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Executives

Rob Dougherty – FD Ashton Partners

Thomas Reilly - President, Chief Executive Officer & Director

Stewart Grierson - Chief Financial Officer

Analysts

Rob Breza – RBC Capital Markets

Jonathan Ruykhaver – ThinkEquity

Scott Zeller – Needham & Company

Erik Suppiger – Signal Hill Capital Group

Keith Weiss – Morgan Stanley

Phil Rueppel – Wachovia Securities

Craig Nankervis – First Analysis

Jay Meier – Feltl & Company

ArcSight, Inc. (ARST) F3Q09 Earnings Call March 5, 2009 5:00 PM ET

Operator

Welcome to the ArcSight third quarter 2009 financial results conference call. Today’s call is being recorded. At this time for our opening remarks and introductions I would like to turn the conference over to Mr. Rob Dougherty with FD.

Rob Dougherty

Thanks for joining us today for the ArcSight third quarter fiscal 2009 conference call. On the call today are Tom Reilly, President and CEO and Stewart Grierson, CFO of ArcSight. During the course of this call we will make forward-looking statements regarding future events and the future financial performance of the company. Generally these statements are identified by the use of words such as except, believe, anticipate, intend and other words that denote future events.

These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements in the press release and on this conference call.

These risk factors are described in our press release and are more fully detailed under the caption Risk Factors in ArcSight’s quarterly report on Form 10-Q as filed with the SEC on December 12th, 2008 and the company’s other filings with the SEC. During this call we will present both GAAP and non-GAAP financial measures. Non-GAAP measures exclude amortization of intangibles and stock-based compensation expenses.

These non-GAAP measures are not intended to be considered in isolation from, a substitute for or superior to our GAAP results and we encourage you to consider all measures when analyzing ArcSight’s performance. For complete information regarding our non-GAAP financial information the most directly comparable GAAP measures and a quantitative reconciliation of those figures please refer to today’s press release regarding our third quarter fiscal 2009 results.

The press release has also been furnished to the SEC as part of a Form 8-K. In addition please note that the date of this conference call is March 5th, 2009 and any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events.

Lastly this conference call is the property of ArcSight and any recording, reproduction or rebroadcast of this conference call without the express written permission of ArcSight is strictly prohibited. Now I’ll turn the call over to Tom Reilly, President and CEO of ArcSight.

Thomas Reilly

I also wish to thank everyone on this call for your continued support of our business and for taking the time to learn about our fiscal 2009 third quarter earnings results. On behalf of ArcSight’s hard working employees I’m extremely pleased to report yet another record quarter in which ArcSight has achieved all time highs for both revenue and net income.

Total revenue for the third quarter of fiscal 2009 was $36.4 million a 32% year-over-year increase. In addition we achieved record profits on both a GAAP and non-GAAP basis. With these combined results we’ve exceeded both top and bottom line expectations. It was just a little over 12 months ago on Valentine’s Day of last year that we announced our Initial Public Offering.

In the four quarters since that time we have grown revenue by approximately 30% and have added over 200 new customers to the ArcSight family. While we continue t focus on top line growth it is important to note that we are not just a growth story. During that same period we generated more than $14 million in positive cash flows from operations.

We have also reported non-GAAP net income each quarter since our IPO and have demonstrated our ability to deliver operating margin expansion. We are extremely proud of our accomplishments this past year and particularly this last quarter since ArcSight’s strong growth has occurred amidst the financial meltdown that is unprecedented in most of our lifetimes and certainly has not been seen in decades.

As we’re all painfully aware the stock market is down 40% to 50% this past year. The liquidity crisis has resulted in billions of dollars in government bailouts and there’s little optimism looking forward. Our ability to grow at nearly 30% in this challenging environment not only reflects the resilience of our value proposition but also reflects the perseverance and hard work of our employees, the productivity and effectiveness of our partner community and the loyalty of our customer base.

I cannot thank all of you enough. It is with this combination of strengths and our continued ability to perform in tough markets that I remain very optimistic about ArcSight’s opportunity looking forward. In fact over the past year our management team has adapted how we run the business with the expectation that the current economic environment will be the norm for some time to come.

Any uncertainty looking forward only lies in those things which we cannot control especially given the rapidly unfolding financial crisis and the prospect that markets may deteriorate even more thereby drastically changing purchase behaviors. Let me shift topics and now share some specifics behind our strong results this past quarter and then I’ll discuss some of the key drivers that we believe are fueling this growth.

In the third quarter we continued to see demand across multiple verticals consistent with past performance. The top three contributing verticals were government, financial services and telecommunications each of which contributed more than 20% of the business in the quarter. We are pleased with the contributions from all other verticals on par with past performance including healthcare, utilities, transportation, retail, higher education and pharmaceuticals.

Our install base was once again a very reliable source of revenues contributing 69% of product revenue in the quarter. This is the result of expanding projects, new products that we can up sell and new solutions we are introducing such as fraud and identify monitoring.

Our customers are finding significant cost savings by leveraging their existing ArcSight platform to solve new pressing business problems at a much lower cost instead of introducing new technologies or vendors that are unproven. Having a strong customer base with expanding projects is a key component of our growth strategy especially during this tough market.

In addition to strong purchases from our existing customers we also added 59 new customers to the ArcSight family. These new customers come from many verticals and interestingly 14 of them are financial services companies which reflects the importance of our solutions to that vertical despite the extreme fiscal challenges they face.

