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Check Point Software Technologies, Ltd. (NASDAQ:CHKP)

Q2 2006 Earnings Conference Call

July 18, 2006 5:00 pm ET

Executives

Anne Marie McCauley - Director of Investor Relations

Eyal Desheh - EVP, CFO

Jerry Ungerman - Vice Chairman

Gil Shwed - Founder, Chairman and CEO

Analysts

Robert Breza – RBC Capital Markets

Dino Diana – UBS Securities LLC

Edward Maguire - Merrill Lynch

Philip Winslow – Credit Suisse First Boston, Inc.

Georgy Grigoriyants - Thomas Weisel Partners LLC

Horacio Zambrano - Wedbush Morgan Securities Inc.

Michael Turits - Prudential

Ehud Eisenstein - Oscar Gruss & Son

Sean Jackson – Avondale Partners, LLC

Shaul Eyal - CIBC World Markets

Sarah Friar - Goldman Sachs

Gregg Moskowitz – Susquehanna Financial Group

Katherine Egbert – Jefferies & Company, Inc.

Presentation

Operator

Good afternoon. My name is Henry, and I’ll be your conference facilitator today. At this time, I’d like to welcome everyone to the Check Point Software Technologies second quarter 2006 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Ms. Anne Marie McCauley. Ma’am, you may begin your conference.

Anne Marie McCauley

Thank you, Henry. Good afternoon and evening. I’m Anne Marie McCauley, Director of Investor Relations for Check Point. Thank you for joining us to discuss the second quarter 2006 results.

As a reminder, this call is being webcast live from our web site and is being recorded. To access the live webcast and replay information, please visit the company’s web site at checkpoint.com/ir. The replay will be available through August 1.

If you would like to reach us after the call, please contact the Investor Relations Department at 650 628 2050.

On the call with me today is Gil Shwed, Chairman and CEO; Jerry Ungerman, Vice Chairman; and Eyal Desheh, Executive Vice President and CFO.

Before we start our management presentation I would like to make the following disclaimer:

During the course of this call the Company will make certain forward-looking statements. Forward-looking statements include statements pertaining to Check Point’s expectations and beliefs regarding operating results for the third quarter of 2006 and for the full year 2006; the competitive position of Check Point’s products; trends toward technology consolidation; initiatives for sales of expanded solutions; delivery of product introductions; enhancements and product acceptance; the impact of new products on ASPs; and benefits and plans for customer and partner events. Other statements which may be made in response to questions which refer to our beliefs, plans, expectations or intentions are also forward-looking statements for purposes of the Safe Harbor provided by the Securities Litigation Reform Act.

Because these statements pertain to future events, they are subject to various risks and uncertainties, and actual results could differ materially from Check Point’s current expectations and beliefs. Factors that could cause or contribute to such differences include, but are not limited to, the impact on revenues of general market conditions in the Company’s industry; the mix of sales of new products and long-term subscriptions; economic and political uncertainties; the impact of political change and weaknesses in various regions of the world, including the further escalation of hostilities or acts of terrorism in Israel; the inclusion of network security functionality and third-party hardware or system software; any foreseen and unforeseen developmental or technological difficulties with regard to Check Point’s products; changes in the competitive landscape, including new competitors or the impact of competitive pricing and products; rapid technological advances and changes in customer requirements to which Check Point is unable to respond expeditiously, if at all; a shift in demand for products such as Check Point’s; factors affecting third parties with which Check Point has formed business alliances; timely availability, features, performance and customer acceptance of Check Point’s new and existing products; the amount of equity-based compensation charges; the ability to recognize deferred revenues and other factors and risks discussed in Check Point’s annual report on Form 20-F for the year ended December 31, 2005, which is on with the Securities and Exchange Commission. Check Point assumes no obligation to update information concerning its expectations.

Now, let me turn the call over to Eyal Desheh for financial review.

Eyal Desheh

Thank you very much, Anne Marie. Good afternoon, good evening, everyone. Let me share with you the results of the quarter and provide some more details on the financials.

Our second quarter of 2006 results are in line with our projection and reflect an encouraging sequential growth in total revenues and in license revenues. We show the beginning of a smooth transition to our new perimeter security product line and nice traction given that these solutions were just introduced this quarter.

We also experienced continued adoption of our emerging products which contributed just over 30% of product revenues with strength in high end products, NGX and VSX, in VPN-1 Edge, our branch office appliances, and Connectra, our web security solution. We also experienced continued success of our SmartDefense program.

