VMware, Inc. Q1 2009 Earnings Call Transcript

Apr.23.09 | About: VMware, Inc. (VMW)

VMware, Inc. (NYSE:VMW)

F1Q09 Earnings Call Transcript

April 22, 2009 at 5:00 pm ET

Executives

Paul A. Maritz - President, Chief Executive Officer

Mark S. Peek - Chief Financial Officer

Mike Haase - Vice President of Investor Relations

Tod Neilsen - Chief Operating Officer

Analysts

Heather Bellini - UBS

Adam Holt - Morgan Stanley

Sarah Friar - Goldman Sachs

Kash Rangan - Merrill Lynch

Israel Hernandez - Barclays Capital

Brent Thill - Citi

John Difucci - J.P. Morgan

Philip Winslow - Credit Suisse

Matthew Whittaker - FTN Equity Capital Markets

Jason Noland - Robert W. Baird

Robert Breza - RBC Capital Markets

Operator

Please standby we are about to begin. Good afternoon. Welcome to VMware’s first quarter 2009 conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. At this time, I would like to turn the call over to Mr. Mike Haase, Vice President of Investor Relations. Please go ahead sir.

Mike Haase

Thank you. Good afternoon and welcome to VMware’s first quarter 2009 earnings call. We will have prepared remarks from Paul Maritz, President and CEO and Mark Peek, our CFO. Following the prepared remarks from Paul, Mark, and Tod Nielsen, our COO, will be available for Q&A.

Please note that this call is being simultaneously webcast on our Investor Relations website. Our press release was issued today after the close of market and is also posted on the website.

I would like to remind you that statements made in today’s discussion that are not statements of historical fact are forward-looking statements subject to the Safe Harbor Provisions under federal securities laws. This includes but is not limited to, statements regarding our financial outlook, future product offerings and projected demand. These statements are based on current expectations as of the date of this call and are subject to uncertainties and changes in condition, significance, value and effect as well as other risks detailed in documents filed with the Securities and Exchange Commission including our annual report on Form 10-K for the period ending December 31st, 2008 that may cause actual results to differ materially from those set forth in our statements.

In addition, during today’s call, we will discuss certain non-GAAP financial measures. These non-GAAP financial measures which are used as measures of VMware’s performance should be considered in addition to, not as a substitute for or in isolation from measures of VMware’s financial performance prepared in accordance with GAAP. Our non-GAAP financial measures differ from GAAP and they exclude stock based compensation, amortization of intangible assets, the write-off of in-process research and development, employer payroll tax on employee stock transactions, and the net effect of the amortization and capitalization of software under Statement of Financial Accounting Standards No. 86. You can find additional disclosures regarding these non-GAAP measures including reconciliations with comparable GAAP measures in our earnings release for the period ended December 31st, 2009 and on the Investor Relations page of our website.

The webcast replay of this call will be available for the next 30 days on our Company website under the Investor Relations link.

For your planning purposes, our first quarter [quiet] period begins at the close of business June 16th, 2009. Also, unless otherwise stated, all financial comparisons in this call will be in reference to our results for the comparable period of 2008.

With that, let me hand it off to Mark Peek.

Mark S. Peek

Thanks Mike and good afternoon everyone. Welcome to our first quarter earnings call. Despite the challenging economic environment, VMware had a good quarter in the context of the difficult macro environment and reduced IT spending. We are very pleased with our execution in the field operationally and in our R&D organization.

Customers continue to adopt the VMware platform as a strategic investment to deliver substantial cost savings, improved efficiency and flexibility for their business. But with the economic uncertainty, we are seeing customers reduced their IT purchases in order to preserve cash.

Despite the quick ROI from virtualization, customers have generally put the brakes on all new investments. With the uncertain macro environment, people are doing what you would expect them to do, conserve cash and focus on operations. Any investment has done with extreme caution and done with just enough and just in time.

As a result, despite a couple of large deals, our ELA volumes fell to less than 20% of bookings during the quarter and our total license volumes lag consistent with new server shipment.

In January, I told you that for planning purposes we were estimating first quarter revenue of approximately $475 million. Total revenue for the quarter was $470 million about 1% off of our planning assumptions and candidly given the market condition we feel pretty good about these planning accuracies. However, we saw our continued weakness throughout the quarter in all geographies particularly Europe. Total license revenue declined 12.6% from the very strong first quarter of a year ago compared to our estimate of roughly 10%.

On the other hand, services revenue increased to a very strong 48% as we benefit from our models selling multiple years of maintenance and saw a very strong growth in renewals.

We adopted very well the economic conditions by reducing our non-GAAP operating cost sequentially by 8%, resulting in non-GAAP operating margin of 25.7% and non-GAAP diluted EPS of $0.25 per share. We executed well on the austerity measures we instituted at the end of last year and we will continue to have a laser focus on cost management. But at the same time, and this is a point I want to emphasize, we were able to sustain our investments in the strategic areas of our business and we will continue to invest through this recession.

Our strong balance sheet became even stronger as we now have over $2 billion in cash and $917 million in deferred revenue. Our non-GAAP operating cash flows led by strong receivables management, bookings and cost control were $230 million growth of 51% from last year.