I welcome all of our new customers to the ArcSight family and we look forward to helping you protect your businesses in the years to come. Our push into the mid-markets continues and we are very pleased with the results of Logger sales and the performance of our channel partners. As we have shared in the past we are primarily focused on improving the productivity of our 140 plus channel partners versus the recruitment of new ones at this time.

This past quarter we rolled out a training and certification program for our partners to improve their ability to consult, sell, effectively implement and support our solutions. We had 13 firms participate in this inaugural program with each company sending three to four individuals on average. Our commitment to the channel is paying off and recently our Vice President of Channels was recognized by CRN as the 2009 Channel Chief Award recipient.

A little over two years when we began building our channel program. We believe that the effectiveness of this program in increasing loyalty of partners is a strong contributor to our success in this market. From a geographic perspective we are very pleased with the performance of our North America business particularly in the US Federal Government.

There are regional challenges and we are seeing sales cycles elongate as buyers seem to be much more cautious in making final purchase decisions particularly in the EMEA and APAC markets. However our level of sales activities in these regions remains high with plenty of projects to pursue.

We are still finding strong pockets of opportunity in specific areas like Eastern Europe, the Middle East and Southeast Asia where compelling drivers for our technology are delivering results. Fortunately across every vertical and geography we are able to find multiple drivers for our business.

However our success is a result of our ability to identify those industries our countries where external forces are driving spend for our solutions and we are targeting our efforts in these areas. Let me focus in on several we are finding to be resilient in this market. First compliance projects are still a big part of our business and ArcSight has the unique value proposition in lowering the cost of achieving compliance.

Successfully completing IT audits is very costly and time consuming whether you’re working on SOX, PCI, HIPAA or other compliance mandates. ArcSight’s solution is not only a necessary monitoring capability that addresses specific compliance controls but we also can play a key role in shortening audit cycles.

Numerous customers have told us that they have lowered their audit costs and shortened their audit process as a result of ArcSight’s single console that provides visibility of multiple controls across a heterogeneous IT infrastructure.

In fact one of our design goals is to present auditor friendly dashboards and reports such as auditors can complete much of their reviews from a single console versus mainly sifting through documents, reviewing policies and procedures, examining technology deployment and conducting IT interviews across multiple locations in order to uncover the truth.

I’d also like to say auditors show up as frequently in bad times as they do in good times. In the current environment when CIOs are looking for ways to do more with less our solutions allow them to create efficiencies while also improving the overall governance and risk profile of their company.

The next major business driver we are seeing is the heightened concern of cyber warfare conducted by enemy nation states. Although defense of a nation is normally the domain of government agencies in the case of cyber warfare it is much different. The vast majority of a nation’s critical infrastructure susceptible to cyber attacks resides within the private sector including telecommunications, utilities, energy, financial services and transportation.

Corporate CIOs in these industries could expect tougher regulations and greater accountability for ensuring and demonstration the security of their networks as governments put controls in place to protect critical infrastructure from outside attacks. In fact last month the Obama Administration appointed our nation’s first National Cyber Security Advisor, Melissa Hathaway, a telling sign that the new Administration is taking cyber security seriously.

The Administration has already outlined a cyber security policy which includes initiatives to work with the private sector at an unprecedented level to establish standards for cyber security and protect trade secrets. We also expect the government to increase spending on the protection of its own global network infrastructure.

The Administration has stated it is imperative for government agencies to more broadly share information in an effort to improve awareness of potential threats. Securing an integrated network of this size will be an enormous undertaking and the government is expected to spend billions on this initiative over the next several years.

The concerns for cyber warfare are not just those of the US government. In fact much of our recent success in Eastern Europe and the APAC region is driven by concerns of enemy nation cyber attacks. We feel protecting the critical infrastructure in government operations of nations across the globe will be a strong driver for our business.

Another are of opportunity for ArcSight is in the healthcare industry. With the recent passing of the Federal Stimulus Bill the Obama Administration has made it clear that the transformation of the nation’s healthcare system from paper to electronic health records is a priority. This will not only automate hospital processes and streamline billing and payment cycles but will likely result in expanded Federal regulations for the privacy and security protection of patient information.

It is expected that existing compliance mandates such has HIPAA will be enhanced and will have increased scrutiny. ArcSight already has many healthcare industry clients and we expect the push to electronic health records will open up many new opportunities and will enable us to further penetrate into existing customer environments to protect sensitive patient information.

Finally we have seen many of our existing clients leverage their ArcSight implementation to address new and more serious threats that are emerging in these difficult times. In particular during times of employment turmoil corporations have heightened concern around fraud, theft of high value assets or malicious intent to disrupt services.

The perpetrators of these crimes are increasingly trusted users or they’re employees, contractors, suppliers or partners with access to critical business systems. As an example earlier this month the FBI revealed an alleged plot to destroy data at one of the nation’s largest mortgage finance companies. A recently fired contractor was indicted for entering malicious codes designed to destroy all of the data on more than 4,000 servers nationwide.

Before surrendering his badge and laptop computer this recently terminated contractor alleged planted a virus that had it gone undetected would have resulted in destroying all of the data on the company’s servers costing millions of dollars in damage and leading to a shutdown in operations impacting the management of trillions of dollars in home loans.

