Wind River Systems, Inc. Q4 2008 Earnings Call Transcript

Mar. 6.09 | About: Wind River (WIND)

Wind River Systems, Inc. (NYSE:TLM)

Q4 2008 Earnings Call

March 5, 2009 5:00 pm ET

Executives

Anne Marie McCauley – Vice President of Investor Relations

Kenneth R. Klein – Chairman of the Board, President & Chief Executive Officer

Ian R. Halifax – Chief Financial Officer, Senior Vice President Finance and Administration & Secretary

Analysts

Matt Petkun – D. A. Davidson & Company

John Difucci – JP Morgan

Nabil Elsheshai – Pacific Crest Securities

Richard Williams – Cross Research

Brent C. Williams – The Benchmark Company

Operator

Thank you for joining the Wind River Systems Q4 fiscal year 2009 earnings conference call. After prepared comments by management the company will host a Q&A session. At this time I will turn the call over to Anne Marie McCauley, Vice President of Investor Relations at Wind River Systems.

Anne Marie McCauley

Welcome to Wind River’s Q4 and fiscal year 2009 conference call. Joining me today is Ken Klein, our Chairman, CEO and President and Ian Halifax, our CFO. Before we start I’d like to remind you that this call is being webcast. The webcast and a fourth quarter update presentation can be accessed on the Wind River investor relations website at www.WindRiver.com. A replay will also be available shortly after the conclusion of the call and will remain available for approximately one year.

The purpose of this cal is to provide you with information regarding Q4 and fiscal year 2009. However, some of our comments and responses to your questions will include forward-looking statements such as statements regarding our estimated revenue, GAAP net income per share, non-GAAP net income per share and estimated expenses, margins, cash flows and tax rates for the upcoming year or full fiscal year 201 potential design wins, market opportunities, expected business or market development and expected new products or product features or the benefits of new products.

These forward-looking statements are based on certain assumptions and are subject to a number of risks and uncertainties. Actual future results may vary materially. I encourage you to read the risk factors described in the company’s annual report on Form 10K for the fiscal year ended January 31, 2008 as well as other reports filed with the SEC after that date including our Form 8K filed today.

I would also like to point out that results discussed today include certain supplemental non-GAAP financial measures. We provide these non-GAAP financial measures because we believe they provide important supplemental information about our core operating results. These non-GAAP financial measures have not been prepared under any comprehensive set of accounting rules.

All non-GAAP financial measures should be read in conjunction with the comparable GAAP information. For a description of non-GAAP financial measures and reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures please see the section of Wind River’s earnings release issued today entitled about non-GAAP financial measures and supplemental information posted on the Wind River investor relations website at www.WindRiver.com.

With that I’ll turn the call over to Ken Klein.

Kenneth R. Klein

Our fourth quarter performance capped a year of extremely solid execution in a most demanding economic environment. As a result we are pleased with our top and bottom line performance. Our disciplined expense management in this challenging climate enabled us to exceed our operating profitability and non-GAAP earnings per share targets for both the quarter and the fiscal year.

We remain focused on our strategy of targeting select, diverse vertical markets, enhancing our product portfolio and optimizing our go to market model and alliance partnerships. And, we are unwavering in our focus on growth and profitability. Revenue for the quarter was $88.4 million, an increase of 5% over Q4 last year. Bookings again exceeded revenue. The combination of deferred revenue and services backlog was approximately $154 million, a slight increase over Q4 last year.

Q4 GAAP net loss per share was $0.06 due to one-time non-cash non-recurring items. Non-GAAP earnings per diluted share were $0.17 and increase of 89% over the $0.09 reported in Q4 last year. Our focus this year has been on consistent execution and return on investment. Our annual results demonstrate our ability to deliver on our commitments. Revenue for FY 2009 was $359.8 million, an increase of 9% over FY 2008. GAAP earnings per share for 2009 were $0.13 and non-GAAP earnings per share for the year were $0.58, an increase of 76% over the $0.33 reported in FY ’08.

As we have noted in prior conference calls we are by no means immune to the trends in the macro environment and we saw some impact on our Q4 business. With that said, I want to highlight broad market drivers and what we are seeing from customers in our markets. There are five key market drivers we are tracking and believe we can leverage in the coming year. First, the current economic environment is driving a change in our customer’s buying behavior from build to buy, a development which plays to our favor.

Second, we are at the beginning of a technology disruption as the market adopts multicore and software. The multicore promise is tied to achieving higher performance and power at significantly lower prices. With Wind River’s new multicore solution we are in the vanguard in this rapidly developing market.