As a reminder, our quarterly results for 2006 include the impact of SFAS 123R, which is the inclusion of equity compensation expenses in the P&L. It is in our GAAP financial results. In our press release, which has been posted on our web site at www.checkpoint.com, we are presenting GAAP and non GAAP results and reconciliation tables which highlights this data.

Now let me share with you the financial details for the second quarter of 2006. The revenues for the second quarter were $139 million, compared to a $134 million in Q1 this year and $145 million in the second quarter of 2005.

GAAP net income for the second quarter of 2006 was $66 million, compared with $62 million in Q1.

Equity-based compensation expenses accounted for $9.3 million in this quarter. Non GAAP net income, excluding acquisition-related and equity-based compensation charges, was $76 million this quarter compared to $75 million last quarter and $80 million in the second quarter of 2005.

GAAP earnings per diluted share for the second quarter of 2006 were $0.27. This compares to $0.25 last quarter, and $0.31 last year. Last year we did not include equity-based compensation in our expenses. Had we done that, earnings per share results for Q2 this year and last year would be the same.

And finally, non GAAP earnings per share, excluding acquisition-related and equity-based compensation charges was $0.32 compared to $0.31 last quarter and the same when compared to $0.32 in the second quarter of 2005.

Deferred revenues this quarter were $176.5 million, an increase of $22 million or 14% over Q2 2005.

We did increase our operating expenses this quarter. Total operating expenses were $75 million. Excluding equity-based compensation and acquisition-related charged of $11 million, operating expenses were $64 million. This compares to $59 million in Q1 this year and $61 million in Q2 last year. The increase is a result of growth in headcount, mostly in sales and technical services, bringing our total headcount close to 1,500.

Total operating income was $64 million. Excluding equity-based compensation and acquisition-related charges of $11 million, operating income was $75 million, similar to last quarter and compared to $82 million in the second quarter of 2005.

Our effective income tax rate was stable at approximately 18%.

For the second quarter, our days sales outstanding, DSO, were 55 days. This compares to 61 days in the first quarter of this year. We saw similar trends in the timing of orders in the quarter as we have seen for the past few quarters as the business continues to be more backend loaded. Roughly half of our business occurs in the last month of the quarter.

Cash collection and cash flow continue to be strong. We generated strong cash flow from operating activities of $87 million, compared to $85 million for the same period last year. Our cash and investment balance at the end of the quarter was $1.73 billion.

During the second quarter we purchased approximately 7.4 million shares for a total cost of roughly $138 million as part of our expanded share repurchase program. A portion of these shares were purchased under a 10b-5 program which was introduced in June 2006.

Our second quarter revenues again were well-diversified with the Americas leading the way, contributing 47% of revenues. EMEA contributed 40% and the Asia Pacific and Japan region contributed 13% to our revenues this quarter.

In the second quarter large orders, which are greater than $50,000, accounted for roughly 28% of total orders. We also had seven deals greater than $1 million this quarter.

We continue to grow our installed base, bringing the total to over 500,000 security gateways.

In summary, we are pleased with the financial result we posted this quarter. Our market environment has not changed dramatically from Q1 which means that it remains challenging, while we believe that our performance and execution has improved, and we head into the second half of the year with a robust product portfolio.

I will now let Jerry and Gil speak more about our business and our plans. Jerry, please go ahead.

Jerry Ungerman

Thank you, Eyal, and hello everyone. I appreciate your taking your time to be on the call with us today.

I would like to focus my comments on what we’re doing relative to improving our execution, as we discussed during our last call. Hopefully this will provide some insight into our actions and activities we initiated this past quarter that will impact our performance going forward.

As I mentioned, our focus has been and continues to be on execution. As you have heard us mention many times, our strategy revolves around providing our customers a unified security architecture enabling them to manage, from a single console, a wide range of integrated security solutions that share the same code base, can be updated dynamically and be deployed across multiple layers of the network architecture. We believe we are the only vendor with a fully integrated set of solutions to meet the broad security needs of our customers.

While we continue to extend our strategy, which we did with the latest product realignment that we announced this past quarter, we have also focused on the need to execute on our total business objectives and capabilities.

During our first quarter earnings call, I mentioned we had a number of new initiatives we were working on that would make it easier and more cost effective for our customers to buy our expanded solution set sooner rather than later.

So let me recap what we’ve accomplished in the second quarter in the area of packaging, positioning, pricing and promotions.