Had this occurred the economic damage could have been catastrophic with an industry wide ripple effect considering the fragile nature of the financial markets. Similar to this we have seen many financial institutions stepping up their fraud and insider threat monitoring capabilities as the industry goes through unprecedented turmoil. I’ve shared in the past our strategy to make our solution a platform for multiple use cases covering all types of external and internal threats.

The use cases are numerous and the timing of our strategy to deliver a single platform to solve these problems is being very well received by our customer base. I have just summarized several areas driving our business. These examples included efficiently demonstrating compliance controls, protecting critical infrastructure from cyber attacks, securing electronic medical records in healthcare and proactive awareness of insider threat and financial fraud.

These are just a few of the business challenges that appear to be somewhat nondiscretionary for our customers to address despite the broader economic challenges. With the ever expanding global connectivity and the increasing sophistication of attacks we expect there will be many more new use cases to solve in the future.

In our last earnings call I reviewed our four point plan to grow our business that we initially presented at the time of our IPO. This plan includes introducing new products to sell to the install base, penetrating the mid-market, expanding into new geographies and positioning our solution as a platform for multiple use cases.

I will not delve further into these four points today other than to say we are continuing to execute on our plan and we are pleased with the results. While we have made some operational changes in how we manage the business to adapt to the current market climate fundamentally our growth plan remains in tact.

I would now like to turn the call over to Stewart to discuss our Q3 fiscal 2009 financials in much greater detail.

Stewart Grierson

As previously mentioned for the third quarter ended January 31st, 2009 we had total revenues of $36.4 million representing year-over-year growth of 32%. We recorded non-GAAP net income of $6.9 million or $0.21 per diluted share. This excludes stock-based compensation expense of $1.7 million and amortization of intangibles of $210,000.

We recorded a GAAP net income of $5.1 million or $0.15 per diluted share. This is our sixth consecutive quarter in which we have generated net income on a non-GAAP basis. We have consistently talked about our ability to derive revenue from our install base and this trend continued in the third quarter with 59% of our product revenue coming from our existing customers.

While we did not have any customers that contributed more than 10% of revenue in the quarter we did have some sizable deals from existing customers which resulted in the strong results of our install base. We believe the ability to generate revenue from our existing customers is particularly important in this challenging economic environment and demonstrates the value our products deliver to our customers.

As Tom noted we added 50 new customers in the quarter representing 31% of product revenue. The high number of new customers reflects the successful execution of our strategy to penetrate. On a non-GAAP basis gross margin for the quarter was 82%. Appliances continue to represent an increasing proportion of product revenue and contributed 46% of total product revenue in the quarter.

While the majority of the appliance revenue is driven by sales of our Logger product both on a stand alone basis and in conjunction with ESM this results in the first quarter in which we sold appliance versions of ESM. Non-GAAP operating costs for the quarter were $20.8 million which is a $2.3 million decrease from 2Q. Given the uncertainty in the broader economy we have continued to monitor and control our expenses carefully.

While Q2’s operating expenses included the one time cost of our User Conference we also created savings across the board in Q3 with particular focus on reductions in contract and temporary employees, travel and entertainment expenses and recruiting costs. As a result of our significant over achievement on revenue and prudent cost controls we generated a Q3 non-GAAP operating margin of $9 million or 25% of revenue.

While these strong operating margins reflect the leverage in our business model they are not sustainable in the near to intermediate term given the investments required to take advantage of the market opportunity in front of us. We ended the quarter with 383 employees and based on the strength of the opportunities highlighted earlier by Tom we are actively hiring in both our sales and development organizations.

As a result we expect operating costs to increase in the fourth quarter with an associated reduction in operating margins as we invest for the future. Turning to the balance sheet we ended the third with cash and cash equivalents of $82.9 million an increase of $7.2 million from the prior quarter. We generated $7.8 million in cash from operations and used roughly $0.2 million for capital expenditures and $0.3 million related to financing activities.

We continue to invest our cash in highly rated conservative investment vehicles. In accordance with GAAP and as discussed on prior calls we net down accounts receivable and deferred revenue for sales transactions that are recognized on a cash basis. As a result in order to understand the change in accounts receivable and deferred revenue from period to period one must take the impact of the net down into consideration.

Deferred revenue of $37.5 million at January 31st, 2009 was net of $7.8 million of sales transactions that are recognized as revenue on a cash basis. This compares to second quarter deferred revenue of $39.5 million and was net of $9.3 million of cash basis transactions. Accordingly gross deferred revenue decreased by approximately $3.5 million from the second quarter to the third quarter of fiscal ’09.

On a sequential basis gross product deferred revenue decreased by $3.7 million while gross maintenance and service deferred revenue combined increased by $0.2 million. Accounts receivable was $22.2 million at January 31st, 2009 compared to $23.2 million at the end of the second quarter. Once again both these balances are net of $7.8 million and $9.3 million respectively for cash basis transactions.

Consistent with our standard practice we continue to evaluate the creditworthiness of our customers and resellers. Our DSOs for the quarter was 56 days which is below our stated target of 60 to 70 days. I will now provide guidance for the fourth quarter of fiscal 2009. We currently expect revenue for the fourth quarter of fiscal 2009 to be in the range of $34 million to $38 million which represents growth of 16% to 29% over the prior year.