Now, let me take you through some of the details of the quarter. First quarter total revenues were $470 million growth of 7% compared to last year. Services revenues were $213 million or 48% increase compared to last year and up 7% sequentially.

As you would expect given the economic condition, our business mix continues to shift with services revenues continuing to become a larger proportion of total revenue. In the first quarter, services revenues were 45% of total revenues as compared to 33% a year ago.

Total services revenues included software maintenance of $176 million, a 57% increase from last year and professional services revenue of $37 million, up 17% compared to last year.

The professional services delivered around VMware products throughout the ecosystem are growing much faster. Our strategy has been to help our partners to build consulting businesses around VMware to leverage the total capacity available to customers and as a result we expect to see only modest growth in our professional services revenues.

The customer renewal rate from maintenance agreement continues to be strong as demonstrated by growth in renewals of 42% compared the Q1 of 2008. License revenues were $257 million down 12.6% from last year, primarily reflecting a decline in ELAs during the quarter and declining server shipments.

Geographically, United States revenues increased 8% from a year ago to $244 million, representing 52% of total revenue. International revenue grew 6% to $226 million.

I will now provide some details on operating expenses. I must otherwise noted all references to our expenses and operating results on a non-GAAP basis which are reconciled on the press release’s table and on our website.

Total non-GAAP operating expenses including cost of goods sold declined 8% sequentially the $349 million given largely by strong cost management and improved operating efficiencies.

Our total headcount increased by approximately 50 people. Our international expenses were $3 million lower sequentially as the result of the benefits from the strengthening of the United States dollar.

The Q1 operating margin was approximately 120 basis points less due to the operating costs associated with acquisitions we closed over the last 12 months. As a percentage of first quarter revenue, cost of revenues increased sequentially to 12.3% from 10.5%. The increase is due to cost of services revenues driven primarily by some one time support expenses and the professional services mix it was more awaited toward consulting versus training that carries a higher cost of sales.

First quarter R&D expenses totaled $111 million or 23.7% of revenues as compared with 23.1% in the fourth quarter of 2008. On a GAAP basis, we capitalized $36 million for issuance of FAS86 including $6 million of stock based comp and $30 million in cash salaries.

Our accounting policy under GAAP requires us to capitalize cost once we are invaded versions of our product, driven by the GA of vSphere; we expect the amount of capitalized software to decline significantly over the next several quarters of the amortization which is required in cost of license revenues will increase. This will have no affect on our non-GAAP results.

Sales and marketing in expenses were $140 million or 29.7% of revenues compared with 31.9% in the fourth quarter. The improvement was largely due to lower variable costs in the form of commissions as maintenance made up a larger percentage of total revenue.

G&A expenses declined $2 million to $40 million or 8.6% of revenue compared to 8.3% of revenue in Q4. Our operating profit measured on a non-GAAP basis increased 14% from a year ago to $121 million or 25.7% of revenue. Although our current focus is on continued investment and expansion of our market opportunity, we believe we have a strong business model with a long term margin expansion.

Our non-GAAP tax rate in the quarter was 17% and a non-GAAP diluted EPS was $0.25 a share on $391 million diluted share. The Q1 non-GAAP tax rate was lower in the GAAP tax rate for the quarter due to significant FAS86 capitalization related to our vSphere launch.

After with GA vSphere, this difference reversed and we expect our non-GAAP tax rate to increase in subsequent quarters. As a reminder, the guidance we have provided last quarter projected our GAAP tax rate for the full year to be in the 16% to 18% range and a non-GAAP rate approximately four to five points higher in the GAAP rate.

Now, on to our balance sheet and cash flow statements, our balance sheet, once again, strengthened with cash at quarter end of $2 billion a sequential increase of $191 million. We remain invested in short term cash and cash equivalent and have not experienced any decline in valuation of our holdings.

Total deferred revenues increased 5% sequentially the $917 million. Our net accounts receivable declined $74 million from last year and our DSO including the change in deferred revenue was approximately 46 days, primarily driven by the sequential decline in bookings from Q4.

Capital expenditures were $36 million compared to $58 million in Q4. During the quarter, we completed the final building on our follow out at campus and completed our datacenter in Washington State.

The interest rate on our $450 million note with EMC adjusts each quarter at LIBOR plus 55 basis points. For Q2 2009, the rate is 1.76%, 23 basis points lower than in Q1. Similarly, we anticipate our investment rate to be sequentially lower.

Non-GAAP operating cash flows which included adjustments for capitalization under FAS86, and excess tax benefits from stock compensation were $230 million for the first quarter, an increase of 51% from Q1 2008.

On a trailing 12 months basis, non-GAAP operating cash flows were $873 million up 56% compared to the 12 months ended March 2008. Our fulltime headcount at the end of the first quarter was approximately 6,700 people and grew about 50 people from year end.

Before I hand it off to Paul, I want to share with you how we are looking at the business to give you some assistance in developing your estimates. This quite there that IT spending in the first half of 2009 is lower than most third party for predicting at the beginning of the year as demonstrated by both IDC and Gartner revising their 2009 IT spending projections downward to reflect the worsening environment in Q1.

There are a number of factors that impacted VMware’s reported revenues over the near term. First, customers have a little appetite for any CapEx outlays for new projects. Although, virtualization has a high ROI, it is frequently accompanied with hardware purchases and professional service engagements.

