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Executives

Dominic Orr –President, Chief Executive Officer

Steffan Tomlinson – Chief Executive Officer

Analysts

Sanjiv Wadhwani – Stifel Nicolaus

Ryan Hutchinson – Lazard Capital Markets

Mark Sue – RBC Capital Markets

Erik Suppiger – Signal Hill

Kim Watkins – J.P. Morgan

Jeffrey Kvaal – Barclays Capital

Greg Mesniaeff – Needham and Company

[Roe Chapra – Wedbush Morgan]

Eric Kainer – Thinkequity.

Bill Choi – Jefferies & Co.

Blaine Carroll – Ftn Equity Capital Markets

Aruba Networks, Inc. (ARUN) Q2 2009 Earnings Call February 25, 2009 5:00 PM ET

Operator

Welcome to the Aruba Networks second quarter 2009 earnings conference call. (Operator Instructions) I'd like to turn the conference over to Miss Jill Eisenstat with Investor Relations.

Jill Eisenstat

Thank you for joining us on today's conference call to discuss Aruba Networks second quarter 2009 results. This call is also being broadcast live over the web and can be accessed in the Investor Relations section of the Aruba Networks web site at www.arubanetworks.com.

With me on today's call are Dominic Orr, Aruba's Chief Executive Officer, Steffan Tomlinson, Chief Financial Officer and Keerti Melkote, Aruba's Founder and Chief Technology Officer.

After the market closed today, Aruba Networks issued a press release announcing the results for fiscal second quarter ended January 31, 2009. If you'd like a copy of the release you can access it online at the company's web site or you can call the Blueshirt Group at 415-217-7722 and they will fax or email you a copy.

We would like to remind you that during the course of this conference call, Aruba's management may make forward-looking statements including statements regarding expected revenue, gross margins, non-GAAP EPS and tax rates for the third quarter of fiscal 2009, expected operating expense reductions in the second half of fiscal 2009 resulting from the company's cost reduction efforts, expected changes and developments in the networking industry, the company's belief that it can significantly strengthen its position by capitalizing on verticals already committed to wireless, narrowing competitive fields and the growing realization that wireless networking is the most efficient and cost effect method of connectivity, expected near term bookings and revenue softness until the company's potential customers finalize their 2009 budgets, the company's law suit against Motorola and other statements as to the company's future economic performance, financial condition or results of operation.

These forward-looking statements are not historical fact but rather based on the company's current expectations and beliefs. These statements involve a number of risks and uncertainties some of which are beyond our control that could cause actual results to differ materially from those anticipated by these forward-looking statements.

These forward-looking statements apply as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more detailed description of the risks and uncertainties that may affect our results, please refer to the risks and uncertainties described under the caption risk factors and management discussion and analysis of financial condition and results of operation in our quarterly report on Form 10-Q filed with the SEC on December 10, 2008 and the risk factors contained in our Schedule TO filed with the SEC on February 17, 2009 as well as our earnings release posted a few minutes ago on our website. A copy of these documents may be obtained from the SEC or by visiting the investor relations section of our website.

Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to include certain charges including non cash stock based expenses, amortization expenses of acquired intangible assets and restructuring expenses. We have provided reconciliations of these non-GAAP measures to GAAP financial measures in the investor relations sections of our website located at www.arubanetworks.com and in our earnings press release.

Now, I'd like to introduce Dominic Orr, President and Chief Executive Officer of Aruba Networks.

Dominic Orr

Good afternoon and thank you for taking the time to attend our fiscal second quarter conference call. Overall, we had a strong quarter with 17% year over year revenue growth to $47.7 million, non-GAAP gross margins of 70.2% and non-GAAP net income of $0.02 per share, ahead of expectations.

Additionally, we added over 500 new customers across a wide range of industries and geographies. These new customers included a major specialty retailer with over 1,000 stores, one of the largest off price retail chains in the world, a leading health insurance company serving the Pacific Northwest, a health care system of nine hospitals and four stand alone clinics, one of the largest electrical grid RTO's in the United States, a leading provider of wire line telecommunications services in China, a large branch of a municipal government in the United States and major universities both domestically and abroad.

The vast majority of these customers have not completed their roll outs yet. The new customer growth is a strong complement to continuing demand from existing customers, many of whom are already fully committed to wireless LAN's as a key component of their networking infrastructure.

While prospects are slower to procure products in this tough economic environment, wireless LAN project investigation, planning and R&D activities have not slowed down appreciably. Field activities level on big project remains very high and our pipeline is robust. We are also focusing on design wins regardless of budget availability.

These encouraging signs point out that while we cannot control the market dynamics, we can continue to execute under the current market conditions and position the company well for the long term future.

Today, I would like to outline three key factors that are driving demands for our products right now despite the challenging economic conditions. First, we sell to a broad range of verticals, many of which are already committed to wireless as an essential part of their infrastructure. For many of our education, health care, high tech and retail customers, there is no alternative to wireless and while the economy may delay purchases, our customers in these verticals remain fully committed to wireless as the de facto standard user connectivity.