As you are aware the uncertainty of the current economic environment creates significant challenges in providing forward-looking guidance. The broader revenue range reflects our desire to provide relevant guidance while also taking into consideration current market volatility.

Non-GAAP net income for the fourth quarter of fiscal 2009 is expected to be in the range of $3 million to $5.1 million or $0.09 to $0.15 per diluted share excluding stock-based compensation expense and amortization of intangibles. Based on our fourth quarter guidance we expect full year fiscal 2009 revenues to be in the range of $130.9 million to $134.9 million which represents year-over-year growth of 29% to 33%.

We expect non-GAAP net income for the full fiscal 2009 year to be in the range of $13.8 million to $15.9 million or $0.41 to $0.48 per diluted share excluding stock-based comp expense and amortization of intangibles. I will now turn the call back over to Tom to provide his concluding remarks.

Thomas Reilly

Our results demonstrate that ArcSight’s compliance and security management solutions are delivering critical and compelling value to enterprises and governments that need to protect their businesses. The drivers that have fueled our growth to date remain in tact and as discussed we believe that new drivers are continually emerging that will create further growth opportunities in the future.

These are very difficult times for all of us and we have our fair share of challenges with the market and the uncertainty it presents. However as I stated earlier the management team at ArcSight has taken the position that the environment we are in will be the norm for the foreseeable future and hence we have made adjustments in our operating procedures and tactics in order to best weather a lengthy storm.

Much of our uncertainty lies in not knowing whether things will stay the same or get drastically worse. As such we remain heads down executing on our plan that has successfully gotten us to this point. I am pleased at this time that we have the opportunity to continue hiring in our development and sales organizations which will allow us to further advance our platform, get closer to our customers and to pursue more opportunities.

As the market leader in our category we feel well positioned to benefit from these opportunities and to expand our share in the SIM market. This concludes our prepared comments for today. We will now take your questions.

Question-And-Answer Session

Operator

(Operator Instructions) We’ll go first to Rob Breza – RBC Capital Markets.

Rob Breza – RBC Capital Markets

From a high level could you give us a sense, you guys are obviously executing in a challenging environment, could you talk a little bit about the competitive standpoint? What are you guys seeing in that front, share gains versus just the straight out competitive wins or organic business? Could you give us a sense for the competitive environment?

Thomas Reilly

We’re not seeing new competitors. We are competing against the same competitors. That hasn’t changed. We are getting more competitive so one of our tactics we believe is that in these tough environments when there are deals we have to improve our competitive win rate. We have tactics that I won’t go into but we feel we are doing a better job of improving our win rates and we are focused on doing displacements in the competitive environment.

But we’re not seeing a change in the competitive landscape as far s who we’re competing against.

Rob Breza – RBC Capital Markets

Stewart, appreciate the additional color on the percentage of product revenue from appliance. Can you give us a sense on how that was on a sequential and a year-over-year basis?

Stewart Grierson

Off the top of my head I don’t have year-over-year but appliances was, the last couple of quarters anyway, was roughly a third of product revenue and obviously getting up now to 46%. It was a fairly big increase in Q3 vis-à-vis the earlier quarters in the year.

Rob Breza – RBC Capital Markets

From the channel perspective, it sounds like you guys are having a good success cultivating the current channel, can you give us a sense of how that is? I don’t know if you can give us a percentage of revenue that’s indirect versus direct but how you see that growing longer term and becoming a bigger portion of the overall business?

Thomas Reilly

We think that the greatest opportunity with the channel is pushing into the mid-market. We expect that to grow and part of our means of gaining loyalty with our channel partners is making it very clear where we see opportunities for them to grow their markets and us being very loyal to that commitment.

We also find that we’re gaining loyalty of partners back to us in this tough market because we know that their businesses are tough and so we are working with them to have joint wins and help drive their revenues which we think in the long term will benefit us as we get more loyalty from those partners.

We expect our channel to increase and become more productive as we open new geographies or countries and go down market.

Rob Breza – RBC Capital Markets

One last question to follow to that, do you guys have the rough breakdown on a geo basis?

Stewart Grierson

About 22% of revenue was international.

Operator

Next to Jonathan Ruykhaver – ThinkEquity.

Jonathan Ruykhaver – ThinkEquity

Stewart just to clarify, it sounds like what you’re saying as it relates to deferred revenues is that there was some product that was booked in 2Q is deferred and then subsequently shifted in the 3Q period. Is that correct?

Stewart Grierson

No, not 100%, Jonathan. You’ll recall we had, if you go back to the end of last year, we had those large deals that had been amortizing off the balance sheet each quarter and so we had some of that impact. I think the other factor when you look at the decline in deferred revenue Q2 to Q3 was particularly with the strong revenue from our existing customers this quarter you saw drop off in those net down adjustments I talked about.

That shift as well results in customers where the revenue is recognized within the quarter. That’s probably the other factor so it wasn’t just Q2 deals coming off into Q3.

Jonathan Ruykhaver – ThinkEquity

Just a quick question on product gross margins, a slight decrease sequentially. Is that due to mix or other factors and should we think about a high 80% type product gross margin going forward?

Stewart Grierson

It’s really mix as the first question there with appliances now at 46% of product revenue in the quarter that has some impact on overall product gross margins. As that shift continues I think product gross margins in the high 80s is the right way to think about it.

Jonathan Ruykhaver – ThinkEquity

On Logger 3.0 which I think began shipping in November, can you give some color on what kind of impact that had on the appliance growth in the quarter?