Second, we recognized OEM royalty revenue in a rears accordingly shipments made by the x86 system vendors in November through January were our Q1 results and shipments made in February through April will be in our Q2 results. We believe we benefited from the moderate Q4 budget flush in a reported Q1, from what we have seen thus far Q2 will be sequentially weaker.

And finally, yesterday, we introduced VMware’s vSphere to the world. Q2 will be the quarter when we and our expensive set of ecosystem partners begin to go to market transition of vSphere.

The product introduces significant changes in our pricing and our packaging. We will also be billing in foreign currencies for the first time after the GA of vSphere. We believe that in the short term there will be a disruption in the sales profit and close rate thereby potentially impacting our near term license revenue.

Based on these factors, we expect our second quarter revenue was essentially flat compared to Q2 of last year and very likely to decline. For operating costs will increase sequentially from Q1 primarily from activities with the vSphere launch and as a result non-GAAP operating margins could deep to 20% or even slightly below depending on revenue.

This is after taking into accounts or adjustments to GAAP operating income that Mike have listed at the start of the call. Due to the decline in cost capitalize under FAS86; we expect our Q2 GAAP operating margin will be approximately 15 points lower than the non-GAAP margin.

To summarize, we are in this business for the long term and believe we have tremendous opportunities ahead of us. We are managing the business prudently, mindful of providing a reasonable return or continuing to fund the important investment in our strategic initiative.

We have great confidence in our ability to execute on the unique opportunity in front of us. We want to thank our people, our partners and our customers for the strong start to the year and look forward to delivering vSphere during this quarter. Paul?

Paul A. Maritz

Thanks Mark. Good afternoon. As Mark outlined, we managed to return a solid quarter in tough times to amplify on what Mark said, I will give some additional color on both the challenges and the opportunities we faced.

As we outlined during our last quarterly call, we expected that this quarter up to the year end budget flush that we saw in December would be tough and indeed it was. Basically, customers button down their hatches and are reluctant to spend on anything that was not operational. One can see this in the overall x86 server shipments which based on our feedback from OEM partners contracted sharply in the last part of 2008.

The official IDC numbers for server shipments in the first quarter are not out yet that is when they come out I do not expect that they are going to make pretty reading. We also continue to see larger customers to be reluctant to enter in the enterprise license agreements preferring instead to by just enough just in time, and as Mark noted, this has affected our abilities to close large ELAs with some noticeable exceptions that I will mention later on.

On the other hand, we continue to not see significant competitive pressure of pricing pressure. The primary factor seems to be just the board decline in IT spend particularly on new investments with customers buying in small increments.

Against this backdrop for frightening conditions, I am happy to say as Mark outlined that we have executed well in terms of the austerity measures that we instituted late last year and this is reflected in our strong margin performance for the quarter and gives us the financial strength to continue to invest and launch a new generation of products.

Our customers continue to report a virtualization in VMware and particular important to them. We staged three major events so far this year, the VMworld, the European February where we had over 4,700 attendees, one of the few industry events to show an increase from last year in terms of attendance and the most recently we had partner exchange down in Florida where 1,500 of our channel and technology partners attended, again, a very strong attendance and then yesterday as we will cover we obviously have the launch of vSphere.

These customers and partners report the virtualization VMware remains as the top of their priorities. This is confirmed by the various industry surveys. Companies continue to show confidence in VMware and our products particularly in those sectors were spending is still strong. During the first quarter, we booked two of the largest enterprise license agreements deals in our history both for $20 million and over. One with a leading outsourcing and service vendor, they will use those licenses to provision their outsource customers and another one in the defense sector where the licenses will be used to increase the mobility and flexibility of forward trip deployments.

In addition, we now track the deployments and other detailed attributes of over 300 of our major customers and of the 350 major customers that we have surveyed recently over 70% of them have standardized on VMware for their virtualization needs. The more aggressive of these companies have now actually costs the 5,000 mark in terms of the number of virtual machines that they are now managing using VMware software and many of them are heading to 10,000 and beyond.

Another hardening factor that our customers support contracts as they come up for renewal is being renewed in increasing rates. In fact our overall services revenue as Mark outlined for the quarter and grew close to 50% year on year and all of this contributes further to our financial stamina...

Our acquisition of new customers continues to be strong. We had over 11,000 customers. New customers are purchasing virtual infrastructure products for the first time in the first quarter of 2009 and this excludes customers for our work station and products and for our free ESXi server product. But most important of all is new product, the lifeblood of any software company. Yesterday, we formally introduced vSphere, the first generation of new products and we are lucky enough to have executives from our key partners come in person to attend the launch, John Chambers of Cisco, Michael Dell of Dell, Pat Gelsinger from Intel and James Mouton from Hewlett Packard.

This reforms the foundation of a family of new products that are in development. In keeping with our revenue recognition policy, we do not formally announce products until the quarter in which they are available but you should expect us to continue to introduce major products built on this VC Foundation through the remainder of 2009 and into 2010. The products that really transform virtualization from being a narrow CapEx play into a fully pledged system software platform targeting both CapEx and OpEx. It speaks to a new way of organizing x86 based service storage and networking equipment, aggregating them into a cloud hiding the underlying plumbing and allowing fundamentally higher level of management.