Second, we believe that we are benefiting from continued consolidation in our industry resulting in a more narrowed competitive view as privately help POP play wireless companies have been acquired or dropped away, we are often the POP play wireless LAN company in competition, and are therefore able to more clearly articulate our strong technological differentiation and positioning. As a result, I believe that we have actually become more competitive and successful over the last six months.

Third and finally, the economic environment is forcing CIO's and CTO's to rethink the efficiency of their infrastructure and investments. When they do this, many customers get clarity that wireless, particularly Aruba's solution is simply a more effective, more secure and less expensive solution for connecting users to their enterprise network.

We believe the IT world in on the cusp of embracing radical changes to basic networking and wireless is at the heart of these changes. The Virgin Group recently issued a report claiming that "802.11 LAN is the beginning of the end of wired internet as the dominant LAN access technology in the enterprise."

The Yankee Group added that they project that "wire switch port sales will decline for the first time in history. Wireless LAN will transform from being an augmentation to the wired network to being the primary means of deployment."

We believe that the combination of the speed of 802-11N and the protection afforded by identity based security has propelled market acceptance of wireless in applications we would not even been considered just two or three years ago.

We are seeing these changes in the field. CIO's are examining every line item in the budgets and asking hard questions about existing network infrastructure. When so many employees have laptop PC, does IT really need to provide multiple wired internet ports per user, each with far more capacity than an average user requires.

Can multiple users connect to a single wired access point instead? Can IT then reduce the number of wire switches in the wiring closets? And will that also allow them to cut the cost of annual support contracts? Would enterprise consolidates facilities and when they do, can it eliminate cabling and reduce the cost of moves and changes?

These questions lead to the conclusion that Aruba products offer more than secure mobility. They can also deliver hard cost savings for this year's budget. For example, we were recently able to reduce the roll out cost of a 700,000 square foot office building in Europe by $2.1 million or approximately 40% of the alternative approach.

In addition, that customer will be saving almost $800,000 a year in projected recurring costs. The recurring cost savings along would have justified employing an Aruba solution.

When another large customer in the U.S. was planning to upgrade his existing switching infrastructure, they monitored the network and determined that approximately 40% of their wire ports has zero usage. That customer concluded that they did not need to upgrade wire ports that were not being used. Instead, they right sized their network by eliminating those ports and deploying an Aruba wireless LAN.

They were able to shrink almost all of the wiring closets and bought over 2,000 Aruba access points for much less than it would have cost to replace those existing ports. In today's environment, savings such as this resonates with customers.

While revenues in Q2 were at the top end of our guidance, it remains a very tough sales environment. On our last quarterly conference call, we outlined a couple of key things that we expected to happen. First, we forecast that customers would continue buying our products for the ROI benefits. That clearly happened.

Second, we were concerned about the beginning of calendar year 2009, describing it as a period during which budgets were still being finalized. As expected, January was a challenging period and we expect that delayed budgets will continue to impact our operating results over the next couple of months.

With this in mind we are focused on carefully controlling our operating expenses. The risk that we completed in the fiscal second quarter while very difficult was the right move to make.

To summarize, while it remains a tough and challenging market, we continue to believe in the strength of our technology and the long term growth opportunities in our market. Setting aside factors that are beyond our control, what we can do is execute to the best of our ability, take advantage of new opportunities, continue to add new customers and change established ways of providing user access to the enterprise network.

Our recent design wins at key customers regardless of the immediate ability to spend is an example of Aruba executing now to take advantage of budget recovery in the future. In addition, by capitalizing on the three key factors that I mentioned earlier, namely; verticals already committed to wireless, a narrowing competitive field and the growing realization that wireless is the most efficient, most cost effective method of user activity, we believe that we can significantly strengthen our position for the long term.

Our success was evident in the second quarter with solid financial results, encouraging new customer growth and our consistent win rate even as growth remained a challenge for all in this environment.

A little later in the call, I'll be happy to answer any questions you may, and will now turn to Steffan to go through the financials in more detail.

Steffan Tomlinson

In Q2, total revenue of $7.7 million increased 17% year over year. Product revenue of $38.9 million increased 14% year over year. Professional services and support revenue of $8.5 million increased 53% year over year.

As expected, routable product in related services revenue of $342,000 declined 63% year over year. On a sequential basis, product and routable product in related services categories were down as anticipated.

In Q2, approximately 85% of our revenue came from indirect channels while 15% was direct. As a reminder, our indirect channels represent sales through our VARS and distributors as well as our strategic partner Alcatel Lucent. Additionally, during the quarter, existing customer accounted for 71% of sales, up 9% from Q1. Alcatel Lucent and Advent were 10% partners.

Approximately 62% of our sales were generated in the U.S. with the remaining 38% coming from international theatres. We had solid bookings across all geographies. Given the unique environment and the fact that we are one of the few networking companies with a January quarter end, I'll provide further detail on a monthly bookings growth rates basis within the quarter on a year over year basis.

