward-looking statements are subject to risks, uncertainties and assumptions. If the risks or uncertainties ever materialize or the assumptions prove in correct our actual results may differ materially from those expressed or implied by our forward-looking statements.
For a detailed description of these risks, uncertainties and assumptions, please read our quarterly report on Form 10Q for the quarter ended September 30, 2008, our annual report on Form 10K for the fiscal year ended December 30, 2007 and our other filings with the Securities & Exchange Commission. Isilon assumes no obligation and does not intend to update these forward looking statements.
With that, I’d like to turn the call over to Sujal.
Sujal M. Patel
Overall, I’m pleased with Isilon’s fourth quarter and full year performance. We’ve steadily driven top line growth and are converging towards profitability. Our results for the quarter and the year clearly demonstrate solid execution against our plan. I’d like to now ask Bill to review our financial results. After that I’ll step back in and share my thoughts on the successes in 2008 and discuss how we’ll build on the momentum moving forward in 2009.
William D. Richter
Total revenue in the fourth quarter was $31.8 million, up 19% from $26.6 million in the fourth quarter of last year. Sequentially total revenue increased 5% from $30.3 million in Q3. For the year, Isilon grew revenue 29% to $114.4 million versus $89 million in 2007. Like a lot of companies in this sector, we did notice a slower than normal December budget flush but overall we were pleased with our progress in the fourth quarter recognizing the challenges of the broader economic environment.
Let me give you some detail on our Q4 revenue. Geographically the breakdown was 64% North America and 36% international. The channel drove 54% of revenue in Q4 roughly flat with the prior quarter. Sales of software applications contributed 10% of our total revenue or about $3.2 million. In Q4 we acquired 60 new customers representing 26% of total revenue.
Gross margin was 57.1% approximately flat with Q3. Our core product margins were 60.1% compared to 62.4% last quarter. Service margins were 46.1% compared with 36.4% in Q3. Our service margins continue to show some lumpiness as the timing of individual service contract renewals can cause the results to fluctuate significantly quarter-to-quarter. As our services business grows we expect these variations to smooth out. From a business model perspective, we continue to expect service margins to hover around 40% in the near to medium term.
Moving on to operating expenses; overall op ex in the fourth quarter was $20.9 million, a slight decrease from last quarter. Within op ex R&D decreased 1% sequentially, sales and marketing increased 3.2% sequentially primarily associated with new headcount in our channel organization and G&A expense decreased 7.8%. Most of the savings in G&A resulted from a decrease in legal expenses.
In the fourth quarter we continued to incur costs in shareholder litigation and related matters however these expenses were partially offset from recoveries from our D&O insurance. As you can see in the fourth quarter we continued our model of generating leverage in the business through operational improvements and cost rationalizations while continuing to make strategic investments.
Our non-GAAP net loss per share was $0.04 in Q4 down sequentially from $0.05 in Q3 and half the net loss per share from the same period a year ago. For the full year our non-GAAP net loss per share was $0.30 compared with $0.37 in 2007. As a reminder, our 2008 non-GAAP net loss per share included $0.04 of loss associated with the cost of our audit committee investigation compared with $0.02 in 2007.
Now I’d like to review some highlights on the balance sheet and our cash flows. We ended Q4 with over $77.8 million in cash, cash equivalents and marketable securities up $1.1 million from the end of Q3. Deferred revenue was $27.2 million up 15% from $23.7 million in Q3 and up about 50% from last year. DSOs improved again to 41 days from 45 days in the previous quarter, inventory at $12.4 million was up $1.9 million from the prior quarter and in Q4 we generated $2.7 million of positive operating cash flows and about $700,000 of free cash flows.
Overall, these results demonstrate solid execution of our business plan driving revenue growth, generating increased leverage in the business and advancing towards profitability. We are continuing our practice of not providing quantitative top or bottom line guidance. Having said that I do want to share some perspective on how we view Q1.