During the second quarter we again introduced new products and technologies across the various security segments we address through our expanding portfolio of security solutions. We have done this based on what we have heard from our partners and customers telling us what they need to better secure their network. The input I get during my travels and subsequent conversations with the partners and customers is that they want to minimize the number of vendors they use, but they don’t want to have to compromise their security.

This is what we have done this quarter. We announced first VPN 1 Power, which features integrated firewall, VPN and intrusion prevention along with our patented SecureXL acceleration technologies for enterprises with demanding performance requirements.

Second, VPN 1 UTM, our new unified threat management product which combines firewall, VPN, intrusion prevention, antivirus and more in a fully integrated, easy to manage solution.

And VPN 1 Power UTM, which combines the full integration of the new UTM version and the performance of the Power version.

We also announced a new version of our NGX platform, which integrates endpoint security with perimeter, internal and web security through our unified security management console and introduces centralized real-time updates of all Check Point security products to guard against the latest security threats and vulnerabilities.

And finally, we announced ZoneAlarm Internet Security Suite 6.5, a new solution which defends consumers against identity theft and advances spyware prevention.

All this comes in new price points and expands the markets we serve and improves our competitive position for customers looking for high performance, an integrated solution, or both.

Generally speaking, most of our solutions are now packaged to include more capability at a lower overall package price, effectively increasing the value customers receive. As a result, we anticipate these changes will result in an increase to overall ASPs while making our solutions more competitively positioned in the market.

During Q2 we also held our annual partner and customer events, Check Point Experience, in both Europe and the United States, with almost 2,000 attendees. The focus of events was to train the attendees on our new offerings and to receive feedback regarding additional needs requirements they have that we can address with new versions currently under development. I believe both events were very successful and of mutual benefit. This quarter we will be doing the same with our Asia Pacific region.

In addition to bringing new solutions to market and holding our major partner and customer events during the quarter, we also continued to work on the restructuring of our field organization. I had previously mentioned that last year we restructured our operations in Asia and have seen a positive upturn in business the past two quarters. We also have communicated that we would be doing the same in Japan, and that process has resulted in a new country manager joining us on August 1.

And just two weeks ago, we created a new executive position responsible for both sales and service globally. The person we selected to run this field operations organization, which combines sales, services and sales operations into one team, is Amnon Barlow. Amnon has been with us for almost a year now and has been managing our worldwide technical services group. In addition, earlier this year he picked up responsibilities for managing our international operations group. He brings a very strong and impressive background to the position. He was the founder and CEO of a very successful systems integrator for over eight years, so he understands the market, security and the channel. This combination of knowing the needs of the customer, understanding the channel and its motivation and business, are important and of value to our execution efforts.

In summary, we have taken a number of steps this quarter to improve our ability to execute against our business objectives. We have done this by addressing the positioning, packaging, pricing and promotions of our products, by communicating with our partners and customers and by restructuring our field organization.

We will continue to do so, as these are steps in a process and not one-time events. We need to continually focus on our solution set to ensure it is in line with the needs and requirements of our customers, which is why we will continue to hold events around the globe that will allow us to get feedback.

We will continue to focus on the organizational structure we have in place and take steps to improve our ability to execute effectively.

Thank you again for being on the call with us today, and now let me turn the call over to Gil for additional comments and insights.

Gil Shwed

Thank you Jerry, and good afternoon, everyone.

Our second quarter business reflected many of the trends we’ve seen over the past couple of quarters. While our market environment continues to be challenging and the business is more backend loaded than it was a couple of years ago, we are pleased with the sequential increase in many of our key financial metrics this quarter over the first quarter, and enthusiastic about the products and organizational initiatives that Jerry just mentioned.

We attribute some of the trends we are seeing in the microsecurity environment to what we have dubbed security sprawl. The security market today is awash with solutions which address security threats and vulnerabilities either on a reactive basis or from a stream of point product offerings. While the volume of disparate security solutions in the market today can lead to confusion, we believe it will drive technology consolidation as customers recognize the value of having an integrated, comprehensive set of security solutions.

With our unified security architecture, we believe we are well-positioned to help customers proactively address the rapidly changing security threat environment.

During the second quarter we extended the next phase of our strategy with our latest version of the NGX platform and the consolidation of many products in our own VPN-1 Power and UTM products line. So while many companies continue to provide and promote point products, our strategic direction, we focus on innovation and creating a unified security architecture to address the market’s evolving security needs.