The month of November declined 1%, December increased 78% and January declined 15% year over year. The year over year decline in January was in line with our expectations.

Non-GAAP gross margins were 70.2% an over 300 basis point versus 66.5% in the prior quarter and above our target range for gross margins of 65% to 68%. Q2 product gross margins of 67.8% compared to 64.1% in the prior quarter benefited from a mix of higher margin units being sold of 802.11 access points accounting for about 28% of all access points shipped.

Q2 services gross margins of 81.3% compared to 79.5% in the prior quarter, benefited from an increase in service renewals. Going forward, we expect total gross margin to fall within our target range.

Moving on to operating expenses, we are already starting to benefit from the cost efficiency measures implemented last quarter. These included curtailing discretionary marketing spending, implementing travel restrictions, decreasing outside professional services and various other items. I'd like to thank all of our employees who are helping with our efforts to control and limit costs. We remain focused on controlling costs without impacting our long term growth and are pleased with our progress so far.

Non-GAAP research and development expenses was down $142,000 from the prior quarter and increased as a percentage of revenue from 15.9% in Q1 '09 to 17.2% in Q2 '09. Non-GAAP sales and marketing expenses were down $2.9 million from the prior quarter and decreased as a percentage of revenue from 41% in Q1 '09 to 39.1% in Q2 '09.

Non-GAAP G&A expenses increased by $870,000 and relative to Q1 '09 were up as a percentage of revenue to 10.1% in Q2 '09 driven primarily by an increase in legal costs.

As we move deeper into the discovery phase of our lawsuit with Motorola and prepare for the upcoming Markman hearing, legal expenses for Q2 continue to impact our G&A line and total approximately $1.2 million. We've said from the outset that we do not infringe any of Motorola's patents, that the patents asserted against us are invalid and that the U.S. PTO would never have issued a patent had they been properly apprised of the prior art.

We continue to believe this is the case. We were pleased t his month to receive three favorable actions from the U.S. PTO. First, the U.S. PTO issued a preliminary report invalidating one of the wireless value patents against us in its entirety. A week later, the U.S. PTO issued a second preliminary report invalidating the majority of the claims of the remaining wireless value patent asserted against us with the two surviving claims not at issue in the case.

Finally, just this week, the U.S. PTO issued a preliminary report invalidating one of the two symbol patents asserted against us in its entirety. The only remaining patent of the four that were originally asserted against us in August 2007 is a continuation of the symbol patent recently rejected by the U.S. PTO and is itself the subject of a pending re-examination by the U.S. PTO.

While we cannot predict the outcome of the law suit with Motorola, we look forward to receiving final reports on all these patents from the U.S. PTO and to proving our case at trial in January 2010.

Even with the increase of legal costs, I'm pleased that we lowered operating expenses by more than $2.1 million during the quarter, down 6% from Q1 actual operating expenses of $33.8 million. Based on the Q1 OpEx run rate of $35 million, the savings is actually $3.4 million or 10%.

Both on an actual and run rate basis, these savings are in line with or ahead of our announced cost reduction plan. With Q2 OpEx at $31.6 million, our continued efforts on controlling expenses, we're on track to achieve operating expense reductions of $5 million to $6 million over the second half of fiscal 2009.

Our non-GAAP tax rate was 9% in Q2 compared to 6% in Q1 and we expect our tax rate in Q3 to be approximately 12%. Non-GAAP net income for the quarter was approximately $2 million or $0.02 per share. This compares to non-GAAP net income of $1.4 million or $0.02 per share in Q1 '09 and non-GAAP net income of $800,000 or $0.01 per share in Q2 '08.

GAAP and non-GAAP net income include approximately $0.01 per share worth of expenses related to the Motorola lawsuit.

Q2 '09 non-GAAP weighted average shares outstanding were approximately 84.8 million shares on a diluted basis. The GAAP net loss for the quarter was $6.8 million or $0.08 per share compared to a GAAP net loss of $6.4 million or $0.08 per share in Q1 '09 and a GAAP net loss of $3.5 million or $0.04 per share in Q2 '08.

Our second quarter 2009 GAAP results included $6.1 million of non cash stock based expenses, $1.2 million of amortization expenses as acquired intangible assets and a one time restructuring expense of $1.4 million.

Turning to the balance sheet, we finished January with $115.2 million or $1.36 per share of cash and short term investments. This represented an increase of $7 million from last quarter and we generated a record $7.6 million of cash flow from operations.

Accounts receivable was $23.6 million at the end of Q2, down from Q1 '09 balance of $32.3 million. Moving down the balance sheet, short term deferred revenue was $28 million at quarter end compared to $28.9 million at the end of Q1.

Day sales outstanding were 44 days, a decrease of 11 days from Q1 and below our long term DSO target of between 50 and 55 days. Both DSO's and accounts receivable benefited in part from exceeding our cash collection goals for the quarter.