Q1 has traditionally been a seasonally slower quarter for us and this phenomenon may be more pronounced this year as customers respond to the current economic conditions by delaying the roll out of operating budgets. We expect these cyclical buying patterns to cause Q1 to be more back end loaded from a linearity perspective which will results in an increase in our DSOs. These factors along with some larger annual and one-time payments that come due in the first quarter will prevent us from generating positive operating cash flows as we did in the second half of 2008.
Turning now to gross margin; our product suite continues to deliver a strong value proposition to customers which has enabled us to maintain our margins. As you know in the fourth quarter we made a strategic decision to invest in the channel. As we roll out these new channel programs in the early stages, we may sacrifice a couple points of gross margin in the near term. Once the programs are up and running we expect gross margins to recover and grow and our overall cost of delivering product to end user customers to decline.
During 2008 we made significant investments in the sales and R&D organizations while still generating leverage during the year. As ended Q4 most of our near term investment had been completed. Going in to Q1 we expect to continue to make targeted investments in strategic areas of our business particularly in the channel but headcount growth will slow substantially. Overall, we expect op ex to be slightly up over our Q4 results. This really represents the full effect of investments we made during last quarter rather than new investments in Q1.
Going forward we will continue to scrutinize our cost structure ensuring that every dollar of investment creates a return for our share holders. We remain firmly committed to creating a business that drives healthy operating margins and believe that our products, team and strategy are well placed to take advantages of the significant opportunity in front of us.
With this, I’ll now turn the call back over to Sujal.
Sujal M. Patel
When I became CEO just before the start of 2008, Isilon was faced with three clear needs right the company’s operations, build an experienced senior management team while maintaining our history of rapid and meaningful production innovation. I’m pleased to report that we accomplished those goals last year.
Through close attention of every facet of business operations we exit 2008 having achieved record gross margins, record revenues, significantly narrowed losses and continued strong progress towards becoming a highly profitable business. We also now have a senior management team in place with deep industry and enterprise experience. A team that’s ready help Isilon fully seize the opportunity before us.
In my first conference call after becoming CEO I spoke to you of strategic investments in the areas of the business that drive competitive advantage among them research and development and our services and support organization. Those investments remain important because as you know, every major storage vendor now recognizes scale-out NAS as the right solution for managing unabated growth of file based data within large enterprises.
To that point, HP recently rolled out their offering and NetApp continues to work on the convergence of their product line towards a unified scale-out architecture. This is tremendous validation of the vision that led to Isilon’s founding in 2001. It also continues to spur our relentless focus on product innovation, innovation that will enable us to build for tomorrow on the already significant technology advantage that we have today.
Our innovations in 2008 marked by the introduction of our fifth generation OneFS operating systems have not only doubled the performance of our product, they have laid a strong foundation for future product enhancements. As we move through the early part of this year you will see Isilon extend our leadership of the scale-out NAS space by bringing to market a set of ground breaking new products that reinforce our heritage of innovation while redefining the competitive advantages of the marketplace.
These products will increase our footprint in enterprise account by dramatically broadening the number of work flows, applications and process for which we offer a unique and compelling proposition. For 2009 new customer acquisition will continue to be one of the most important things we measure as a business. We’ve implemented a plan to drive improved customer acquisition numbers and look forward to that plan bearing fruit in 2009.
The critical element of that plan is more fully leveraging and expanding our indirect sales channels. In Q4 we focused on defining, socializing and implementing and innovative and opportunistic channel program. That program will differentiate Isilon from other major storage vendors. Aside from driving significant product margins for our partners and providing them with new high margin professional services opportunities, Isilon’s program will drive accelerated new customer acquisitions and ultimately increased operating margins.
Our channels VP Leonard Iventosch, has begun the role out of that program with hand selected partners and the response has been very favorable. In addition to channel leverage Isilon will continue to drive growth as we deepen our penetration in to key vertical markets and horizontal applications that benefit from our unique technical and business value propositions.
To that point the [SWAT] analysis on Isilon published by Gartner on January 9th is helpful in understanding my confidence. Besides from clearly identifying Isilon as the market leader in scale-out NAS, Gartner pointed out that we continue to drive strong sales positions in the media and entertainment markets while significantly expanding our presence in other key vertical markets and regions.