This year provides really unprecedented levels of scale in efficiency. We have worked very hard to make sure that there is no computer mode that cannot be virtualized enabling the efficiency and simplicity of turning your entire x 86 servers internal cloud which can support all your applications. We can honestly now say that there is no reasonable technical reason for a custom not to reach 100% virtualization. If you will also carry ground breaking new features full torrents, new ways of doing security, storage Thin Provisioning, Storage V-Motion, distributed power management. We believe that these efficiency benefits alone in vSphere, the ability to achieve greater levels of consolidation and significant gains in storage utilization and power utilization that these gains alone will save customers significant amount of money and justify them moving to vSphere where they be moving up from our current generation of products will be important to the new customers.

We also worked very closely with our ecosystem partners as this vision of an x86-based internal cloud requires that order today physical appliances in fact become virtualized and cooperate with the virtualization layer in the management of the cloud. Now, the canonically example of this is the Cisco Nexus 1000v. Cisco has taken one of their leading mainstream physical switches and converted this into a software module that now plugs into vSphere. The switch can now be associated with application loads, be scheduled with them and travel with it wherever they have application goes enabling greater levels of efficiency and security.

Result is that vSphere is in a very real sense of the world's first operating system for the cloud be it an internal cloud or an external cloud. When I first spoke to you back in July, I said that one of the things that has attracted me to VMWare was the opportunity to build an important new platform and we have realized all the benefits that come from that and we are now actually achieving that goal. We believe that vSphere extends or current lead over our competitors and really changes the nature of the game.

In keeping this, we have refined our packaging and pricing moving some of our older key marquee features down the price curve and replacing them with new features at the top end. While the features of the vSphere speak to the ability to create internal and external clouds, we also believe that these new features are highly relevant to the small and medium size business market. So in addition, we are introducing new packages that are specifically targeted at this end of the market, packages that will provide what we call always on IT in a box as well as packages that will capitalize on our free ESXi server offering. Downloads of ESXi continue to be very strong running at nearly 10,000 a week.

vSphere has significantly broadens and deepens virtualization giving us a foundation to reach for deeper penetration in existing accounts underlying our customers to set a goal of a 100% virtualization. It also opens up new customers for us. So, we will build on this foundation by realizing a series of complementary products that will target three main areas.

The first main area is the series of management suites of products that target important scenarios such as creating the self service datacenter, doing tests and developments, disaster recovery of business continuity and application management. These management suites are important because they will constitute the new user interface to the vSphere platform and allow our customers to get out of the business of managing, plumbing and basically focus on the things that are truly business critical to them.

Second major area is our client desktop space where VMWare view product roadmap continues to be very well received. We have leading edge customers doing large scale deployments of [video IML] and we have many more pilots underway. We expect that the clients for desktop space will contribute significantly to our growth when mainstream deployments kick in probably in 2010.

The third main area is the external cloud which continues to be a very active space for us. Our service providers and enterprise customers alike are attracted to the idea of achieving federation between the internal and the external cloud and that is what the V-cloud initiative is really about. We have over 400 service providers signed up for that initiative and we will be releasing product in the coming quarters specifically targeted at that segment.

On the operational side of the business, we have continued to focus on strengthening the management team here at VMWare. This quarter we welcomed Richard McAniff, the 20-year veteran of Microsoft to become our Chief Development Officer and oversee our product units. We also welcomed Andrew Dutton to be General Manager for our Asia Pacific operations. In fact, without explicitly intending to, each of our geographic regions is now headed by gentlemen who previously fulfilled that role for IBM Software. Equally importantly, we welcomed Scott Bajtos to be Head of Worldwide Support and Renewals. He held similar positions before at SAP and before that, at Cadence. I am now very confident that we have the people management foundation in place that we need.

Looking forward, I am afraid we cannot promise a near-term change from the current tough conditions that we are in. While there are some people promising signs of renewed life in the United States, customers are keeping a very tight reign on any new spend. If there is a bright spot anywhere, it is likely to be confined in the very near term to the federal sector. Europe in particular remains depressed. Asia is more promising but we are still investing there and while growth will be good on a relative basis, it will be small on an absolute basis given from where we are coming.

As Mark noted, the second quarter is also likely to be challenging as it will be the quarter in which we make the major shift from one generation of product to another. We are changing the pricing and packaging with vSphere and that includes a move as Mark said to building in local currencies. In addition, our [eCore] assistant partners basically have to recertify their solutions and while we have made an early and deliberate start on this, it takes time. While these changes are absolutely essential for our future, they are going to have a short term or near term impact as people get educated and make the necessary assessments and changes. What this all means, as Mark noted, is we think it is prudent to basically expect a flat quarter compared to Q2 2008 and even allow for the distinct possibility of downside. As Mark noted, we will continue to be disciplined and manage towards healthy margins but given the transition, we probably will not see a repeat of this quarter's margins in the second quarter of the year.

So, in summary, I am now very confident that we now have the right foundations, vision, products and people to benefit significantly when the economy turns around. At this point, we will open up for questions. I am here. Mark is here obviously and Ted Neilsen, Our COO, is also here. Operator, let us begin the Q&A session please.

Question-and-Answer Session

Operator

(Operator's instruction) Your first question comes from the line of Heather Bellini - UBS.