Third, the competitive landscape is shifting to our advantage and traditional vertical markets of aerospace and defense, networking equipment and industrial. Fourth, we are seeing the emergence of application platforms for consortia based ecosystems like LiMo, Android, Moblin and others. And fifth, there is a brewing war of giants at the market intersection of Smartphones and netbooks that includes MIDs as a subcategory. A market with growth opportunity at the expense of PCs and future phones.

Against this backdrop of market drivers we are seeing customers and partners continuing to design, build and deliver devices across the products, vertical markets and geographies we target. We believe our value proposition enabling customers and partners to do more with less is extremely compelling in today’s cost conscious market.

In Q4 our sales teams continued to execute well and demonstrate success selling higher and more broadly in to customer’s organizations. As buyers focus on managing spend, we have seen some compression in the size and duration of our larger transactions, specifically those in the $1 million and above range with multiyear commitments. With that said, we had eight deals greater than $1 million. In contrast we saw strength in deals over $100,000 with over 190 deals greater than $100K in Q4. These transactions were spread across all of our target vertical markets.

We had another strong design win quarter with nearly 300 design wins in Q4. Our sales pipelines continue to be healthy. Let me take a few minutes to review Q4 highlights and to describe in more detail the key market trends that are benefitting us. From product line perspective we posted a solid VxWorks quarter. Our VxWorks 6 bookings increased 11% over last quarter with strong demand in the networking equipment, aerospace and defense and industrial verticals.

In aerospace and defense vertical we had a number of key wins and continued to expand our presence in the avionics market with bookings for our ARINC 653 solution up over 35% compared to last year. This platform provides customers with a proven, safe and reliable solution for their safety critical control systems. During the quarter we had a large win in this segment with a Tier-1 supplier to Airbus.

In Q4 we continued to see strong demand for our VxWorks offerings in the industrial vertical market. During the quarter we had a large win with KUKA Robotics, a leading provider of industrial robotics for our VxWorks 6.6 Symmetric Multiprocessing solution. This will allow them to achieve performance benefits and differentiate their high precision technology in core and emerging target markets.

We recently announced the availability of two new VxWorks platforms. VxWorks 61508 for industrial and medical applications and VxWorks DO-178B for aerospace and defense applications with stringent safety certification requirements. These platforms are based on VxWorks 6.6 and are offered with their respective certification evidence.

Let me spend a minute highlighting our multicore efforts that will benefit our entire product portfolio. As a reminder, the adoption of multicore technology, the ability to run multiple cores on a single processor represents a disruptive technology trend in the device market. It’s adoption increases the complexity of both porting and developing applications for multicore processors and is changing the way devices, write software and configure their systems.

Multicore equips customers to build devices that achieve higher performance with reduced power consumption and lower cost. With the availability of VxWorks 6.7 we’re advancing our multicore leadership. We now enable customers to select the optimal multicore design configuration asymmetric multiprocessing AMP or symmetric multiprocessing SMP to deliver next generation devices. These devices will have higher performance thresholds while maintaining and reducing power consumption.

We are focused on implementing multicore technology across our entire product portfolio. We are investing in the development and delivery of broad multicore software solutions to support growing demand and expect to introduce new multicore capabilities for all of our products during FY ’10.

Yesterday we announced that we are expanding our existing relationship with Intel to market optimize multicore solutions for the embedded market. The plan to provide co-developed highly optimized solutions will result in unprecedented power, performance and cost advantages to customers moving to multicore computing.

In Q4 we had another strong Linux quarter as booking crew 48% over last year. We were successful in achieving our objective of achieving Linux sales in excess of $65 million in FY ’09. We saw strong demand this quarter for our Linux solutions in the in-vehicle infotainment market as automotive customers continue to embrace open source to address rapid cycle times and design flexibility to integrate both current and future applications and services.

This week the GENIVI Alliance and Automotive Consortium was launched to develop an open source in-vehicle infotainment platform. This industry collaboration will accelerate innovation and time to market while reducing development costs. The founding members of the GENIVI Alliance including BMW, Delphi, General Motors, Intel, Magneti Marelli, PSA Peugeot, Visteon and Wind River are collaborating to create a shared GENIVI platform. A common software architecture that is scalable across product lines and product generations.

The platform will be based on the work we have been doing with BMW and Intel over the past 18 months. The GENIVI platform will accelerate the pace at which automakers can deliver new solutions bringing them closer to the lifecycle of a consumer device and accelerating new business models such as connective services. The first proposal from an auto manufacturer requesting a GENIVI compliant in-vehicle infotainment solution has already been issued.