Inventory totaled $14 million at the end of Q2, slightly down from the end of Q1 while inventory turns decreased from 4.9 to 3.2. Our solid performance in Q2, our current pipeline and continued strong interest we're seeing in the field for our products are all encouraging factors as we look toward the future.

However, global economic conditions continue to impact our business elongating the sales cycle and diminishing our visibility. As we cautioned on our last earnings call, because many of our customers'' budgets were not set in January, we did not see the typical hockey stick in the last month of our quarter.

Given the variability and uncertainties in the market we expect the softness to continue in the near term until 2009 budgets are completely set. These events increase the potential that our actual results could vary materially from these expectations.

Given all these factors, we'll provide guidance for Q3 '09 only and will not be updating or reaffirming guidance for the full year. For our third fiscal quarter 2009, we expect revenues to be approximately flat year over year.

Using a 12% non-GAAP tax rate, we expect EPS of a loss of $0.01 to income of $0.01 per share and 84 million and 89 million shares on a basic and fully diluted basis respectively.

With that, let me turn the call back over to Dominic.

Dominic Orr

We will now be happy to answer any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first call comes from Sanjiv Wadhwani – Stifel Nicolaus.

Sanjiv Wadhwani – Stifel Nicolaus

A quick question on the Federal government vertical. I think that was sort of a wild card. Can you just talk about how that vertical did during the quarter?

Dominic Orr

Federal business for the quarter was roughly flat year over year. We are continuing seeing deployment of the programs that we won from last year and we continue getting traction, on the track of winning new programs. But as you indicated, some of the program purchases are kind of lumped here and there that may not necessarily align to our quarterly boundary. I'm pleased with the state of affairs of our Federal business but for the last quarter it was basically a very uneventful quarter.

Sanjiv Wadhwani – Stifel Nicolaus

Flat year over year, obviously last year January Federal was an issue, so I'm guessing it sort of came in below expectations.

Dominic Orr

I would say again because we have a January end fiscal quarter, it doesn't align to any Federal spending cycle so the fact that some orders come in before or after quarter close does not bother me. I would not classify that as disappointment.

Sanjiv Wadhwani – Stifel Nicolaus

Steffan, you gave November, December, January metrics, those were bookings, right?

Steffan Tomlinson

Correct.

Sanjiv Wadhwani – Stifel Nicolaus

Obviously we are almost through the month of February, do you care to give us any updates on what happened the month of February? Is that a continuation of what you saw in January?

Dominic Orr

Pretty much a continuation of what we saw in January, yes.

Sanjiv Wadhwani – Stifel Nicolaus

Customer count 700 in the October quarter, 500 in the January quarter, obviously it's still a pretty large number but clearly a down take. Is that just given the economy or something else going on?

Dominic Orr

I actually am possibly surprised by the over 500 acquisition. My expectation was a little bit less than that so I'm actually, I thought it was a good thing.

Operator

Your next question comes from Ryan Hutchinson – Lazard Capital Markets.

Ryan Hutchinson – Lazard Capital Markets

First off, I understand the macro as everyone does, but when you look at what IDC said this morning, I just want to get a sense, flat year over year, and I know you're not giving full year guidance, but would you anticipate that you grow faster than what they highlighted today as sort of flat year over year growth for '09 over '08?

Dominic Orr

I think I'm not particularly familiar with that detail, the IDC report but you look at the yet to be finalized customer budgets, the expectation is that they will see year over year decrease, most of our customers. So the question is what line item you can get a piece of the action of the reduced budget.

I think if you recall our earlier discussion, we are now seeing that instead of having a default wire LAN core upgrade refresh budget and then a separate wireless LAN budget, customers are seeing basically there is a connectivity, a user connectivity budget and a right size, what we call kind of a virtualized edge budget independent of remote connection, wireless connection or wired connection.

What is the most cost effective way to maintain and upgrade a per user connectivity in the enterprise and if you look at it that way, and using the examples that we showed you, we actually think that we have now a bigger pie to attack because customers, the IT group has mentioned that the line between wire connectivity and wireless connectivity, you're talking now about the most effective way of user connectivity.

Ryan Hutchinson – Lazard Capital Markets

If you can quantify, what percentage of the deals are outright wired replacements and/or right sized deployments today? What are your expectations then for the remainder of the year, and then finally, on the pipeline you talked about certainly a robust pipeline in January. Bookings were in line with your expectation, so maybe you could just quantify if your methodology for the guidance has changed materially and even better, a sense of what your pipeline to forecasted bookings and revenue looks like today versus a couple of quarters ago.

Dominic Orr

In terms of the number of so called right sizing projects, we are starting to see a significant increase at the design stage and this kind of project tends to have a two to three quarter cycle because customers are clearly grasping the economic advantage but they also want to make sure all the network management and resiliency aspect of the wire network will be accessible to Aruba's offering through the 11-N technology to the wireless end users.