Heather Bellini - UBS

I was wondering, Mark, this might be a better question for you. How much of your guidance for the second quarter could be attributed to the macro environment versus the disruption you mentioned from the vSphere launch because I guess what I am trying to get a sense of is that normally, we should expect your services revenue to grow sequentially. So, I am just trying to get a better sense for the license distribution and then how we should expect things to bounce back in Q3. Thank you.

Mark Peek

Well, Heather as I mentioned in my prepared remarks, there is really three factors. One is the macro environment. What we do have visibility in is our services revenue, particularly the maintenance revenue that will amortize during the quarter and so we would expect maintenance revenue to be up sequentially in the second quarter relative to the first quarter. But we are also citing the revenue recognition that we have on OEM and that we will expect to be down sequentially on license revenue from our OEM royalty business and also we do not expect to see large enterprise agreements in volume during the second quarter and on top of that, the introduction of vSphere and you get the aggregate guidance that we provide.

Heather Bellini - UBS

Okay, so is the macro a bigger factor? Is the macro three quarters of your flat guidance for the year in vSphere? I am just trying to get a sense of the magnitude of each of those.

Mark Peek

Yes, it is hard to disaggregate the component part but what happened is in an uncertain environment in which our visibility is challenging, we are adding more uncertainty with the new product introduction.

Heather Bellini - UBS

Should that bounce back then in the third quarter, from the license perspective?

Mark Peek

Well, in the third quarter, we will provide fuller guidance on the third quarter in July. All we can tell you is that from a historical trend perspective, Q3 and Q2 have looked very similar but we will have more information and more knowledge as to how the launch goes and better market information at that time.

Operator

Your next question comes from the line of Adam Holt - Morgan Stanley.

Adam Holt - Morgan Stanley

A couple of questions about how we should be thinking about the potential impact of vSphere on revenue; you noted that it will take a little while for your partners to get decertified and obviously to get loaded into the channel. If we are assuming a late May release, when should we start to see a sort of general availability in the channel, number one and number two, how should we be thinking about the potential revenue impact? Would you expect the average selling prices to be going up? Would you expect to see acceleration in units possibly as early as the third quarter? How should we be thinking about the elements there?

Paul Maritz

This is Paul. I will jump in there. I think you should think of vSphere having a strategic impact rather than a tactical impact. Our software is foundational software. It sits at the bottom of the stack and has lots of other layers and solutions sitting on top of it which means that while the changes are fundamental, they happen slowly than other forms of software. So, we think that vSphere is very important because it strengthens us strategically. It allows our customers to do new things. It keeps us ahead of our competition. But you cannot think of it in terms of giving a near-term hit. This is something that is going to have to work its way through the system. So, I would be not be looking for a near-term pop from vSphere.

Adam Holt - Morgan Stanley

And what would you, what kind of impact would you expect to have on your ELA business? Are people buying ELAs right now entitled to upgrades or how should we expect to see that unfold?

Mark Peek

One of the things that vSphere will do is quickly show the great value of our maintenance. We are going to provide increased functionality on the like products with the maintenance release that the people are eligible under their current contracts and so we think that what we need to do is to just take our customers for new ELAs, take our customers through the new features and the products along with our channel. They will be looking at certification of their existing hardware and their future hardware purchases and going through the buying decisions but that said, it will be in the headwind of the current macroeconomic environment.

Adam Holt - Morgan Stanley

Just one quick question on the margins, obviously you are looking for margins to be down significantly in the second quarter. Are there any one-time expenses in Q2 either related to launch marketing or anything that maybe unusual in the second quarter or is that kind of the right expense run rate going forward?

Mark Peek

There are a couple of factors. We did add $35 million worth of capital during Q1 and so will have the depreciation addition in the second quarter but we have expenses around not only the launch and the marketing around the launch but also contractors in readiness for the ultimate shipment of the products.

Operator

Your next question comes from the line of Sarah Friar - Goldman Sachs.

Sarah Friar - Goldman Sachs

Paul, I think you laid out quite a lot of points that kind of deflect the competition question but as folks look at your revenues, they always get concerned that it is not just a macro that you are starting to see more of an impact of competitors like Microsoft get their products out into the market or maybe even then kind of coming in at a lower price point. What else can you tell us in terms of how you measure win rates? How those have changed over the past three to six months? So, I think your installed base in clearly quite sticky given the renewal rate but what about new deals as they come up? How has that been changed then?

Paul Maritz

We try and get the very best intelligence that we get on that which clearly our competitors do not tell us directly so we have to rely on our field sales force and our channel partners to tell us that and believe me, this is a question that we constantly ask them. We were just down, as I said, we just had our channel partner vent in Florida last week where they had 1500 is not there and the best intelligence that we can get is that at this point in time, competition is not a factor. That is the macroeconomic conditions are the major factor and that is what our direct sales force tells us as well.

Now, we know that Microsoft is preparing to launch their Window Server 2008 and we expect increased competition from that and we hope that this year, we will further moved the bar for us but the best knowledge that we have at this point in time, competition is not the major factor.

Sarah Friar - Goldman Sachs

Got it and if I could just one more and I wish to have Mark, you talked at the very beginning of the call about being pleased with the accuracy of your prediction on the quarter, I think plus or minus 1%. As you looked out to the guidance for the second quarter, were there any changes in your assumptions about things like coverage rates in the pipeline visibility continuing to decline? How did you think about that as you talked about second quarter guidance?