Stewart Grierson

Logger continues to be a very successful product line for us. We don’t break it out but we roughly talk about it, it is now North of 25% of product revenue so it continues to gain traction. Both on a stand alone basis, and that’s one of our focuses obviously is to go to the mid-market and sell Logger there but also with our ESM product we sell those products combined.

We continue to enjoy very strong success with our Logger product in the market.

Jonathan Ruykhaver – ThinkEquity

So Logger is 20% of product sales, does that mean the remaining 25% of appliances ESM specifically?

Stewart Grierson

Right, I said it’s more than 25% in the quarter. the rest is between our connector appliances and ESM appliances, correct.

Jonathan Ruykhaver – ThinkEquity

On ESM I think in the past you’ve suggested that the Logger product has really been the driver to success on the appliance side. Has anything changed on the ESM appliance side that’s getting you more traction in the market or is it just a matter of better execution in the channel?

Thomas Reilly

There’s a class of customers that prefer to buy their hardware and software in a prepackaged appliance. Our ESM appliances are addressing that customer base.

Jonathan Ruykhaver – ThinkEquity

One final question, I think you’ve said historically that about 40% of your sales go through the channel but that historically at least has been predominantly just fulfillment. Are you starting to see the channel drive direct deals?

Stewart Grierson

I would say that it’s fairly much fulfillment at this point, Jonathan. We do see pockets where with some more mature channel partners they start to carry a bigger part of the burden but Tom talked about one of the initiatives we kicked off this quarter which was really more around enablement, training of sales force, training of services personnel. It’s still largely fulfillment today but we’re working on the strategy to be able to get these guys to be able to sell it stand alone.

Jonathan Ruykhaver – ThinkEquity

So that’s something that should drive greater sales productivity looking out the next 12 months?

Stewart Grierson

Correct.

Operator

We’ll go next to Scott Zeller – Needham & Company.

Scott Zeller – Needham & Company

Regarding the channel, Tom, we’ve been hearing that you’re growing the channel partners’ accounts. How far would you say you are into that growth right now? Would you say you’re 50% of the way to the number of partners you want to get or are you nearly done? Are you at 80%? Can you quantify that for us?

Thomas Reilly

On the number of partners we feel we have recruited enough partners into our program for the foreseeable future. We are not out recruiting new partners. What we are doing is we measure the performance and the effectiveness of our partners. We are really focused on training them, supporting them, giving them sales tools to make them increasingly effective and we are incrementally trying to add more of our existing partners into that effectiveness pool.

I would say that as far as recruiting partners, we’re done for the foreseeable future. We don’t see why we need to add more without getting to know the ones we have much better and getting [inaudible] some more of our products.

Scott Zeller – Needham & Company

I believe you said, Stewart, 69% of product revenue was from repeat customers. Do I have that correct?

Stewart Grierson

Correct.

Scott Zeller – Needham & Company

When you look at that number, could you help us understand what it is that someone who is a large customer already, like a large government agency, what exactly would these customers be buying as follow on? Would it be the prepackaged applications for reporting? Would it be Logger appliances? Would it be the ESM appliance? What would we see them buying?

Stewart Grierson

Our existing customers are typically continuing to expand their deployment of our ESM product, so they’re monitoring greater number of devices, they’re adding use cases and all of that drives incremental revenue but obviously we continue to sell the Logger into that install base. So you have both. When I talked about some of the sizable deals in the quarter those are often driven by incremental ESM revenue is the way that typically plays out.

And that can swing that percentage of the mix between new and existing customers from any quarter to quarter but you’ve got a combination of all the factors you talked about that continue to drive revenue from the existing customers.

Operator

We’ll go next to Erik Suppiger – Signal Hill Capital Group.

Erik Suppiger – Signal Hill Capital Group

First just on the repeat or the new customers, the new customer product revenue in the quarter came down sequentially. Can you comment as to whether or not the new customer environment is getting affected by the economy or was that an anomaly?

Thomas Reilly

A lot of our new customers are mid-market customers that we’ve been targeting with our appliances which by nature are lower initial ASPs. That is by design we’ve introduced these product, we’ve built the channel and we’re going after more mid-market customers at expected lower ASPs. We’re not seeing our products get discounted differently than any time in the past.

In general they’re holding our ASPs up though because on last topic our ASPs of add on purchases into our install base are actually increasing. That’s how we’re holding our general ASPs across our whole business. But I think the price points of our new customers is reflective of they are more mid-market customers leveraging our appliance products.

Erik Suppiger – Signal Hill Capital Group

Is there a greater shift this quarter compared to last quarter?

Stewart Grierson

I think certainly if you just look at the increase in Logger sales, yes that’s reflective of that both from a product mix but also as we look at by size of customer, it is part of our strategy to go after that mid-market

Erik Suppiger – Signal Hill Capital Group

On the Logger versus ESM, can you give us a little sense for what kind of growth you’re seeing on the ESM side because with the growth in the appliance it’s challenging for us to get a good sense for how much of the growth is coming from Logger versus ESM?

Stewart Grierson

I understand that and the way you want to think about this though is that you have to look at what is driving the purchase decision of our customers because two years ago when the only product we offered to the marketplace was ESM, that’s all our customers were buying. We are solving some of those same problems today with a slightly different mix of product.