We continue to gain traction in the mobile handset and mobile Internet device vertical participating in each of the leading mobile Linux consortia the Open Handset Alliance, i.e. Google’s Android, Intel’s Moblin and LiMo positions Wind River to strategically benefit regardless of which mobile Linux approach the market ultimately embraces. We have multiple opportunities with both handset manufacturers and particularly mobile operators looking to over Linux based mobile devices.

In Q4 LiMo selected Wind River as the system integrated to deliver common infrastructure tools, testing and integration services for the LiMo platform. In this strategic role we are well positioned to help LiMo members, mobile operators and handset manufacturers customize, integrate and validate open source handset software. LiMo is now over 50 members strong and is comprised of mobile operators including DoCoMo, Orange and Vodafone and handset manufacturers including Motorola, Samsung, LG, NEC, Panasonic and others.

At the Consumer Electronics Show in January we demonstrated open source Android mobile software running on larger screen size mobile computing devices with WVGA resolution utilizing Qualcomm’s Snapdragon Chipset. This along with the Intel partnership positions us at the heart of the emerging MID netbooks market. At Mobile World Congress, the world’s largest mobile handset event we worked with Intel on a MID Moblin demonstration supporting current and next generation Intel Adam processor technology.

We also collaborated with TI, Texas Instruments on a demonstration showcasing the latest Android release running on TI’s OMAP 3430 chipset. This demonstrates how we are working with device manufacturers to differentiate Android powered handset. A video of this demonstration can be viewed on our website.

In Q4 we had an Android based integration services win with a leading provider of advanced wireless technologies. We are facilitating the integration of their modem with an Android stack on a TI Zoom [board]. Working with us the customer can reduce both risk and time to market as they create a complete reference board solution for OEMs seeking to rapidly deploy and Android base phone.

Q4 marked another solid quarter in our networking equipment vertical. We continue to see strong demand for our portfolio products VxWorks, Linux, Tools and Device Management within our top 20 network equipment customers. We had a meaningful VxWorks win in the quarter with a Tier-I customer. Despite the economy, demand for broadband services continues and service providers are moving forward with their investments in support of next generation 3G and 4G technologies including both LTE and WiMAX.

We are seeing continued adoption of our VxWorks and Wind River Linux platforms tied to 4G technologies. We picked up two new carrier grade Linux LTE design wins in Q4 with one being a significant competitive win. Customers purchasing our network solutions in Q4 included Alcatel Lucent, Ericsson, Motorola, NEC, Nortel Networks, Nokia Siemens and Qualcomm.

We have changed the name of our device management division to device test reflecting our greater focus on testing in the embedded market. In this business we had a blend of both new and repeat customers embracing our solutions during the quarter. Additionally, our Wind River Test Manager 3.1 is now available and is our first solution targeted specifically at the QA department. This application enables our customers to automate the test process and will help our customers shorten their testing cycles, lower product development costs and achieve faster time to market for devices.

We recently announced and completed the acquisition of Tilcon Software. Tilcon is a leading provider of software for creating and deploying graphical user interfaces in embedded devices. Tilcon has been a Wind River partner since 2004. This acquisition provides us with proprietary embedded graphic user interface assets that will enhance the value of VxWorks and Wind River Linux software platforms across multiple device types and target vertical markets including industrial, medical, automotive and aerospace and defense.

To reiterate our focus in 2009 was on continued execution and driving return on the investments we made in prior years. The Wind River team has done an excellent job delivering on these objectives across the board especially in light of the current economy. Importantly as each of the above developments and success show our focus on managing spend has been with an eye on continuing our technology investments to ensure over the long term we retain our competitive differentiation.

Looking forward we highlighted five key market drivers that we believe will position Wind River to grow in FY ’10. Additionally, there are market conditions emerging from recently announced infrastructure investments both domestically and internationally that could present incremental opportunities for Wind River in FY ’10 and beyond. Targeted investment areas span general construction, high speed rail and public transportation to broadband and Internet access could increase demand for our solutions in vertical markets including industrial, transportation and networking equipment.

We are also poised to benefit from investments targeting green energy. Before I summarize and turn the call over to Ian, let me highlight targeted strategic objectives for FY ’10. Our objectives for the year are number one, helping our customers and partners due more with less; two, focusing on high growth vertical market opportunities; number three, gaining market share; number four, targeting strategic acquisitions to add to our product and services portfolio.

As an output of our annual planning process, we implemented some minor rebalancing in our strategic product portfolio. Naturally, we remain very focused on managing costs and expenses. Given our market leadership, vertical market focus, targeted strategic initiatives and diversified business across products, industries and geographies, we believe we are well positioned for continued progress in FY ’10.