Mark Peek

The biggest impact on looking at coverage ratio is in the actual conversion of coverage ratios in the second quarter is what impact would the vSphere launch have and so, we have done some work around that but it is really too early to tell how that will convert into revenue during the second quarter. The other that we have baked in is the fact that we will begin to bill in local currencies, in most major local currencies in the world during the quarter and that will add another level of complexity really from a change management perspective with our channel in EMEA, Australia and Japan.

Sarah Friar - Goldman Sachs

But it sounds like your overarching assumption is things are not getting any better here, that Q2 is just another kind of symptomatic of Q1 in terms of the environment.

Mark Peek

Yes, we are not calling the bottom in Q1.

Sarah Friar - Goldman Sachs

That is okay.

Operator

Your next question comes from the line of Kash Rangan - Merrill Lynch.

Kash Rangan - Merrill Lynch

Mark or Paul, I was wondering if you could give us some commentary on ELA as you have clearly indicated that it was over the less than 20% of bookings. How should we expect that metric to trend over the next couple of quarters and also, Mark I know you have disclosed the license backlog number. I was wondering if we could get an update on that.

Mark Peek

Sure, I will take it. On ELA, that was, we were below 20% this quarter and that was also with a couple of fairly significant enterprise agreement that made up about a third of the dollar value, the total ELAs and so as we are looking ahead, again, the environment we are seeing is that people are being very cautious about large investments and so I think it will be really up more to the macro before we see large enterprises agreements come to fruition again. On deferred license revenue as we have been saying over the last few quarters, it has been relatively flat and once again this quarter, the deferred license revenue under the total deferred revenues are very small percentage and it was up of a few million dollars but not appreciably different from where we ended the year.

Kash Rangan - Merrill Lynch

Got it and also on the webcast yesterday for the vSphere launch, we have been getting actually ton of good feedbacks from customers on fall patterns and some of the other functionality but yet I could not help but notice that the pricing per core went down quite a bit from the previous version. I was wondering why that might be the case or what is the strategy here? Are you looking to offset that pricing per core decline with the higher volumes when the economy starts to, but I just want to get your thinking behind the contradiction here. The functionality is getting stronger and stronger. But the pricing, it looks like it could have been a little bit even better than what you put out there.

Paul Maritz

This is Paul, I will jump in there. We obviously spent many quarters studying that question in detail and the pricing and packaging is always, you are trying to balance many factors and we did an extensive customer survey to try to find the right price points and functionality points that would have appealed to the breadth of customers that we address and we really have three customer segments that we need to at least, three customer segments that we need to be thinking about with what the small and medium size customers at the one end and we have done specific pricing and packaging for them. We have our good enterprise customers at the other end. We are buying large, I do not want to say things of price inelastic but where people are willing to pay for value and we have tried to create packages for them.

If it gets hurry in the middle, they want to have tread carefully and clearly, that is where we know that our competition in the future will focus so we are trying to on the one hand make sure that we harvest value from our customers we appreciated but not inadvertently open up beachheads for our competition and we are in competitive market. We do have to think about that and we have tried to strike the right balance.

Operator

Your next question comes from the line of Israel Hernandez - Barclays Capital.

Israel Hernandez - Barclays Capital

Can you guys talk about what conditions you thought through the quarter in terms of linearity? Did it get off to a tough start and just remained tough or did you see some improvements particularly during the month of March when the capital market seemed to have settled down a bit? Can you just talk about this type of flow in that kind of core mid-market segment as you exited the quarter?

Paul Maritz

I think certainly the year has started very tough. January was as we said after December basically, everyone buttoned down the hatches in January. While there were increasingly some signs of improving sentiment towards the end of the quarter, it has not yet translated into people wanting to open their wallets. We got a lot of positive feedback in April from our channel partners saying that they are feeling better about the rest of the year but we have not seen that actually translate the feet on doing what the mouth are doing here and we have to base our projections on where we see people's feet going as opposed to where we see people's mouth is going.

Israel Hernandez - Barclays Capital

Great, thanks and clearly, you guys are having a tough time and it was a large enterprises with the ELAs. I mean, can you characterize the demand that you are seeing among your mid-market customers? Is it the same trend there as well?

Paul Maritz

They have always been much more cautious buyers. They always tended to buy on a not too forward buying and buy on an as-needed basis. In that area, we are just seeing the same secular decline or easing that we have seen in the market as a whole.

Tod Neilsen

One thing to add to that too just to be clear, we are not seeing the demand for virtualization dropped off from a customer perspective. It is just the scope and size of the project they are trying to contain it more. So they are trying to contain it more so they are absolutely still have virtualization on the top of their priority list. It is just instead of doing a larger EAL and buy forward, they are buying in smaller increments.

Operator

Your next question comes from the line of Brent Thill - Citi.

Brent Thill - Citi

Paul, I have a question for you and a question for Mark. Paul, more on a distribution side, historically you have been 75% indirect, 40% of your accounts receivable in the last quarter came from two distributors. So, as you go towards vSphere, it seems like it is a shift towards a more direct sells but more solution sell. It is going to require having your list from your sales force. Can you just talk about where you think the channels partners are in terms of their training around vSphere and is this tying back in your comments why you do not think there is a minuet pop on vSphere because it is a more complex sale?

