Isilon Systems, Inc. Q1 2009 Earnings Call Transcript

Isilon Systems, Inc. (ISLN)

Q1 2009 Earnings Call

April 23, 2009 5:00 pm ET

Executives

Chris Blessington - Senior Director of Marketing and Communications

Sujal Patel - President and CEO

Bill Richter - VP of Finance and CFO

Analysts

Amit Daryanani - RBC Capital

Kat Smith - Morgan Stanley

Sid Parakh - McAdams Wright Ragen

Presentation

Operator

Good day ladies and gentlemen, and welcome to the First Quarter 2009 Isilon Systems Incorporated Earnings Call. My name is Louisa and I'll be your operator today.

At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions)

I would now like to turn the call over to Mr. Chris Blessington, Senior Director of Marketing and Communications. Please proceed, sir.

Chris Blessington

Thank you, Louisa. Good afternoon everyone. The purpose of our call today is to discuss results for the first quarter of fiscal year 2009. With me this afternoon are Isilon's CEO, Sujal Patel and CFO, Bill Richter. Following their prepared remarks, we will open the call up to questions.

If you haven’t seen a copy of today's press release announcing these results, it's available on the Investor Relations section of our website at www.Isilon.com/company.

A recording of this conference call will be available on the website later this evening through midnight Eastern Time on April 30. Details on the playback are included in the press release mentioned earlier.

On this conference call, we will be referencing both GAAP and non-GAAP financial measures. When we review gross margin, operating expense, operating loss and net and net loss, we may be speaking in non-GAAP terms, which excludes stock based compensation.

We believe that excluding these expenses gives our management and investors a better indication of our operating results.

During this conference call, we will make forward looking statements about our business and expectations for the future. These forward-looking statements are subject to risks, uncertainties and assumptions.

If the risks or uncertainties ever materialize, or the assumptions prove incorrect, our actual results may differ materially from those expressed or implied by our forward-looking statements.

These and other important risk factors and assumptions are detailed in documents field with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the year end of December 31, 2008 and other filings.

These risk factors and assumptions could cause actual results to vary from expectations. The company makes no commitments to revise or update any forward looking statements, in order to reflect subsequent or circumstances.

And with that, I will now turn the call over to Sujal.

Sujal Patel

Thank you, Chris. Good afternoon everyone and thanks for joining us today. To get started, I would like to ask Bill to provide a review of our Q1 financial results. But before he does, let me take a moment to congratulate Bill on being named Isilon's Chief Financial Officer.

During his 17 months as our Interim CFO he earned my confidence and the confidence of Isilon's Board, through his own efforts and by building a world class team, Bill proved that he is the right person to lead Isilon’s finance and accounting organizations.

With that, I will turn the call over to Bill.

Bill Richter

Thanks Sujal, and good afternoon everyone. Let me start my review with the income statement. Total revenue in the first quarter was $26.9 million, up 11% from $24.1 million in the first quarter of last year. Sequentially, total revenue declined 15% from $31.8 million in the fourth quarter.

Let me give me some detail on our Q1 revenue. Geographically, the breakdown was 77% North America and 23% International. In dollar terms, North American revenue in Q1 was essentially flat compared to Q4, so you can see that the international sales really drove the overall sequential decline.

While all territories around the world were impacted by the difficult economy, some particularly in Europe and parts of Asia had the added impact of weakening currencies. Together these factors lead to a disappointing quarter over seas.

Sales through the channel drove 51% of revenue in Q1, down from 54% in Q4. As you'll recall, virtually all of our overseas revenue is through channel partners. So, the decline in the channel revenue percentage was obviously impacted by the decline in international revenue. The percentage of sales through the North American channel increased in Q1 both sequentially and year-over-year.

Software application sales contributed 9% of our total revenue, compared with 10% in Q4 and 9% in the comparative period a year ago. In Q1, we acquired 48 new customers representing 15% of revenue in the quarter. Sujal will comment on new customer results in a minute.

Now I would like to review our gross margin. But before I do, let me just remind you that our Q1 results including $3.8 million non-cash inventory write-down. This reduced both our GAAP and non-GAAP results by 14 percentage point.