You’ve got both ESM and Logger so you’ve got customers who need to do real time analysis of events whether it be for compliance or for security initiatives and they’re typically today buying both ESM and Logger and then you’ve got customers who really are just very compliance focused, they just want to be able to collect the logs and have cost effective storage and those are natural Logger customers.

You can get a little bit off base if you’re just looking at Logger versus Logger and ESM product together.

Erik Suppiger – Signal Hill Capital Group

Previously the compliance driven customer was buying the ESM because that was the only option they had?

Stewart Grierson

Correct.

Erik Suppiger – Signal Hill Capital Group

Can you give us the contribution from government sales? Last quarter I think it was more than 30%. Can you say if it was more than 30% this quarter?

Stewart Grierson

It was in the mid 20s.

Erik Suppiger – Signal Hill Capital Group

On the financial side, can you give us anything more than?

Stewart Grierson

Low 20s. Tom talked about government, financial services and telcos were all greater than 20% in the quarter.

Erik Suppiger – Signal Hill Capital Group

So kind of in the low to mid 20s, for all three of them?

Stewart Grierson

It was government number one, financial services two, telco third.

Erik Suppiger – Signal Hill Capital Group

Lastly, you’ve indicated that the op ex is going to grow next quarter. You’re looking at the model going into the midpoint of your guidance for revenues and earnings, it would suggest the op ex is going to increase pretty substantially. Where do you see the significant increase on the op ex coming from?

Stewart Grierson

We talked about we are hiring both in our development organization as well as in our sales organization and those will be the two line items where you’re going to see the most growth Q3 to Q4 but there are other dynamics where you’re going to see across the board spend increases is what I would expect but those would be where you’d see a higher percentage.

Operator

Next to Keith Weiss – Morgan Stanley.

Keith Weiss – Morgan Stanley

I wanted to ask you a little bit about your pipelines going into 4Q and the visibility you have. Looking at your guidance it looks like your guidance range is about double of what you usually get which would indicate less visibility or less predictability about how 4Q is going to come out. Could you give us some kind of idea of how you’re looking at that dynamic between you are expecting good growth but there is a pretty broad range there.

Thomas Reilly

It’s not so much less visibility. It’s increased uncertainty. When we were sitting here a quarter ago we had an earnings call with you guys, we basically said we don’t know what the future portends and how things could play out. They’ve actually played a lot worse than what we expected at that earnings call in the last quarter that we were executing in.

So here with sit another earnings call and we’ve got visibility into our pipeline but there’s even more uncertainty of what could enfold of things outside our control. If the government decides not to bail out AIG or General Motors or what have you I have no idea what that could do, whether we go to 5,000 or today at 7,000 of the DOW.

The expanded range has to do with there are many things occurring outside our control. We have visibility. We feel that we can stay inside that range if things play out but that’s the why the range had to expand on the guidance. We think it was better to give you that wider range of guidance instead of saying we’re not going to give any guidance at all.

Keith Weiss – Morgan Stanley

If you could give us any color on to your pipeline, where it stands today maybe versus this time last year or this time going into your third quarter?

Thomas Reilly

I would share that some of the challenges in forecasting are that sales cycles are taking longer as I said in the prepared comments. The flip side we’re finding higher volume of opportunities to chase. We’re not seeing the activity of opportunities diminish. They’re getting a little tougher to call but there is a lot of good activity out there.

This is where I give lots of kudos to our sales organization which is very adept at figuring out where opportunities are and targeting them and not wasting their time on opportunities that are not budgeted or we don’t think the driver is strong enough to get approval in this environment.

Keith Weiss – Morgan Stanley

If I could just sneak one last one in, it looks like in 3Q you guys paused hiring, headcount down a little bit sequentially or basically flat sequentially from Q2 into 3Q and now you’re ready to invest again. Is there any change in your thinking about how you’re looking at the outlook or are you looking at the opportunity that is getting confidence to basically restart hiring?

Stewart Grierson

Part of it is that we continue obviously to get validation back from the marketplace in terms of the demands of the driving purchases of our products. So, we talked a lot of about economic backdrop here and Tom sort of talked about our adapting to that. I think it is looking at our success in Q3, what the drivers are for our business as we look forward to some of the opportunities that we think are coming and we’ve talked about what some of those are that we think there is a significant opportunity in front of us and there is some investment required to continue to grow the company. That’s what’s giving us the confidence to go out and hire.

Keith Weiss – Morgan Stanley

Would it be fair to say you guys are more confident in your ability to operate in a difficult environment?

Thomas Reilly

I’m confident of our ability to execute in this environment. What I don’t know is what the environment looks like in 30 days.

Operator

Your next question comes from Phil Rueppel – Wachovia Securities.

Phil Rueppel – Wachovia Securities

A couple of additional questions, first kind of on the product side as you push in to the mid markets Logger 30 looks like it’s been successful, do you see any need for an even more slimmed down ESM or other types of products to successfully address that market or do you feel like the quiver of functionality is complete?

Thomas Reilly

Right now we’re pretty pleased with the performance of Logger in the market. I’d rather not disclose any future product road maps, what we’re thinking in this area. But, we believe as our channel gets skilled enough on Logger that there are opportunities for them to help us in the SIM category.