Ian R. Halifax

I would now like to review our fourth quarter and fiscal year 2009 financial performance as well as review guidance for both the first quarter and for fiscal year 2010. For the fourth quarter of fiscal year 2009 net revenues were $88.4 million reflecting a 5% increase over the fourth quarter of fiscal year 2008. Subscription revenue for the quarter declined 8% to $30.4 million compared with Q4 a year ago due primarily to the adoption of the term license model over the past year.

Product revenue include project based, perpetual and term licenses as well as production licenses was $32.7 million up 20% compared to $27.3 million in the fourth quarter of fiscal year 2008. Perpetual and term licenses contributed $15.1 million to product revenue reflecting continued adoption of our term license model. Production license revenue was $17.6 million, a decrease of 9% compared with Q4 a year ago but an increase of 9% sequentially. The core or run rate production licenses, those attributed to our customer’s device last quarter have remained flat. The decline compared to Q4 a year ago was primarily due to a low level of compliance or customer audit activity and block purchases.

Services revenue including maintenance, professional services and training was $25.3 million up 5% compared to the same quarter a year ago. Deferred revenue for the quarter ended at $131.9 million representing a 2% decrease over the fourth quarter of fiscal year 2008 but a 5% increase sequentially. At the end of the fourth quarter we had services backlog of approximately $22 million. This represents an increase of over 20% compared to the same quarter a year ago.

The combination of deferred revenue and services backlog this quarter is approximately $154 million representing a slight increase over the fourth quarter of fiscal year 2008. As a reminder, this metric is intended to provide a gage over the overall demand of our product and services.

VxWorks revenue for the fourth quarter of fiscal year 2009 was $61.6 million, flat when compared to the fourth quarter of fiscal year 2008. Linux revenue this quarter was $14 million, an increase of 27% compared to the same quarter a year ago. Other revenue including revenue from non-core products, design services, tools and device test for the fourth quarter fiscal year 2009 was $12.9 million an increase of 12% compared to the same quarter a year ago.

In terms of geographies, the Americas represented 54% of total revenue for the fourth quarter, EMEA contributed 25% and Asia Pacific including Japan contributed 21%. In terms of bookings some of the top customers in the quarter included Alcatel Lucent, BAE Systems, Ericsson, Honeywell, Intel, LiMo Foundation, Lockheed, Nortel Networks, Raytheon and Rockwell Collins.

We had over 190 deals greater than $100,000 during the quarter. We had eight deals that were greater than $1 million during the quarter. Our bookings profile by end market for the quarter was as follows: network infrastructure accounted for 33%; aerospace and defense 25%; industrial and automotive 20%; and digital consumer 22%.

Gross margin on a non-GAAP basis for the fourth quarter of fiscal year 2009 was 79% up from 76% in the fourth quarter a year ago. This was driven primarily by the increase in revenue from term licenses and stronger services margins. Non-GAAP operating expenses decreased in Q4 from Q3 levels to $58.9 million. The sequential decrease of $1.9 million or 3% was primarily due to lower compensation expenses and sales commissions.

We remain very focused on managing spend anticipating typical quarterly non-GAAP operating expenses of approximately $60 million. Non-GAAP operating income in the fourth quarter was $11.4 million compared to $6 million in the same quarter a year ago, an increase of 91%. This translates in to fourth quarter non-GAAP operating margin of 13% compared to 7% in the same quarter a year ago. Interest and other income on a non-GAAP basis was $1.4 million for the quarter. The impact of FAS 123R, expensing of stock-based compensation in the quarter was $3.8 million. We incurred an impairment expense of $0.6 million relating to a small component of our investment portfolio.

Q4 GAAP results include a non-cash goodwill impairment charge. During the quarter economic conditions and a minor rebalancing in our strategic product portfolio including a shift in our focus from device management to device test following our annual planning process led us to conclude that there were sufficient indicators to require us to perform a goodwill impairment analysis. This analysis yielded an impairment charge of approximately $12.2 million.

We had a tax credit in Q4 on a GAAP and non-GAAP basis. Our effective tax rate for FY ’09 is projected at the start of the fiscal year and is reviewed each ensuing quarter. In Q4 we were able to utilize certain foreign and other tax credits for the first time which lowered our effective rate for the year. The Q4 tax credit reflects the yearend true up.

Net loss on a GAAP basis in the fourth quarter of fiscal year 2009 was $4.4 million compared to net loss of $2 million in the same quarter a year ago. Non-GAAP net income in the fourth quarter fiscal year 2009 was $13.6 million compared to $8.1 million in the same quarter a year ago, an increase of 68%. On a diluted share base of 76.3 million shares, GAAP net loss per share in the fourth quarter was $0.06. On a diluted share base of 78 million shares, non-GAAP earnings per share in the fourth quarter were $0.17, an increase of 89% over the same quarter a year ago.