So I think we are fundamentally focusing on education of the market and having an increased dominant win ratio in the designs because in Aruba's Q3 time frame we believe most of February and possibly most of March, the customer is still at the network infrastructure level will not see the final, final budget so I think that leads to your second question.

If you look at our year over year January bookings situation, we reported a 15% down and we also say that this condition will also extend into February and possibly into March. However that is reflecting the macro environment. However our momentum and our confidence in our business leads us to guide that actually the overall quarter will be flat year over year. So that gives you the sense of our confidence in our pipeline.

Ryan Hutchinson – Lazard Capital Markets

Is that assuming a close rate or a difference in the methodology you provided in terms of guidance over the last couple of quarters?

Steffan Tomlinson

Close rates have definitely been modified in our calculus of projecting revenues. With that said, we have not seen deals slip or be cancelled. We've seen some slip. The other point that we should not is that the fact that we're guiding flat year over year in this market is something that we think is prudent, especially given the fact that some of the two biggest competitors that we have Cisco and Motorola for the most recent quarter, they did negative year over year growth in the wireless LAN business so we feel that we're actually using this opportunity to build share.

Operator

Your next question comes from Mark Sue – RBC Capital Markets.

Mark Sue – RBC Capital Markets

I'm glad to see that the cost reductions are coming in on schedule if not ahead of schedule, but recognizing that you're now guiding flat year over year, gross margins could return back to your normal range and then recognizing the possibility that there could be another step down in the future, I was just wondering if you still think there could be a possibility for more cost initiatives going forward in order to have break even possibilities.

Dominic Orr

We are very focused on three things; preserving our cash, winning design for large projects and targeted accounts and keeping our talents for long term competitive advantage. I'm very comfortable that we have the structure now to balance between a prudent spending in light of the economic climate and having the critical mass and the right talents to make sure that our competitive advantage win ratios do not fall behind because this is a time to win market share.

I would put what you just said to be highly unlikely.

Mark Sue – RBC Capital Markets

On the environment, realize that projects are getting pushed out, but I was wondering if you've seen any change in average deal size, maybe customers planning for themselves to be smaller enterprises going forward.

Steffan Tomlinson

We haven't seen any appreciable change in average deal size. I'll tell you that it ticks modestly up quarter on quarter, but we haven't seen any market changes. What we're also seeing from the accounts that I speak with and the field contacts that I have, we kind of see two things going on. One is, when we're approaching a LAN right sizing opportunity, those tend to be bigger projects and that kind of flies in the face of people tightening the purse strings a little bit.

The other example that I have is when we're going through an ongoing deployment, people may decide to do a little bit less than they had originally anticipated, but it all balances out and I feel that in this environment, we're optimally positioned to go after both the big deals and also monetize the current business.

Operator

Your next question comes from Erik Suppiger – Signal Hill.

Erik Suppiger – Signal Hill

You gave us the year over year orders; can you just tell us what linearity in the quarter was?

Steffan Tomlinson

It was approximately 20, 30, 50.

Erik Suppiger – Signal Hill

That's fairly consistent, right?

Steffan Tomlinson

Yes.

Erik Suppiger – Signal Hill

What was the head count for the quarter?

Steffan Tomlinson

Head count was 531.

Erik Suppiger – Signal Hill

Is that going to be going down any further?

Steffan Tomlinson

No.

Erik Suppiger – Signal Hill

It looks like your existing customers, revenues of sales to existing customers has been fairly steady in spite of the down tick in revenues for the last couple of quarters. Can you talk about what visibility you have across that portion of your business? It's about 70% of your revenues, so how much confidence do you have there versus your new customer?

Dominic Orr

Those are customers like in the education sector, the health care and the retail land the high tech industries because they already have committed a corporate wide architectural approach to go wireless and so the project deployments go along. However, sometimes to the extent that these projects are tied to a new facility being turned on or some move and reorganization, that is the extent, to which the economy can be affecting the order rate. There's no kind of back tracking of the direction that we have seen.

Operator

Your next question comes from Kim Watkins – J.P. Morgan.

Kim Watkins – J.P. Morgan

I wanted to dig into some of the trends. You mentioned December being up I think it was 785 year over year in terms of booking. Can you dig into that a little bit and give us some insight into what drove that either on a vertical basis or a geographic basis?

Dominic Orr

First of all, that up take was strong around the world not very geographically pinpointed. Secondly, what we're seeing is that there is the traditional year end budget flushing. This year the customers are more desperate. They almost spend their dollar they will see until they get the new budget and everybody knows that the new budget is going to be taking a lot longer.

Traditionally, when you have a year end budget flush, you tend to much easier with the shortened cycle by items, existing line items or existing product category that is well established. Wireless LAN, until last year was still a new category or people were buying it on some special project so we tend previously not to participate in the upside of the year end flush and so I took the fact that we had such significant uptick in December to be a very positive indication that in most of our customers environment, wireless LAN is now a standard category.