Tod Neilsen

This is Tod. I will take the first crack a bit. We actually disagree with your theory there. We think that the partner is going to play an even more important part in the selling of vSphere. At our partner event we have last week in Orlando, we spend a week with our partners working with them on training and really further helping them segment and focus on their core competencies and whether they are adding solution selling or they are bundling us with other solutions that they resell or if they are a technical partner that integrates with us. We are really trying to focus on expanding our reach and breadth through our channel. We have been rolling out a series of training programs over the last few weeks and we will continue to role this out through May and June to make sure our channel is ready to expand.

Our direct model was certainly an important part, selling our value proposition but in many ways, we view that as a complement or a spearhead to help the channel drive and make our revenue happen.

Paul Maritz

The only color I will give on that is well, vSphere can seem somewhat intimidating in terms of the number of new features and functionalities it provides. We have also worked very hard to try and improve the usability and user interface with the product taking a lot of feedback from our customers going through intensive workshops with them and if you are watching the launch yesterday, you would have noticed that even the feature that like full torrents in the previous solutions would have required quite a bit of technology and expertise to set up literally is just turning on a property now.

So, while the product area can seem like an intimidating product, we have tried to work hard to mitigate that and we actually think that some of the more advanced features in the product like full torrent will actually receive a very strong reception at the lower end of the market, the SMB market where they can use if they actually dramatically simplify things.

Brent Thill - Citi

Okay and just really quick for Mark, the international businesses lag two quarters in a row before I’ll trade to the US. Is that more a function of the macro or is it just you do not have the right resources in place to reenergize that growth rate?

Mark Peek

I think it is more a function of the macro. As we mentioned last quarter that we saw particularly late November, December that things in Europe started to soften and that carried through during the entire first quarter.

Paul Maritz

I think one little color here is you have to look at the IMF report that came out today with the German economy contracting 5.6% this year, UK economy contracting 4.something percent. It is pretty dire over there.

Operator

Your next question comes from the line of John Difucci - J.P. Morgan.

John Difucci - J.P. Morgan

I would like to follow up to the first question from Heather. Mark, you gave guidance that total revenue is going to be flat to down year-over-year and that implies license revenue is going to be down about 20% year-over-year and I am just trying to get a better feel for that after being down 13% year-over-year this quarter so that sounds like it is getting worse. Now, do you do vSphere coming out and Paul said that not to expect a pop from the vSphere but it sounds like, we should be expecting this to really I do not know, stall purchases and you do see that ahead some of the release like this. Maybe to help understand this, if you are paying maintenance, if you own the I3, if you own your platform and you are paying maintenance, now vSphere has a lot more functionality you add too. Do you get everything in vSphere if you are paying maintenance and everything and your current platform? And if you are not, then are you putting yourself in a position where everybody is going to delay purchases and maybe this 20% down year-over-year is an optimistic outlook?

Tod Neilsen

This is Tod. I will take your first crack at that. So, regarding the packaging, if you are a current customer and your maintenance contract is current, you are entitled to an equivalent set of functionality or package in the vSphere packaging. However, some of the new higher end features like host profile and things like that, we actually have a package we call Enterprise Plus and that is something that we expect our enterprise customers will upgrade to once they understand that it is more about the technology.

So, we think we have done a good job of migrating some of the functionality further down in this back to remain competitive and extend our lead and make technology more accessible to more folks but putting more value at the higher end and encouraging our existing customers to upgrade as well as new customers to purchase that.

Mark Peek

And we want to make sure that the value proposition of our maintenance continues to be strong as it has been in the past and has been our history but we will have a concerted effort on upgrades to Enterprise Plus or whatever the equivalent packages because not all of our customers have bought enterprise in the past.

John Difucci - J.P. Morgan

Okay, so going from minus 13% in license revenue year-over-year to minus 20%, is that delta that minus 7%? Is that due to people just sort of delaying, just waiting to come out with vSphere before they actually purchase? Is that what you are anticipating? Or again to Heather's first question, is it because the macro economy you think looking at your pipeline is actually getting worse in the second quarter?

Paul Maritz

This is Paul. I think back to Heather's question in a way Mark answered it, it is the three factors that Mark mentioned and at this point, we are providing you our kind of test view of how those three factors will interact. We have, as you have seen in the last two quarters, once we get into the quarter, we have been pretty accurate in where we thinks, where it actually ends up just both good and bad news. But that is our best judgment at this point.

John Difucci - J.P. Morgan

Okay, just one last one on that…

Paul Maritz

Hello?

Operator

One moment, please. You are open, Mr. Difucci.

John Difucci - J.P. Morgan

Yes, I am sorry. On the maintenance stream, getting the macro is tough, some of your customers are having tough times certainly. Are you getting more pushback on maintenance or are people asking for some maintenance relief today and are you actually doing any of that?

Mark Peek

No. In fact, quite the contrary. Our renewal rates on maintenance was very strong during the quarter and we think yesterday was really a proof point as to the value of that maintenance with the vSphere really.

Operator

Your next question comes from the line of Philip Winslow - Credit Suisse.