With that said, let me give you the breakdown on our margin. Product margin in Q1 was 44%, backing out the impact of the inventory write-down product margin was 58%, which was down about two points from Q4.

As we mentioned in early April, we did experience some pricing pressure in the market place with some of our competitors putting forward very low pricing to protect their accounts.

In the first quarter we implemented a number of new programs to reduce our product cost. We expect to see some benefit in Q2, but we will have to wait till Q3 to see the full impact on margin.

Service margin was 31.2% in Q1. Again backing out the inventory write-down, service margin was 46%, which was flat with Q4. In the past, we have said that we expect service margin to hover around 40% in the near to medium term. We now expect near-term service margin to be in the mid 40. That's the result of substantial improvements in our services organization over the course of the last 12 months that are driving better customer experiences, while reducing costs.

In the first quarter, total operating expense was $19.9 million, down from $20.9 million in the fourth quarter of last year. As you recall, during our fourth quarter results call, we said that Q1 OpEx would be sequentially up, due to the full impact of hiring late last year. But as we saw conditions becoming increasing difficult in Q1, we quickly implemented programs to reduce operating expenses across the organization. In fact, if you exclude the costs of the audit committee review that closed in Q1 of 2008, OpEx on a year-over-year basis was virtually flat in the first quarter.

In Q1, the non-GAAP net loss per share was $0.14, which includes $0.06 of loss per share associated with the non-cash inventory write-down. This compares with the non-GAAP net loss per share of $0.04 in Q4 and $0.14 in Q1 of 2008. If you recall, the Q1 2008 results included $0.04 of loss per share associated with the costs of our audit committee review.

I'll wrap up with few highlights on the balance sheet and cash flows and then end with a few comments on our outlook for 2009. We ended Q1 with over $76.3 million in cash, cash equivalents and marketable securities, compared with $77.8 million at the end of last quarter. In the trailing 12 months, we have used less than $2.5 million of our cash in investments and that includes spending $2.9 million on the audit committee review in the second quarter of 2008.

Total deferred revenue grew $1.6 million to $28.8 million, up from $27.2 million last quarter. DSOs were 45 days compared to 41 days last quarter, which was anticipated given the slow start to Q1. I want to spend a minute discussing how we expect to run the business for the rest of 2008.

As we have previously announced earlier this month, we took the difficult but necessary step of cutting headcount by about 10% in order to accelerate our cash profitability and sustainable cash flow. This will result in a charge about to $850,000 in the second quarter and cuts approximately $1 million of excess from our cost structure.

Excluding the cost of restructuring, we expect Q2 OpEx to be around $19.5 million. That reflects the savings I just mentioned, offset by some additional expenses for variable sales comp and seasonal trade shows that occur in the second quarter.

For the remainder of the year, we expect to keep operating expense virtually flat, with the exception of growth of variable comp related to sales compensation expense.

This operating expense path will result in order to achieving non-GAAP breakeven with revenues of about $35 million, a significant improvement from our previous breakeven point, which required revenues in the low 40s.

Internally, we are modeling this with gross margin in the mid to high 30s. As you can see, we are focused on moving towards profitability at an accelerated pace. Now we have made important adjustments to our business model to make it achievable within relatively short period of time. Just how much time will be highly depended on the broader economy, but I can assure you that the whole company is rallying around this objective.

With that, I’ll turn the call back over to Sujal.

Sujal Patel

Thanks, Bill. Well, the first quarter presented most difficult IT selling environment that anyone can remember. Q1 was also a time that, I thought extended our leadership of the scale-out NAS category.

In early March, we introduced a suite of ground breaking new products that again demonstrate our rapid product innovation, while redefining the competitive dynamics of the market place.

These products the ultra high-performance S-Series and the high density, high value NL-Series, extend Isilon's unique and compelling value proposition to a much broader range of work flows, applications and data access patterns. They also broaden our addressable opportunity within new and existing customers.

Uptake of the new products particularly in the S-Series has been strong. The new IQ 5400S, which can scale to three times the IOPS of our X-Series nodes was designed to provide ultra-fast primary storage for highly transactional, low latency and random access file based applications.