They can go out and spend some discretionary dollars on a standard category basis, so we think that's very positive.

Kim Watkins – J.P. Morgan

So there wasn't any particular vertical that showed up on the radar screen as being stronger than another?

Dominic Orr

No. It was really across verticals and across geographies.

Kim Watkins – J.P. Morgan

Stefan you actually alluded to the fact, I know Cisco talked about being down 6% year over year, your product growth was up 14%. The gap seems to be pretty wide this quarter. Any particular comments on where you think you're gaining share and then the second piece of that is also on Nortel, have you seen any pick up in demand from former Nortel customers coming your way?

Dominic Orr

The first part about share, obviously we're picking share up not only across the board but in verticals we have particular attractions like high education, like high tech. We also have traction building in the retail sector. So there are particular faster ramping market segments for us, but overall we feel the fact that all the other POP play companies are kind of falling by the wayside, it is getting very clear much earlier on in the competitive environment that it is a two player competition so we actually have a longer cycle to articulate our differentiation and that tends to be favoring in our direction.

Kim Watkins – J.P. Morgan

On the legal expense side, what was that comparable number of the $1.2 million in Q1?

Steffan Tomlinson

In Q1 it was about $490,000.

Kim Watkins – J.P. Morgan

And what do you expect it to be this quarter? Is it going to be a repeat of Q2?

Steffan Tomlinson

No. We don't have guidance on the legal expense in particular. My expectation is that it will be coming down to the historic run rate levels.

Operator

Your next question comes from Jeffrey Kvaal – Barclays Capital.

Jeffrey Kvaal – Barclays Capital

Could you both hit me again on the delta between the down 15% bookings and the outlook for a flattish year over year revenue outlook?

Dominic Orr

Our logic is that just like last quarter when we did the quarterly announcement, we were predicting that because of all this uncertainty at the macro level and at the highest company level, that we would take the CFO and CIO and therefore the VP of infrastructure and extra couple of more cycles to finish and finalize the budget which mostly expected to be downsized.

Therefore while they are active with projects of all kinds will not get the go ahead to place the P.O. We witnessed that in January which is expected and we have seen the trend continue in February and I believe that they will continue well into March.

So that is the negative factor because the January booking as we mentioned is year to year minus 15%. That trend is going into the first half of our fiscal Q3. However, because our pipeline of design wins are very strong, that we expect that when people's budgets get approved, our high win rate will translate to more order flows and that would make up for some of the shortfall in the first half of the quarter and therefore as a result, we believe a balanced view of a very positive and confident outlook of our design wins moderated significantly by the macro economic environment give us this year over year flat guidance.

Steffan Tomlinson

One thing I failed to mention was bookings for the quarter were actually up 5% year over year so that's one thing. The second is Eric Suppiger had called in and asked what kind of bookings linearity, and I transposed the numbers. The booking linearity for the quarter was approximately 20, 50 30 so I wanted to correct that.

And lastly, given the fact that January was down 15% year over year that's squarely factored into our guidance. As you know, and you're familiar with the company, Q3 tends to be a strong quarter for us and we post quarter on quarter and year on year growth. But given all the factors that are out there, we felt it prudent guiding flat year over year.

Jeffrey Kvaal – Barclays Capital

So this is going to be more of a back end loaded quarter than we just saw.

Steffan Tomlinson

That's what we expect.

Jeffrey Kvaal – Barclays Capital

And that's supported by the order book and the back log, the deferred revenue that you have.

Steffan Tomlinson

Correct.

Jeffrey Kvaal – Barclays Capital

My second question was on the services versus product revenue. Should we expect product revenues to be down more than services again? That would be two or three quarters in a row if that comes to pass. What can you tell us about the trajectory of product revenue? Should we expect that to recover?

Steffan Tomlinson

Product revenue versus service revenue, service revenue typically is growing given the fact that we're adding new customers and support revenue is coming in. So product revenue will, you have to look on a year over year basis. We don't necessarily give firm guidance on product versus service, but I'll tell you that we're absolutely focused on generating new product sales.

We aligned our sales force around that mantra of driving new product sales. That is one of the number one initiatives in the company. So it's our expectation of the long term that product revenue will be growing.

Dominic Orr

Please be mindful also that our biggest competitor's product growth is negative and we are two digit positive.

Operator

Your next question comes from Greg Mesniaeff – Needham and Company.

Greg Mesniaeff – Needham and Company

Can you give us an update on the current status of the 802.11 ratification of the standard and how has the economic uncertainty as it relates to IT budgets impacted the acceptance timeline of that ratification?

Dominic Orr

The ratification actually the time line has moved from June of this year 2009 to January 2010, but that is actually a very good point. Despite that movement, our product mix from Q1 to Q2 has actually surprised us in shifting to 11-N in deployment and also the number of requests that we get from executives to have us to give them a written guarantee that there's no hardware swap once the 11-N gets ratified, those requests have drastically dropped.