Q4 FY ’09 ended with $169.1 million in cash, cash equivalents and investments. Cash flows from operations were $9.2 million for the quarter. This brings cash flows from operations for fiscal year 2009 to $53.8 million, an increase of 26% over fiscal year 2008. As a reminder, we repurchased 30 million shares during FY ’09 for a total amount of $105.3 million. We have a balance of $45 million authorized in our share repurchase program.

The account receivable balance as of January 31, 2009 was $78.3 million. Day sales outstanding was 81 days. Depreciation in the fourth quarter was $2.4 million. Capital expenditures were $3.8 million including approximately $1.1 million for internal use hardware and software projects. At the end of January our total headcount was 1,673 including sales headcount of 418. We had over 165 quota bearing sales personnel at the end of Q4.

Revenue for fiscal year 2009 was $359.8 million an increase of 9% over fiscal year 2008. GAAP net income per share for 2009 was $0.13 and non-GAAP earnings per share for the year were $0.58, an increase of 76% over fiscal year 2008. As noted earlier operating cash flow for the year was $53.8 million.

I would now like to review the financial outlook we included in today’s earnings press release. We are providing guidance for Q1 and for the full fiscal year 2010. As a brief reminder, guidance for the upcoming quarter and for the year is set with a focus on sales forecast and pipelines, the conversion of orders in to revenue and our ability to carefully manage spend. A key challenge is projecting the quarter in which large deals will close and convert to revenue.

Given the deterioration in the economic environment it is important that I provide some cautionary comments to the outlook we are providing. These projections are predicated on a number of factors including: one, the ability to achieve our targeted mix of product and services revenues; two, anticipation of additional tuck in technology or services acquisitions during the FY ’10; and three, some improvement in macroeconomic conditions in the second half of the year. If the macroeconomic were to further deteriorate we may need to revaluate our financial projections.

For fiscal year 2010 the anticipated revenues in a range of $360 to $380 million. we are deliberately providing a broader range than in prior guidance given economic factors and uncertainty around the timing of potential future tuck in acquisitions. We will continue to carefully manage spend in order to deliver on our earnings per share commitments.

GAAP earnings per share is projected at $0.15 to $0.19 and non-GAAP net income per share if forecast to be $0.56 to $0.60. Given the economic environment we’re anticipating that revenues and earnings growth will occur in the second half of fiscal year ’10. For the fourth quarter of fiscal year ’10 we anticipate revenues in the $80 to $82 range, GAAP net loss per share of $0.05 to $0.06 and non-GAAP net income per share of $0.03 to $0.04.

Our first quarter outlook reflects our cautious approach given economic conditions. As we have mentioned over the past two quarters as our GAAP profitability increases and as it becomes more predictable we may be in a position to release our valuation allowance related to our US deferred tax assets. The release would result in a one-time significant benefit to the GAAP tax charge in the quarter within which the release occurs.

While we are unable to predict if this release will occur in FY ’10 or in future years the impact will result in a change to the GAAP tax rate. We do not expect a material impact on the non-GAAP tax rate this year. We continue to assess longer term tax strategies to manage our overall effective tax rate.

In summary, Wind River has demonstrated solid execution in fiscal year 2010. We believe our market leadership, vertical market focus, targeted strategic initiatives and diversified business across products, industries and geographies positions us well for FY ’10. At this point Ken I would like to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matt Petkun – D. A. Davidson & Company.

Matt Petkun – D. A. Davidson & Company

First question, Ian you referred a couple times in your guidance to tuck in acquisitions so from a revenue perspective if we were to assume that you’d make no acquisitions in the year what would you be looking for?

Ian R. Halifax

It would be somewhere in the $360 to $380 range. How high we get in the range will depend on the timing of deals. At this point it’s hard to call.

Matt Petkun – D. A. Davidson & Company

But organically speaking you still think you could do $360 at the bottom end of the range?

Ian R. Halifax

Yes.

Matt Petkun – D. A. Davidson & Company

The other question I had and I hate to harp on this is more to get a sense of what you are looking for in terms of a long term sustainable mix between subscription deals and term deals? We saw nice sequential increase in subscription deals although they’re down year-over-year. The book to bill was positive in that section, so we’re right around 34% of the revenues this last quarter were from subscription deals. Do you see that level stabilizing from at least an absolute dollar perspective?

Ian R. Halifax

No, I think it may come down slightly sequentially quarter-over-quarter on a dollar basis. But, I would not anticipate a rapid overnight flip to term. I believe that in Q4 our term license revenues were a little less than 10% of total revenues and that will creep up gradual over the year but it won’t be a sudden switch.