Phil Rueppel – Wachovia Securities

So shifting to the sales front, you mentioned that sales cycles are lengthening but the ASP really hasn’t changed much, has that been skewed by any sort of barbelling big deals with some small deals or would you say your sweet spot for a new customer is pretty much what it has been in the past few quarters.

Thomas Reilly

Phil, I think the sweet spot is staying the same. One of the things that I think is unique about at least our category and why we can hold ASPs, in our category of security, customers find that good enough is not good enough. So, there is a bit of flight to quality and if you have few projects in the company that you have the opportunity to invest in and you’ve cut all these projects and putting in a security information event management system is one of your few projects you’re going to want that to succeed. So, we think that is helping us win more and it’s helping us keep our price points.

Phil Rueppel – Wachovia Securities

Final point, Stewart you had mentioned that gross margins are likely to stay roughly in the same arena going forward, does that mean that your projections about mix between appliances and pure software is that roughly going to stay the same or do you see appliances growing as a percentage of revenue?

Stewart Grierson

I think appliances have continued to grow as a percentage of revenue and the opportunity exists for that to continue to get bigger particularly with the success of Logger towards the mid market. You know Phil, that can always be skewed by large deals so your prior question about barbells was less of an ASP issue but in terms of product mix that can have an impact from quarter-to-quarter. But, we do expect appliances in general to become a bigger part of the product mix over time. Obviously, it does have some impact on gross margins yet our appliances, we do get gross margins north of 80% so they remain very strong, strong gross margins.

Operator

Your next question comes from Craig Nankervis – First Analysis.

Craig Nankervis – First Analysis

What changed in the quarter that boosted your result relative to the top line guidance? Is there anything you can point to?

Stewart Grierson

I can’t point to anything specifically Craig. I think we sort of gave you a flavor of the verticals it continues [inaudible], we also continue to have a very strong horizontal solution. The drivers for the business continue to hold up so there’s really across the board, there’s no one thing I can point to that says that was what created the over achievement in the quarter.

Craig Nankervis – First Analysis

How about can you talk about evidence, maybe Tom alluded to this a little bit in his opening remarks, evidence that you’re seeing that your installed base strategy to expand beyond the perimeter to do identity monitoring, database monitoring, those kinds of things, can you give any flavor for your traction in that regard?

Thomas Reilly

We’re very pleased with the strategy and the interest levels of our customer base in those areas. We are holding regular regional user groups where we bring together in group forums, we introduce our new capabilities in this area and we’re getting consistent feedback that the areas we’re investing in are of high values to our customers.

That goes back to our fundamental strategy to weather this storm is to continue to give our customers increasing ROI on the investments that they made. When I sit down with CIOs and I say, “Look you’ve invested in installing our hardware, getting it tuned, training their team and they’re doing a great job monitoring your perimeter, with slightly more investment they can now monitor for fraud or they can monitor for identify privileges being compromised.” CIO’s really like the ability that they can reuse an existing asset for newer higher value uses. So I’d just say we’re executing on that strategy.

Craig Nankervis – First Analysis

Was the significant performance on product revenue from the existing base still by in large ESM and then maybe secondly Logger? Or, can you start to throw some of these other follow on opportunities in to the list of the top two or three drivers?

Thomas Reilly

It’s hard to break it all down but a lot of it is expanding ESM licenses. But, the way that ESM is licensed, the more end points that you’re monitoring the greater your license cost. But, a lot of these new use cases drive more endpoints that need to be monitored so it’s interrelated.

Craig Nankervis – First Analysis

How about Tom, you talk about the government and the Obama administration and what not, the CNCI, are you familiar with that? The national critical infrastructure initiative, I take it you’re familiar with that.

Thomas Reilly

Yes.

Craig Nankervis – First Analysis

Is that something separate from what you were talking about or is that wrapped in to what you were alluding to as a potential positive for you?

Thomas Reilly

That’s wrapped in to it, there’s the National Security President’s Directive 54, the NSPD54 that is a big driver of this. We are collaborating with most of the larger government systems integrators who are the big players around the government sector where they have lots of service dollars at stake. Many of them are not only partners of ours but clients of ours so there is a growing ground swell of opportunity around the CNIC and NSPD54.

Craig Nankervis – First Analysis

Just geographically Europe was maybe up a little bit sequentially but still probably on a percentage basis down from where I think it’s been by in large for the few quarters before that. You invested in Europe sales heads the beginning of the fiscal year, where are the new sales heads going geographically and do you feel like the utilization of your heads in Europe is play out reasonably well or are you having to cut sales heads over there? What’s the scene in Europe relative to your staffing up there?

Thomas Reilly

You are right, we did invest heavily almost 12 months ago in to the European market. I personally have spent a lot of time recently in that market to better understand it. It is a more difficult market than what we’re seeing in North America. They are just much more cautious by nature there. As I said, we are finding pockets of opportunity in Eastern Europe and the Middle East but through Western Europe it’s slower than we would like.

We haven’t determined where we’re going to place our new sales heads. We’re going through that planning right now. We want to get a little more visibility in to the results of Q4 and what have you. All I can say is Europe has been a tough market. We’re very excited about our team, we’re very excited about the opportunities and quite a number of big opportunities it’s just a little hard to wrestle to the ground.

Craig Nankervis – First Analysis

Last question, Stewart can you just help me understand how the sales and marketing expense could decline somewhat significantly sequentially on meaningfully higher sequential revenue?