For me, that is an indication that people have taken a de facto standard of what has been shipping with the common knowledge that we now have shipped so much of this 11-N. We're talking about million of clients and hundreds of thousands access points and so that factor actually has been quite almost irrelevant.

Secondly, the budget, the enterprise budget, IT budget reduction does not first of all, does not cross over into any inference over the standardized station process, but actually as we explained, the fact is, we started out with 11-N first to be introduced to be compared to the cost differential of 11-ABG. And now with the drastic reduction of the budget, 11-N shared by a dozen user access is now compared to the equivalent wire connectivity of traditional Ethernet and that gives them a much more favorable economic comparison.

Greg Mesniaeff – Needham and Company

Are you noticing the 70% of your existing customers are they the ones mostly going for the 802.11 N upgrades or is it more heavily skewed towards new customers?

Dominic Orr

It's actually across the board. We are seeing pretty much large installations to 11-N because of the future looking architecture and some of the larger installations that we had installed earlier are continuing to complete their installations but are clearly looking ahead from 11-N perspective for the next generation architecture.

Greg Mesniaeff – Needham and Company

Steffan could you repeat that linearity data point? It's 20, 50, 30 for the bookings linearity, correct?

Steffan Tomlinson

Correct.

Operator

Your next question comes from [Roe Chapra – Wedbush Morgan]

[Roe Chapra – Wedbush Morgan]

We haven't talked about airwaves in awhile and I wanted to get a sense of how airwaves is helping you in the quarter and is that one of the reasons that it's helping you gain share from some of your competitors?

Dominic Orr

I think in the most extreme situation where the customer and we have encountered several of them, at the highest order directive saying that in the next 12 months there will be no hardware purchase of any kind of computation or communication equipment. In those environments, applying the airwave management platform allows the customer to extend the functionality and manageability of the network without the hardware upgrade, and we actually get into several of those situations.

Secondly, you are right in pointing out that the airwave multi-vendor management platform particularly with exceptionally good functionality in managing Cisco thicken and thin access point in combination, that has gained us entry into many customers who later get exposed to the Aruba architecture.

Steffan Tomlinson

At this point we are managing some of Cisco's largest wireless plan implementations in the United States and airways has been a fantastic success in terms of adding accretive benefit to the company both from a financial standpoint and from a business standpoint.

[Roe Chapra – Wedbush Morgan]

I wanted to get a sense of your international sales. They went up as a percentage and even on the dollar amount they were up fairly decently I guess for a really difficult environment. Can you talk about where these deals are coming from? Are there any specific countries or any specific deployments that are really helping you make some international headway?

Dominic Orr

The last quarter we actually see generally international business not as constrained as the U.S. business with a couple of exceptions. I think the exception is in Europe. The U.K. environment is a bit more difficult. In Asia Pacific the most difficult environment we saw was Korea followed by Taiwan. Other than those geographies and some verticals, other than those we generally experienced overall strength in across the board geographic growth.

[Roe Chapra – Wedbush Morgan]

Other than budget not being set or you've heard recently from many people that budget are in flux, has financing been an issue for customers are far as the spending this year? Is that part of the equation as well?

Steffan Tomlinson

Financing for Aruba products has not been an issue. That has not been slowing things down.

Operator

Your next question comes from Eric Kainer – Thinkequity.

Eric Kainer – Thinkequity

I'd like to jump into actually picking right up where you stopped on air wave, what is the attach rate there?

Steffan Tomlinson

The attach rates, I would call it situational. At this point what we've done is, we've gone through and taken the airwave product and we're actually going through our customer base of install accounts to sell them the airwave product.

On new sales to new customers, the airwave attach rate is in line with our internal expectation and there's obviously room for us to grow the sales as it becomes a competitive differentiator.

Eric Kainer – Thinkequity

I assume that your attach rate especially on new sales skews towards the bigger installations that you're getting right?

Dominic Orr

That's correct. I would say one of the key benefits of airwave is multi-vendor nature. Most of our customers, particularly those who choose us because of the 11-N advantage tend to have some existing incumbent vendors equipment and those situations having airwave to be able to kind of unify the management is a value for our customers.

Eric Kainer – Thinkequity

Obviously you made an announcement about PC IDSS here, can I assume that there were certain retail customers who are waiting in the wings for that capability?

Dominic Orr

That latest idea is a bit from last year and one of the key differences was wireless LAN security to go to an even higher status in the latest PC IDSS standard, so that is a positive development for us as a business because it is does reflect clearly a very, very important consideration.

Eric Kainer – Thinkequity

And probably more so in this environment where everybody's more security conscious. The last thing I wanted to explore is it looks like with the new customer count coming down a little bit while still at a very probably surprisingly strong level, should we be expecting that for the calendar year that 2009 is probably going to look more tilted to sales to existing customers than that new customers? I guess that's a fairly logical conclusion. Did you want to dispute that?