One such area of growth is the life sciences and bioinformatics market. We continue to see terrific new and repeat orders from research organizations around the global. This massive growth of file based data is being driven by their rapid adoption of next generation research instruments. Our growth in this space from just 2% of revenue in the first quarter of 2008 to more than 10% in Q4 reflects a combination of great product set and focused market outreach. I’m pleased with our growth in this rapidly evolving and extraordinarily data rich market.
While I’m generally satisfied with our Q4 results, we did see some slowing of orders as we got deeper in to December and January has been off to a slow start. These trends give me pause and I want to share with you my thoughts on how I’ll be managing Isilon’s operations through the current economic climate.
First and foremost let me say that we are firmly committed to keeping Isilon on a path towards profitability. I will prudently allocate our resources to take full advantage of the market opportunity before us while ensuring that we do not compromise the bottom line. Keeping op ex virtually flat in the second half of 2008 indicates that we have a good handle on our cost structure and have already made some tough decisions on spending.
That said, should economic conditions continue to worse, we stand ready to make whatever adjustments are necessary quickly to ensure that we keep Isilon positioned for the long term. Looking ahead, I’m very excited to be starting 2009 with an experienced and energized leadership team, a team that is ready to embrace opportunities and manage through potentially harsh economic realities in a way that enables Isilon to emerge stronger, better positioned and more focused than ever on our long term success.
With that Bill and I are happy to take your questions.
Question –and-Answer Session
Operator
(Operator Instructions) Your first question comes from Katie Huberty – Morgan Stanley.
Katie Huberty – Morgan Stanley
Sujal, given the drop off in product revenue growth was pretty noticeable in the quarter, can you just talk about which industry verticals in particular were weak and maybe a little more what the linearity looks like in the quarter versus typical.
Sujal M. Patel
Sure. As I mentioned earlier, the order pattern as we went through Q4 did show some slowing in December as we got deeper in to that month. Both October and November were quite good from a linearity perspective, December slowed down. I think that if you look at it from a vertical market perspective I don’t think that you could necessarily draw any conclusions. I think that the numbers are pretty small and I don’t think you can draw any conclusions on a particular vertical market that slowed more than others.
What I think you really saw was one, a little bit of caution to spend as we approached the end of the year and some deferrals in to the next quarter and the first half of next year. But, in addition to that, a slower than normal budget flush than you typically see in Q4.
Katie Huberty – Morgan Stanley
Any difference between US versus international markets?
William D. Richter
Katie, you can see in our results that international grew slightly faster in the US from Q3 to Q4 and that’s just a function I think of the economic climate being not quite as bad as some regions around the world. Then also, it’s just simply a return on some of the investments we’ve been making over the past couple of years abroad.
Katie Huberty – Morgan Stanley
Then just lastly it sounds like you expect the first quarter to be more back end loaded. What in your pipeline gives you confidence that some demand can come back over the next couple of months?
Sujal M. Patel
I think that we like everybody are watching like a hawk what’s going on within our pipelines, what customers are saying, what they’re talking about with respect to their budgets. I think that obviously the current economic climate introduced some uncertainty in to what our results will be but given conversations that we’re having and the way that our quarter is trending, we feel confident that spending should continue and that storage spend isn’t going to fall off a cliff over the course of the first half of ’09.
Operator
Your next question comes from Glenn Hanus – Needham & Company.
Glenn Hanus – Needham & Company
Maybe gross margins, could you talk a little bit more about the investment in the channel you mentioned in your script that is going to sacrifice gross margins near term? Maybe just kind of a little more detail about the nature of the expenses and then how that should sort of turnaround over time and how to think about that?
Sujal M. Patel
Glenn, let me try to frame this so that you can understand it better. Our business abroad is basically 100% through the channel already so that’s roughly 35% of our revenue. Within the US we’re running at somewhere between 25% to 30% through the channel already and the goal really is to up that percentage in the near term from 25% to 50% in the sort of near to medium term and then long term even higher.