Stewart Grierson

Sure, so from Q2 to Q3 you’re referencing Craig?

Craig Nankervis – First Analysis

Yes, sir.

Stewart Grierson

There’s one just period cost that creates a drop off which is a user conference cost in Q2 which isn’t insignificant. But, in general if we look at our sales and marketing expenses across the board, we reduced costs really everywhere. Quite frankly, we didn’t hire all of the heads to plan, you can see that just from the overall headcount and so there were savings there but there were savings in T&E, obviously recruiting costs even with the hiring but, really across the board we had savings.

Operator

Your next question comes from Jay Meier – Feltl & Company.

Jay Meier – Feltl & Company

I have a question about the cash revenue during the quarter. Did I understand you correctly Stewart, was it $7.8 million in Q3?

Stewart Grierson

The net down, correct.

Jay Meier – Feltl & Company

Just so I understand what that means, it implies that you booked revenue that was paid for in cash during the quarter at a total of $7.8 million?

Stewart Grierson

No, we closed $7.8 million of sales transactions. There was no revenue associated with those, we will recognize the revenue when we collect the cash in the future. So although you think of those as legitimate receivables, legitimate deferred revenue, under GAAP we net those down. But, that will be future revenue.

Jay Meier – Feltl & Company

As we look at deferred revenue and the relationship to your revenue that you generated during the quarter, is there any way to get a sense of what your bookings actually are? Because, if the cash component that you discussed feel as you mentioned from $9.3 million in Q2 and GAAP deferred revenue fell, what does that mean potentially or can we imply anything about your visibility based on that?

Stewart Grierson

Jay obviously as you know, we don’t talk about bookings, we talk about revenue. But, I know you all do the delta between changes in the balance sheet which is why we provide you with the gross numbers I think just to help you give some sense there. But, I don’t think that’s a visibility issue quite frankly. I think Tom in an earlier question talked about our pipeline and how we look at that but you can do the math to get an approximation of where you think bookings might be.

Jay Meier – Feltl & Company

From outside of the company, it appears that bookings were not as robust and yet guidance is strong and that would imply that you guys have visibility beyond what is visible on the balance sheet to us. So, how do we rationalize that? The idea that your service revenues are growing rather quickly because the maintenance and service revenues grew substantially over the last year, I wonder how we can rationalize those dynamics?

Stewart Grierson

The guidance we provided for Q4 Jay is obviously based off of some of that comes off the balance sheet and you can see the color we talked about there but it is looking at our pipeline and what we are forecasting for business that we are going to close in Q4 and based on those two dynamics drives the guidance that we gave for the quarter. Obviously, this is a perpetual license model and so we are dependent on closing business within the quarter to deliver our results.

Jay Meier – Feltl & Company

What percentage of the revenue that you generated during the quarter was cash then?

Stewart Grierson

What do you mean by cash Jay?

Jay Meier – Feltl & Company

I’m having a hard time understanding the relationship between [inaudible].

Stewart Grierson

We can do it through the net down adjustment Jay.

Operator

Your next question comes from Erik Suppiger – Signal Hill Capital Group.

Erik Suppiger – Signal Hill Capital Group

Just two quick ones, on the earnings call last quarter you had said you thought the op ex for the first half of ’09 would be more than the op ex for the second half of ’09, is that still your expectation?

Stewart Grierson

I don’t think I said that Erik, I think you may have misinterpreted what I said on a prior call. I did say that there were some periodic expenses in the first half which would not occur in the second half and the user conference was one of those. Obviously, as I’ve talked about we do expect to increase our expenses in Q4 from Q3.

Erik Suppiger – Signal Hill Capital Group

Secondly, how was the market environment in January? A number of vendors have suggested that January was down considerably. Obviously, you’re doing well but did you see any notable change in the month of January?

Thomas Reilly

Our January performance [inaudible] the last month of our quarter, was on par with prior years so it was very similar. So, we delivered on the numbers. I do sense that it was in general a tough month to close business. Most software companies have customers trained to close in December so that is why our sales force is very much trained to try and bring our quarter business as much in to December as possible and not be too dependent on January. But, our January performance was right in line with prior years.

Operator

That does conclude the question and answer session. At this time I’d like to turn the call back to Mr. Tom Reilly for any additional or closing comments.

Thomas Reilly

Thank you everyone and thanks for the excellent questions and we appreciate how much time you’re spending to get to know our business. We’re very proud of what we’re doing. These are difficult times for all of us whether we’re trying to sell software or invest in companies. Those of here at ArcSight, we do feel very fortunate that we have a solution and value proposition that is of immense value to our customers and we can continue to earn their business even in these tough times.

Our number one strategy is to stay focused on our customers’ success and it’s absolutely turned out to be the right priority. Quite simply, if we’re focused on helping them protect their businesses that’s what’s protecting our business. So, even though there’s a lot of uncertainty going forward, as I answered everyone’s questions earlier in this market we feel pretty confident it’s just the uncertainty of what may happen that we all have to deal with.

But, we’re prepared to keep executing on our plan and finishing out our fiscal year in the current quarter that we’re in. Thank you everybody and we look forward to talking to all of you in the future. Have a good evening.

Operator

That does conclude today’s conference call. Again, we thank you for your participation and you may disconnect at this time.

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Source: ArcSight, Inc. F3Q09 (Qtr End 1/31/09) Earnings Call Transcript
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