Matt Petkun – D. A. Davidson & Company

Why do customers make the switch?

Kenneth R. Klein

Well, a couple of reasons, number one by embracing term they can effectively lock in pricing for a number of years. Generally term is down in two and three year increments so it’s predictable to them. Then, in the out years they’re generally paying what we’ve referred to as super maintenance a 30% maintenance rate. That’s probably the main reason is really to provide predictability from an expense standpoint.

Matt Petkun – D. A. Davidson & Company

Then just one final technology question, Ken a lot of focus here on multicore, how man transactions are you seeing out there where your hypervisor is actually being employed? And, is that really just early days or do you see it as a meaningful competitive edge already in today’s marketplace?

Kenneth R. Klein

It’s meaningful in the aerospace and defense market. If you think about our hypervisor was really born out of addressing the MILs opportunity which creates time and space partitioning. We’re leveraging that technology in the next quarter. The next couple of months we’ll be rolling in to all of the key verticals. We see multicore really kicking off broadly starting in networking equipment, industrial, medical and to a certain extent consumer. We see it really spreading out.

I would say the fact that it’s road mapped right now, it’s actually impacting deals right now and from the feedback that we’re getting from our customers and partners we’re ahead of the competition here and we’re unique. The fact that we’ve spent a lot of time working very closely with a lot of the key semis in this area, Intel, the announcement that was made yesterday and historically we’ve been working very closely with focus like Cavium and RMI gives us a competitive advantage.

This is a shift, it’s going to cause customers to migrate faster to commercial solutions because it’s too difficult to port, to develop, to debug without the tools, the capabilities and virtualization technology.

Operator

Your next question comes from John Difucci – JP Morgan.

John Difucci – JP Morgan

I’m sorry I got disconnected there so I don’t think this question was asked, you said that for the first quarter outlook you said it implied a cautious approach given the economic conditions out there but you also said you expect improvement in the second half. Does this imply that there’s going to be macro improvement in the second half? I know there are still some economists that are hoping that happens but there are also I guess just as many more, if not more that are actually starting to push that out the closer we get to the second half. Or, are there some things that are unique to Wind River that will result in your operational improvement in the second half even if we don’t see any macro improvement or even if it gets perhaps a little bit worse?

Kenneth R. Klein

I don’t think we’re under any illusion here that somehow there’s going to be secular improvement in H2 versus H1. The reason for the stair step guidance that Ian provided really has to do with the seasonality of our business particularly in Q3 and Q4 which generally are stronger quarters under normal conditions.

John Difucci – JP Morgan

So you just sort of expecting just a tough macro going forward then?

Kenneth R. Klein

We do. I think that’s one of the reasons why we provided cautious guidance.

John Difucci – JP Morgan

Ken, if you can talk a little bit about the end markets here especially a couple of them that sort of stood out this quarter, digital consumer which actually looked pretty solid especially given what we hear about the consumer again, with a reference to the macro environment it looks like it really held in there well and you saw what you usually see a sequential uptick I would assume around the holidays but I’m just a little bit surprised to see that here? Then also on aero and defense, that actually looked a little weaker than we were looking for and maybe you can comment on that, how much is commercial and how much of that is defense?

Kenneth R. Klein

First, I wouldn’t read too much in to sort of the moving around of the percentages by market segment. That’s one of the benefits of having a diversified mode. There’s a certain amount of lumpiness just due to various deals that happen to land in a particular quarter. Having said that I think we’ve picked wisely in terms of targeting growth areas within these various segments. You referenced digital consumer, clearly we’re seeing a lot of energy and uptick around the whole mobility initiatives, the work we’re doing with LiMo, with Android, with Moblin.

If you look at sort of the growth rates for example in Smartphones and in MIDs, they’re still growing while there is compression in some of the other segments. The other point is that we’re gaining a lot of market share against roll your own Linux and competitive Linux. That’s also contributing to a lot of the growth you see in consumer.

On aerospace and defense side there’s a lot of excitement around our ARINC 653 offering and the MILs offering that’s really coming on very nicely and we’re getting a lot of feedback on that and that’s obviously going to be a growth area for us in FY ’10 in the aerospace and defense segment.

John Difucci – JP Morgan

I’m sorry just one final questions, op ex was down sequentially and I think Ian mentioned that was because of lower compensation and sales commission but you actually had an increase in headcount and sales headcount sequentially and I’m just curious when we start to model this forward, you’re obviously looking out at the macro environment and it appears you’re adjusting your operations accordingly but, should we continue to look at this kind of op ex rate kind of going forward?