Customers in the media and entertainment space use the S-Series to drive their most demanding post production work flows. In Web 2.0, customers are using S-Series in environment where they are injecting large amounts of parallel data.

In chip design and the IC manufacturing space, customers have dramatically shortened their time to market by utilizing the S-Series nodes to optimize the performance of their mission-critical design and simulation work flows.

At the other end of the storage spectrum, the new Isilon NL-Series is purposely built for cost-effective, large capacity storage; pure and simple. It's designed for organizations weighing the cost of storing ancient data set, against the need for online availability.

The Isilon IQ 36NL redefines the economics of scale-out NAS solutions by proving near primary scaled performance at near take cost. By that I mean that the 36NL allows customers buying Enterprise class scale-out NAS solutions at a price approaching at $1000 per terabyte.

Needless to say, this makes the NL-Series of very compelling value at a time of flat and shrinking IT budgets. As we moved through this quarter, you can expect to see additional products and partnership announcements that result from this move into a broader range of workflows and applications. I'm very excited by the opportunities that these new products create.

Let me just take a moment to address new customer acquisitions. There is no question that Q1's soft economic conditions were a major factor in our new customer results.

Many companies did not release budgets until late in the quarter, and when they did, they were written in pencil. A pervasive sense of caution on the part of IT buyers caused the lengthening of sales cycles and in many cases, pushing off of deals.

Despite the short-term delays we saw in Q1, enterprises continue to experience a massive growth in their file-based data, and Isilon's product remain the best available solution to the challenges caused by that data growth.

I'm confident that our new customer acquisition rate will improve, when that pent up demand begins to create more normalized purchasing patterns. That being said, we are not simply waiting for an economic turnaround.

We've implemented a multi-faceted, cross-functional plan to drive improved new customer revenue and look forward to seeing results from those actions.

Critical element of that plan is to more fully leverage and expand our indirect sales channels. The new channel program that I discussed during our last results call differentiates Isilon from other major storage vendors, and continues to receive a very favorable response.

As I mentioned though, it will take some time for that program to take root. Knowing how to build out and optimize each of our critical routes to market, direct, channel, strategic alliances is something that George Bennett, our new Senior Vice President of Worldwide Field Operations understands very well and has deep experience with.

During his year of running America Sales at NetApp, George worked very closely with Leonard Iventosch, Isilon's Vice President of Global Channels and OEM. Together they build and drove NetApp's indirect sales channel often mentioned among the best in IT. I am pleased that George and Leonard have been reunited here at Isilon with a clear mission to recreate the same kind of success and to drive our company to the next level of growth.

As Bill reported during his remarks, I am going to close management of cost enable that to keep operating expenses flat for the back half of 2008 and to reduce them by nearly 5% in Q1.

In addition, and in response to challenging economic conditions, at the very start of Q2, we took swift and decisive action to further control cost by implementing a workforce reduction that impacted approximately 10% of our global employee base. The reduction further optimizes our cost structure, while enabling us to maintain a rapid rate of product innovation. That product innovation is the foundation of our long-term value and success.

Looking forward, I am excited about the opportunities before us, we have made some tough, but necessary decisions and our team is focused and energized with a new sense of urgency and purpose. Our ability to innovate is firmly intact and we have a team that’s ready to embrace the opportunities and challenges away.

I am confident that with our senior leadership team now fully in place, our broad new suite of scale-out NAS solution, strong balance sheet and focused business execution will emerge stronger and better position then ever for long-term success.

With that Bill and I are happy to take your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Amit Daryanani with RBC Capitals. Please proceed.

Amit Daryanani - RBC Capital

Just a question on the international side, I may have missed the start of this thing, but it looks like it's down about 50% sequentially. Could you just talk about what's driving the softness there really and have you done some management changes in your media operations as well recently?

Bill Richter

Sure, Amit, just on international sales. You are right the results this quarter were significantly less than last quarter, which is a real 180 from the performance of the last few quarters. Where the economy was challenging in the US in Q1, I think it was even more difficult abroad.

It seems that their economic pain lagged ours by a couple of months and so in a while we saw the US sales in March improve, international was slow to recover. Overall, we continue to like the bet that we placed abroad and believe that they’re certainly part of our long-term strategy.