Philip Winslow - Credit Suisse

I just wanted again to extend a little bit, you mentioned they will be up quarter to quarter. I am just wondering if how you see that playing out across sales and marketing, and R&D and also on R&D, obviously you have seen pretty high level as you have with the past three quarters. With the launch of vSphere, how should we think about that trend and also just the impact on OpEx?

Paul Maritz

We lost the first part of your question. Can you just summarize it for us again, please?

Philip Winslow - Credit Suisse

Just on the spending side with operating expenses, you mentioned they will be up quarter to quarter. I am just wondering if you can give some ties between sales and marketing and R&D and G&A.

Mark Peek

Yes, most of the sequential increase that we expect to see during the quarter is related to the launch and that is a combination of marketing and engineering.

Philip Winslow - Credit Suisse

And then also just to the effect going forward of the vSphere launches where you have mentioned the capitalization of R&D would come down. I am wondering if you could just give as little more direction on that.

Mark Peek

Yes, what we called out on operating margins is that we expect the total of about a 15 point gap in the second quarter between the non-GAAP operating margins and the GAAP operating margins. So, when you look at what historically has been primarily driven by the stock-based compensation, you will see that gap widening a bit because of capitalization.

Operator

Your next question comes from the line of William Fearnley - FTN Equity Capital Markets.

Matthew Whittaker - FTN Equity Capital Markets

This is Matt Whittaker on for Bill this evening. My question was on, there is a little commentary on we think customers buy more or just in time, just enough. On the just in time part, is that also to say that decision cycles themselves are getting shorter, customers just need less time to do the evaluation and they are just trying to pull the trigger with much less hesitation?

Tod Neilsen

Unfortunately not. It means that they are basically just bending cash and try to distribute that in the small amount as possible, as late as possible.

Matthew Whittaker - FTN Equity Capital Markets

Okay and I guess on the just enough side, you think customers forego substantial long-term discounts just in order to meet short term needs?

Tod Neilsen

Without any question.

Matthew Whittaker - FTN Equity Capital Markets

Any chance that you quantify that a little?

Paul Maritz

It is hard to quantify it but it is a very distinct trend that we have seen. We have seen it in many cases where we have even been fairly far into the cycle of the getting an ELA structured and approved through the CI organization have it get to the CFO's desk and then be converted into a less of purchasing.

Tod Neilsen

Operator, we are going to take two more questions please.

Operator

Your next question comes from the line of Jason Noland - Robert W. Baird.

Jason Noland - Robert W. Baird

Just a couple of short questions. First on the large deals $20 million plus I believe For each, certainly those are going to be hard to come by in this environment but do you have more visibility in a deal of that size and then just broadly, is the opportunity for deals like that in more normal days real?

Paul Maritz

Well, those deals, one of them just came out of the outsourcing sector and the other came out of the federal sector. If there is any silver lining in the current situation is the federal government has money and is spending it and we think that while we cannot guarantee that we will get another deal like that in this quarter, there are certainly the opportunities for more deals like that in the federal sector.

Jason Noland - Robert W. Baird

Fair enough and then just a short question for me on the launch yesterday. There was a couple of storage features highlighted, Storage V-Motion and then Thin Provisioning. I guess, are these complementary to what a storage hardware vendor would do or would they be viewed as substitute solutions?

Paul Maritz

No, they are complementary. The one they both work with existing storage solutions. The one, Thin Provisioning as you consider think of as virtual memory for storage. So, it allows basically much more efficient use of storage and the Storage V-Motion allows you to migrate information from one storage array to another without stopping or starting your virtual machines. So, customers love that in terms of a number of scenarios.

Operator

Your final question comes from the line of Robert Breza - RBC Capital Markets.

Robert Breza - RBC Capital Markets

Paul, I was wondering, you just comment in talking with customers in the launch around the new product, do you see that extending the sales cycle? Obviously, the more complexity has introduced a longer sale cycle and then maybe can you comment on how ready do you think the sales force channel is ready to sell the new products or is there quite a bit more training you need to go through? Thanks.

Paul Maritz

Well, as Tod said, we have been working very hard on preparing our channel and doing training and there are a number of programs we have instituted there. We have increased the number of authorized partners who can conduct training so our capacity to do training on a worldwide basis in local languages is dramatically higher than it was for the previous launch that we had. So, we would be doing a lot in that department but we think actually that the genius of virtualization is that is an undisruptive technology and a lot of these features that we provide are designed to kind of just slot right in without disturbing anything. So, if you want to do full torrents as I said it is literally, basically you fire up the management console and you pick the load that you want protected and you check a box next to them. If you want to migrate storage in real time from one array to the other, again, you fire up console and basically initiate it and it will happen automatically.

So, well conceptually these are sort of new concepts for the industry and they have historically been associated with fairly complex solutions. Our value proposition is we take the complexity out of it. Our whole essence is to hide the plumbing and make it happen. So, while we think that there is going to be certainly some near-term lag while people just grab their money around these issues, we are hopeful that the combination of the investment of training we have made and the investment in product that we have made that this will not create an undue burden. It may very well in fact have the opposite effect.

Tod Neilsen

Okay, great. Thank you everyone for participating.

Operator

And this does conclude today's conference call. We appreciate your participation. You may disconnect at this time.

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