Kenneth R. Klein

I’ll let Ian comment on the op ex rate going forward but, one of the things we did is we were very proactive to move headcount to low cost geographies. Q4 we continued that movement, we have about 200 or so engineers in Beijing China, to put things in perspective. In terms of some of the gross margin improvement you saw reflective of better professional services margins, again that was leveraging the acquisitions that we did in Romani and Soul Korea as well. Again, with these moves its enabled us to effectively just like our customers are trying to do, to do more with less.

Ian R. Halifax

Let me add to that if I may. I said in my prepared remarks that we anticipate quarterly non-GAAP operating expense of around $60 million. Depending on how the year progresses clearly we will try to make sure we have that expense profile fit in to our revenue ramp. We will look very carefully at hiring plans throughout the course of the year and any discretionary spend items. We will keep very focused on making sure spend does not creep up above current run rates.

Operator

Your next question comes from Nabil Elsheshai – Pacific Crest Securities.

Nabil Elsheshai – Pacific Crest Securities

I guess I have to ask, in November when you guys gave out your guidance you were thinking 10%, now it’s lower single digits. Can you talk a little bit about kind of a little granularity on where you saw the deterioration from November when we were already pretty well in to the economics?

Kenneth R. Klein

Basically I think to reiterate what Ian mentioned, we’re being cautious right now. I think it makes sense, it really does. There’s just an incredible amount of uncertainty right now. I would say sort of anecdotally that our customers are buying line of sight versus over the horizon right now so they’re really only buying what they’re going to need in the short term. Though our business is showing a lot of momentum in the $100,000 and above range, we did see compression in the $1 million and above range although we didn’t see compression in the number of deals in that range but really the size of the deals in that range.

We just can’t count on the fact that we’re going to see a preponderance of mega deals in FY ’10 so those are the factors that go in to the guidance. Obviously we have a lot of exciting things that we’re doing around multicore, around the targeted vertical initiatives, around what we’re doing with our alliance partnerships and our go to market model and so forth so it kind of all goes in to the mix. But, I would say the kind of overall view that we’re taking is one of caution.

Operator

Your next question comes from Richard Williams – Cross Research.

Richard Williams – Cross Research

Could you give some color in terms of the government segment? Kind of focus on the trends in the business and also talk about the state and local?

Kenneth R. Klein

I think that’s one thing where we really don’t anticipate a slow down right, in the US defense spending. As I mentioned in previous remarks, particularly around ARINC 653 and the MILs effort, I think that’s going to provide short term opportunity. The other thing that I mentioned is around the infrastructure investments that are being contemplated and being made and by the way those are not just domestically and also internationally if you think about what China is doing in terms of their large railroad project. These are very complicated systems, they are distributed systems, they involve lots and lots of microprocessors and lots and lots of embedded software so they are going to benefit us.

In addition we see investments in areas such as green energy, wind, solar and to a certain degree nuclear also being investment areas except for those investment occur in FY ’10 and they get started, I think there’s upside for Wind River. From a government perspective in the aggregate I’d say we’re constructive.

Richard Williams – Cross Research

Also, could you talk about the longer term trends in the VxWorks business? Any reason to think that there might be risk to VxWorks over a longer perspective?

Kenneth R. Klein

Actually, I think we’re still very bullish on VxWorks particularly with our new release 6.7 that provides both SMP and AMP capability. If you think about where VxWorks is targeted in terms of the growth vertical markets and the one that comes to mind right now that’s most exciting for us is industrial and medical. We’re going to market with Intel in that spot as part of the announcement we made yesterday. VxWorks is going to have a very, very long life. It’s still doing very nicely in aerospace, specifically in the 653 marketplace and networking equipment as well.

Actually, in certain consumer segments as it turns out too and some of the broadband applications VxWorks is very important particularly in areas that require very high speed packet processing packet forwarding, VxWorks is a great fit. That complimented with Linux, complimented with the fact that we run everything in a multicore environment on our hypervisor to provide a complete solution I think bodes well for VxWorks and the rest of our products.

Richard Williams – Cross Research

Also I wasn’t clear if I heard you properly but is there going to be an Android operating system for netbooks or any other Linux based OS for netbooks?

Kenneth R. Klein

Well, I think it’s pretty clear that there’s going to be a Linux offering in the netbooks space. Therefore, we believe that’s an upside opportunity. There’s not a lot of clarity around what exactly it’s going to look like. One of the things we demonstrated at Mobile World Congress was a mid device that was running on Adam silicon and really with a flip of a switch that could be a net book. What was missing from that demo was some of the for example Open Office applications, etc. So, that’s one approach.