As we do that one of the things that we’re doing that really differentiates our program is putting something together that makes a compelling case for channel partners to do business with Isilon and built their business models and align them with ours. So really, it’s a matter of setting up a model that allows them to build a profitable business.
Having said that, our goal in the process is essentially to maintain street pricing. By doing that as we allocate more and more business through the channel from a street pricing perspective we expect that to go up over time or up over time in relative terms and help us build a strong gross margin overall. I think you can see that with a lot of companies in the space that run 80% to 90% of their business through the channel.
Glenn Hanus – Needham & Company
I take it your performance in the quarter was about in line with your internal plans?
Sujal M. Patel
I think we were pretty much right on our bottom line plan for Q4 and slightly ahead of it for the year. From the top line I think with the slowdown and the lack of a strong budget flush at the end of Q4 we were a little off our plan for revenue.
Glenn Hanus – Needham & Company
On the competitive front, can you comment about pricing or competitive tactics, sales cycles, the new [Atmost] offering, a couple of those things?
Sujal M. Patel
For Q4 we didn’t see any material change in the competitive environment either with respect to what we compete with nor the pricing. Let’s talk about what we compete with first. The majority of our sales engagement continue to be against NetApp and EMC. The majority of those continue to be against NetApp with their traditional ONTAP 7G products. From a pricing perspective we didn’t see any pricing pressures in particular related to the macro conditions or any changes relative to what we saw throughout 2008.
With respect to the [Atmost] product, we haven’t competed against the [Atmost] product in the field and my sense is that if you look at how the [Atmost] product is positioned and where it is positioned I’m not sure that we’re really going to see it in the marketplace.
Glenn Hanus – Needham & Company
Sales cycles, anything there?
Sujal M. Patel
What I would say with respect to sales cycles, I don’t think that competitive dynamic had any impact on sales cycles at all. Even if I take the competitive dynamics out, I don’t think the sales cycles materially changed in Q4 but you may have seen a slight lengthening of cycles that slip in to the next quarter due to budgetary cuts or constraints.
Operator
Your next question comes from Amit Daryanani – RBC Capital Markets.
Amit Daryanani – RBC Capital Markets
Just a question on the channel initiative, when do you expect to roll this out broadly across the entire channel?
Sujal M. Patel
Well, it’s really already begun Amit. I think the strategy for Leonard who arrived here in the middle of Q4 was really to formulate a plan and in the early part of Q1 he’s rolled it out. Of course, it’s not a light switch and its going to take a couple of quarters to really take root but I think in terms of where we want to be with respect to our plan, we are executing well.
Amit Daryanani – RBC Capital Markets
In the past you’ve just sort of talked about curtailing the absolute number of channel partners that you have, is that kind of behind us or does that process still need to happen?
Sujal M. Patel
I think that process is a constant process for us. We are constantly looking at our channel partners, making sure that one, they’re effective, that they’re trained properly but as well that within the various levels of our channel program they’re pushing an appropriate level of business to meet the minimums for the program.
I think that’s a constant process and with the hiring of Leonard it is our hope that we will over the course of the next four, six, eight quarters be able to not only make our channel partners that we have today more effective but really recruit more board, horizontal storage partners that are going to help us get access to new market opportunity.
Amit Daryanani – RBC Capital Markets
Then just finally you guys have made pretty good progress I think reducing the pro forma losses, at least throughout 2008, I wondered if you would care to take a stab at what sort of revenue run rate do you see getting to breakeven?
Sujal M. Patel
What I will say just to help from a modeling perspective is when we look at it we think that we can get to breakeven somewhere in the low to mid 40s. In terms of when exactly that revenue number comes is highly dependent on both our internal execution but as well as the broader economic climate.
Operator
That concludes the question and answer session. I’ll now pass it back to Sujal Patel, Isilon’s CEO for closing remarks.
Sujal M. Patel
I want to thank everybody for being on the call today and we look forward to updating you on our progress in late April.
Operator
Ladies and gentlemen thank you for your participation on today’s conference. This concludes the presentation. You may now disconnect.
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