Sujal Patel

Amit, this is Sujal. The answer to the other half of your question, you asked about leadership changes. I will confirm that, we are in the process of making a leadership change in EMEA and that’s not really in response to Q1 results, which were down significantly. But I think more in response to the fact that we see a tremendous amount of potential in Europe and the broader EMEA territory. And we are in the process of that talking to a number of industry leaders, who have been very successful in EMEA in the past and expect to make an announcement there in the future.

Amit Daryanani - RBC Capital

And then Sujal just to make this clear, on the European side, the softness is really more a reflection of macro issues rather than anything Isilon or Isilon's channel specific. Is that fair?

Sujal Patel

What I would say is that the sequential change that you saw from Q4 to Q1 is largely driven by macroeconomic condition. So, I don't believe anywhere in 2008 we achieved the potential that the EMEA territory has and that's what the leadership change is all about.

Amit Daryanani - RBC Capital

Got it. Could you just maybe talk in general about what you see in terms of pricing and sales cycle. I know you talked about the fact that it’s stretching out a little. But, one of your larger peers was on today and talked about seeing more pricing pressure in the business. Are you guys seeing the same thing and how do you react to that?

Sujal Patel

There's kind of two parts to your question. The first part is really about sales cycles and one of the trends that we and I believe every major storage vendor is seeing today is elongation of sales cycles.

Getting a PL from a customer and getting an order takes extra signatures than it took a year ago. Ever single dollar of CapEx is being scrutinized at multiple levels, customers' budgets, like as I mentioned in my prepared remarks are written in pencil and they are reevaluated on a quarter-by-quarter basis.

What that does is it, it not only reduces the supposed rates of deals in the pipeline, but you certainly see an elongation of sales cycle. And that's really causing us to re-look at the metrics that we use to run the business in this new economy.

The other part of the question was really related to the pricing pressure. As I mentioned in the prepared remarks, we also mentioned on our early April call, we certainly have seen the incumbent vendors of the state, NetApp and EMC and perhaps some others get very aggressive on price, and we certainly had a little bit of March compression which you saw on our results relative to that.

All-in-all I was pretty pleased with our ability to maintain product gross margins in face of that pricing pressure, and I think that's really a testament to the value proposition and the importance of our products in the customer base that we go after.

Amit Daryanani - RBC Capital

Just a final one from me, the interim 50,000 charge in Q2 is that all essentially cash charges or is there a non-cash component as well.

Bill Ritcher

It will all be ultimately cash, although the cash effect will be spread over Q2 and Q3.

Amit Daryanani - RBC Capital

Thanks a lot guys.

Operator

Your next question comes from the line of Kat Smith with Morgan Stanley. Please proceed.

Kat Smith - Morgan Stanley

Good afternoon, guys. Just wanted to talk about the relative strength that you saw in March, are you seeing that continue in to April or are you way back to the soft stuff that you experienced in January?

Sujal Patel

It's an interesting question. If you looked at order patterns for Q1, January was off to a very slow start and February was pretty slow as well, and the bulk of the business in Q1 was really backend loaded into March.

As we are about two-thirds of the way through April here, we are certainly feeling much better about April than we did January. I think the tough economic condition continue’s and its clearly too early to make a prediction for the rest of the quarter, but the pipeline is better than it's ever been and we are exercising caution around our assumptions of business metrics, but April's been off to a decent starts.

Kat Smith - Morgan Stanley

Has your visibility improved at all or is it pretty much the same at this point.

Sujal Patel

What I would say on that front is that, from an execution standpoint, I think that the processes that we have been put in place and the discipline with respect to pipeline management and forecasting, have certainly improved our visibility. That being said, the flipside of that coin is that, with the economy in the shape that it is, all the metrics that we would traditionally use to run the business that were pretty steady, year-over-year for the last few years prior to the current economic recession.

I think those metrics have changed dramatically and those rates are different, (Inaudible) are different and so. As we are looking at those changes on a quarter-by-quarter basis, I think we’re starting to get a better sense of when we think the bottom is, and when we start pulling out of it.