Another approach we may see Android move in to that space. It’s unclear right now. But, I think the great news about our position is no matter which way OEMs go to serve their consumer audiences, we’re very, very well positioned. If it turns out to be Android, if it turns out to be Moblin, if it turns out to be something else, we’re going to be there with a Linux based offering.

Operator

Your next question comes from Brent C. Williams – The Benchmark Company.

Brent C. Williams – The Benchmark Company

I wanted to go back and look at the Tilcon acquisition, which vertical specifically do you think that Tilcon is going to be used in most immediately? I think medical stuff I’ve seen typically uses standard PC type displays. Is this stuff really designed for embedded or specialized type displays? Where would we look to see it?

Kenneth R. Klein

We think we’re going to see, in fact our sales force is very excited about it in fact, $4 to $6 million excited about it to be precise, in the industrial and medical areas. We also think it has applicability in automotive and aerospace and defense. The great news is this product has already been integrated with both the VxWorks and Wind River Linux and the fact that it works on competitive offerings as well which we’ll continue to support.

It’s going to enable us to provide a full value solution particularly in industrial and medical – particularly those areas which require a graphic user interface, that was a competitive disadvantage we had. This basically closes the gap there. I should also mention that it’s royalty bearing in the high single digits so we’re pretty excited about that as well.

Brent C. Williams – The Benchmark Company

If we look at sort of the expectation on the large deal environment could we saw that it’s pretty much we shouldn’t really expect any $1 million deals in Q1 or completely minimal?

Kenneth R. Klein

No, I wouldn’t look at it that way, that’s not what we said. What we said was the size of those greater than $1 million deals was compressed in Q4. I don’t see that changing, it’s not that I don’t see $1 million plus deals I just don’t see multimillion deals or at least the same magnitude multimillion deals that we’ve seen historically. Now again, there may be exceptions to that but for right now that’s the way – we’re not predicating our guidance on achieving those like we have in the past.

Brent C. Williams – The Benchmark Company

Moving on, the comment that you made about moving away from device management more towards the testing types of uses, does that involve redeploying engineering sources or is the code maintainable in its current state and you’re just redeploying sales and marketing? What exactly does that shift look like?

Kenneth R. Klein

Strategically we needed to get this division profitable in the short term. That’s why we went about sort of refactoring this and focusing if you will in a laser like way on the testing aspect of the quality lifecycle so not on the diagnostics portion of the lifecycle and not on the device management portion. We have a brand new product that’s just begun to ship Test Manager 3.1. I think our engineers are proud of what they’ve been able to do, the sales force seems pretty excited but again it was really about streamlining this business so that we could get profitable on a division basis this fiscal year.

We just can’t afford to invest in three areas. We had to focus those investments in one area and we chose what we believe to be the highest impact area, this testing area where between 30% and 50% in some cases of the engineering spend is being deployed on testing so we’re pretty excited about the opportunity.

Operator

Your final question comes from Matt Petkun – D. A. Davidson & Company.

Matt Petkun – D. A. Davidson & Company

A quick follow up, the royalty and kind of production run rate line item, what are your expectations for that for the next couple of quarters and for the full year Ian?

Ian R. Halifax

I think over the next couple of quarters it will probably fall to a similar trajectory to what you’ve seen the last couple of quarters which is flat to slightly down depending on the level of compliance activity.

Matt Petkun – D. A. Davidson & Company

So I actually view flat as maybe perhaps positive, is that indicative of new designs coming in and paying royalties or do you really think that your general products that you’re exposed to are seeing flat production rates?

Kenneth R. Klein

Matt, let me take it, basically you have contra trends. We’re seeing several thousand designs which were booked as royalty bearing come on line. On the other hand, designs we already had in production you’re seeing reduced volumes of those and I think that in the aggregate is creating this flatness. In addition to that sort of is on one hand the compliance activity is difficult to forecast but certainly as I mentioned before this kind of line of sight behavior by our customers of not doing bulk purchases, they’re just not doing that. So, I think all those factors in the aggregate would lead us to say that it should be roughly flat. Yes, we view flat is good in this environment, absolutely.

Matt Petkun – D. A. Davidson & Company

Finally, Ian cash flow expectations/hopes for the next fiscal year?

Ian R. Halifax

We haven’t given explicit guidance on that. I think the best we can say right now is something similar to FY ’09.

Matt Petkun – D. A. Davidson & Company

So you actually think you can maintain similar levels? The earnings look similar.

Ian R. Halifax

That’s why.

Kenneth R. Klein

Matt, we’d love to do better but I think it would be imprudent at this point to go out there with anything but cautious guidance.

Anne Marie McCauley

That concludes today’s call. Thank you so much for joining us and for your questions. We look forward to speaking with you soon.

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