Dominic Orr

That's really not our inclination because as I mentioned early on, our focus right now is keeping our talent, keeping our cash and winning new designs for big projects in large accounts. Those projects can come from our install base. It can come from competitors install base. Certainly I don't look at the business from that perspective.

Given that we have gained the 500 plus customers, you can understand that even though it is smaller than last quarter compared to a year ago, that is still a pretty significant, the number of new customers we gained.

So I would say a structural derivative of having more customers cumulatively will give you more opportunity of sales in the install base. In a tough environment the easy way is get business from your install base but I think for the long term future and positioning of this company it is very important that we win those big projects independent of whether the customer has any immediate budget, that we got the design and wait for the budget to come through. That is our current mindset.

Eric Kainer – Thinkequity

Have you seen, just talking about some of these larger roll outs, have you seen that these larger roll outs, when you've got the customer committed to these larger roll outs that their rolling out maybe a little slower than you expected or is it basically right on track?

Dominic Orr

This kind of project is like any other kind of project in enterprise now that people are more cautious and they can face it. They will face it. So I will say yes, people are more cautious and try to face things out. But the size of the project, like Steffan mentioned, we're actually seeing a slight increase just because it used to be people thinking about wireless adjunct to the wired network, and now they are talking about displacing it so it is a different mindset that we're getting to it.

Operator

Your next question comes from Bill Choi – Jefferies & Co.

Bill Choi – Jefferies & Co.

Do you expect the 802.11 N and mix to continue to improve as you go through the year or do you think it will decline?

Dominic Orr

We actually think that progressively each quarter we will see the mix will shift. That will continue.

Bill Choi – Jefferies & Co.

On gross margins, is the pressure coming totally from lower volumes because it seems like mix is going to continue to improve, or do you think that margins could decline?

Steffan Tomlinson

What goes into gross margin is multi-faceted. It's product gross margins, but it's also channel mix, customer mix. There are lots of things that go into it. The fact at 801.11-N is coming up the stack in terms of share of our access points that are shipped, that is good news for us from a gross margin standpoint without question.

The other variances and vagaries that goes into the overall gross margin calculation, it's hard to predict. So channel mix, product mix, customer mix and lower volumes potentially will all have an impact on overall gross margins.

Bill Choi – Jefferies & Co.

The new activity is that with new customers or is that with existing customers as well?

Dominic Orr

It's both. I would say it would be slightly tilted towards new customers.

Operator

Your next question comes from Blaine Carroll – Ftn Equity Capital Markets.

Blaine Carroll – Ftn Equity Capital Markets

Can you do me a favor and repeat what you said about operating expenses? I thought I heard you say that the second half '09 would be down $5 million to $6 million versus the second half of '08. Is that right?

Steffan Tomlinson

The accurate statement is they'll be down $5 million to $6 million in the second half relative to what the Q1 run rate was. The Q1 OpEx run rate was approximately $35 million.

Blaine Carroll – Ftn Equity Capital Markets

So down $5 million to $6 million off of $140 million. So it will actually increase sequentially over the next couple of quarters.

Steffan Tomlinson

We also talked about the fact that we feel comfortable with the current level of OpEx with the cost controls in place. We feel that those two things combined will help us get to the savings that we had outlined last quarter.

Blaine Carroll – Ftn Equity Capital Markets

On the analyst meeting, is there going to be any increase because of the analyst meeting coming up?

Steffan Tomlinson

That's factored into our guidance.

Blaine Carroll – Ftn Equity Capital Markets

On the budgets and the ratifications or approvals of budget, could you talk about that over the different verticals? Which verticals could end up approving budgets earlier and which one you're a little more concerned about getting pushed out?

Dominic Orr

About three quarters ago, seeing the downturn we geared quite a bit of lead generation activities towards the government, health care and education sector and we have been monitoring the deal flows in those sectors. They tend to be relatively speaking more stable than the general enterprise sectors and that continues to be holding up.

Blaine Carroll – Ftn Equity Capital Markets

Is there any increased concern on the government with the new administration in place?

Dominic Orr

Actually if you look into the stimulus package, it actually is quite a bit in favor of the state and local government and higher education and health care which are all very relevant to us.

Blaine Carroll – Ftn Equity Capital Markets

Anything new on pricing?

Steffan Tomlinson

Pricing has been stable.

Dominic Orr

We thank you for being on the call today and we appreciate your continued support. Clearly this is a tough market and tough economy and while we are realistic about how hard it is to grow in this current market, we also believe that the force of this economic downturn are actually encouraging customers to rethink their approach to connecting users to their enterprise network.

I believe our competitive position has never been stronger and the long term value of our customer base is highly encouraging for the future. I want to thank all of our employees and our partners for the outstanding efforts in the last quarter that resulted in results that we are very proud of. Please continue your excellent work.

We look forward to updating all of you on our progress in the coming months. Thank you very much. Have a good afternoon or evening ladies and gentlemen.

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Source: Aruba Networks, Inc. Q2 2009 Earnings Call Transcript
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