Kat Smith - Morgan Stanley

Okay, great. And then just one last one from me, I think hey you mentioned the software as a percentage of revenue declined. Can you just talk about what’s going on with that metric?

Bill Richter

This quarter it was 9%. A year ago it was 9%. Last quarter it was 10% and so. And you are right that it declined, but by a relatively small amount and that metric to some extend tracks our percentage of contribution from new customers, which were also down in Q1 and so. To the extent that new customer revenue increase, we expect the software contribution to increase as well.

Kat Smith - Morgan Stanley

Thanks guys.

Operator

(Operator Instructions)

And your next question comes from the line of Sid Parakh with McAdams Wright Ragen. Please proceed.

Sid Parakh - McAdams Wright Ragen

Just a quick question on international revenues, can you speak to with the currency impact of the negative currency impact during the quarter.

Bill Richter

Sure, let me see if I can give some more color on this. Our major territories overseas are Germany, France and the UK and EMEA. Japan, and Korea and Asia in the Asia Pacific and Australia and if you think about those regions, in Q1, all the European territories, their currencies weakened against the dollar

And then in Asia was split, the Japan Yen strengthened and the Korean Won weakened significantly, and so to the extent that price is a factor in a customer decision and now a days for most IT budget owners it is. It makes Isilon’s products more expensive and makes the process a bit more challenging.

Sid Parakh - McAdams Wright Ragen

So, can you give us some quantitative estimate of maybe what that impact was?

Bill Richter

So, I won't give a quantitative estimate because frankly its really difficult to measure, but what I can tell you is, our sets from what we hear from the field is that pricing became incrementally more difficult in those territories, where currency weakened.

Sid Parakh - McAdams Wright Ragen

Okay. That's fair. And a lot of things that I’m thinking about is services revenues, now securities have been doing well and my guess is, a lot of these revenues are tied to product sales and with product sales being softer at some point, the services is probably going to start to like soften as well. And maybe you can help me understand how you believe that revenue line might play out.

Bill Richter

Sure. Let me try to address your question. You're right. The services revenue had been very healthy and for the first time in a while, we're feeling more confident on the services margin as well. What you're seeing is the impact of our overall customer base growing over time and we're fortunate to have a very loyal base, which has a very high percentage rate in terms of renewing their service contract.

So, as the book of business grows, so does the services revenue and even if they grows more poorly as it has over the last quarter or two, the base renewing their service contracts at pretty healthy rate. So, you're right that over time that if product revenue continues to grow slowly, so will services revenue.. We're not immediately concerned with that given the book of business.

Sid Parakh - McAdams Wright Ragen

Okay. Can you speak to maybe contract attach rates or service attach rates for new sales in the current environment versus how they've been and maybe even a better sense for a renewal rate?

Bill Richter

So, I'll address the first part and now I'll give you sense on the second part. So, virtually a 100% of our customers buy products from us with a service contract. It's very rare for one have to buy without, in fact probably have less, less than once per quarter. And then in terms of renewal rate it's very high, I won’t give out a precise percentage, but it’s very healthy rate, you could see that profit of service revenue.

Sid Parakh - McAdams Wright Ragen

Okay. And then just one last question, from a cash perspective, for now I think you have done a great job managing that cash level, but at some point, there is only so much you can cut from the balance sheet and at some point the operation does have to start pouring cash out. Can you help me understand at what point do you see that happen or how you believe cash might be having in near future?

Bill Richter

Well, I think I can help you understand how we think about it. So, we will continue to optimize every element of the balance sheet to drive cash flows. But the real key is sustainable cash flows is profitability and I think if you refer back to some of our prepared remarks, you can see that we've made some significant changes to our models to accelerate the path to profitability and it sense that we progressed on that line so well sustainable cash flow.

Sid Parakh - McAdams Wright Ragen

All right, that's sounds good. Thanks.

Bill Richter

Okay. Thanks Sid.

Operator

We've no further questions in the queue. I would like to turn the call back over to Mr. Sujal Patel. Please proceed, sir.

Sujal Patel

Thank you. Thanks very much to everyone for being on the call today. We look forward to updating you on Q2 in late July.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great day.

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