Now let me share with you our thoughts on financial targets for the third quarter and the full year of 2006. We expect Q3 revenues to be in the range of $135 million to $144 million; GAAP-based EPS in the range of $0.27 to $0.30 per share; and non-GAAP EPS, excluding the effects of stock-based compensation and acquisition-related charges, to be in the range of $0.31 to $0.34.

For the full year 2006, revenues are expected to be in the range of $570 million to $600 million; GAAP EPS in the range of $1.12 to $1.20; and non GAAP EPS, excluding the effects of stock-based compensation and acquisition-related charges, to be in the range of $1.33 to $1.40.

In summary, we’ve executed a number of strategic initiatives around our security solution and improved our operation during the quarter. We believe that these steps should have positive impacts on our business performance going forward.

With that, I’d like to open the call for your questions. Thank you very much.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question is coming from Robert Breza of RBC Capital Markets. Please go ahead.

Robert Breza - RBC Capital Markets

Hi. Good afternoon. Talking about the operating expenses, you did increase operating expenses this quarter. Clearly, the partner events played a part in that. How shall we think about it as a baseline going forward, as you continue to evolve the pricing and packaging of the new products?

Eyal Desheh

I think the level of operating expenses that we have this quarter is a good basis for the future. There will be some activities that won’t take place in the third quarter. At the same time, we are investing a lot and adding people and having the right infrastructure, especially around the sales force, hiring many people and so on. So that will have some impact there, moving forward.

The pricing, the packaging that we have right now should have a small impact on expenses. They will have a pricing that will hopefully have an effect on the revenue line.

Robert Breza - RBC Capital Markets

Gil, as you look at the investments you’re making in sales and marketing, when do you think we see the inflection point? Should we think about that more on the core products side or more on the emerging side?

Gil Shwed

I think the investments that we are doing is on both sides. Our sales force is a single sales force for all our products, so that shouldn’t have much. Usually when you hire a salesperson, you should expect results in roughly six months. But that also depends on the market condition and on many, many other things.

We do believe there’s reasonable potential in the marketplace and that’s why we are accelerating the hiring of salespeople. We actually, for the first time that I can remember, we are ahead of our hiring plan for salespeople and I think that says something about our belief in the market opportunity and the fact that we want to capture as big a portion as we can out of it.

Robert Breza - RBC Capital Markets

Okay. One last housekeeping item. Eyal, the $38 million in expenditures on the cash flow statement, what was that for?

Eyal Desheh

For the building in Tel Aviv. Our new headquarters.

Robert Breza - RBC Capital Markets

Okay. Thank you.

Jerry Ungerman

You’re welcome.

Operator

Thank you. Your next question is coming from Dino Diana of UBS. Please go ahead.

Dino Diana – UBS Securities LLC

Thank you. You consolidated your product lines into two primary lines. Can you give us some early color on what you’ve noticed so far from this move, given that they group together? Can you just give us, you know, first VPN-1, UTM and then VPN-1 Power?

Gil Shwed

I think overall we got very positive acceptance and very positive feedback from our customers and channel partners. They found the new product lines to be very, very competitive. Address, really, the market segments that we’re trying to address and be relatively easy to sell because it’s becoming simpler. I think we’ve consolidated five to seven different product lines into these two brands, the VPN 1 Power and the VPN-1 UTM.

And so overall, some of the pricing stays and is becoming more and more competitive. So I mean generally the feedback and the acceptance that we’ve gotten so far is very, very positive.

Dino Diana – UBS Securities LLC

Okay. And we’re still seeing double-digit growth in deferred revenue. I’ve noticed in the second quarter where subscription revenue is in the high single digits, 7% to 8%. Can you talk about what the dynamic is over there?

Jerry Ungerman

Well, first let’s not forget that our deferred revenue increased by $10 million, which is a very large number, in Q1, so we do have to look at this from an annual perspective. It grew 14% year over year, $22 million. The majority of the deferred are EBS, our subscription and technical services contracts. Very little of product that we need to defer for accounting reasons, but the majority of the mix has not changed. We see that our customers are synchronizing and combining all their EBSs into a single annual renewal date, which is good. It is easier to control and it’s better and more efficient for us in terms of having them renewing.

Eyal Desheh

Most of these contracts are shifting towards either Q4 or Q1, or around year end. Some are closing in December, some in January, and that’s why you see big increases in deferred revenues in both Q4 and Q1.

Jerry Ungerman

December 31 and January 1 are target dates for a lot of companies. But we do have, as you can see, we do have also pretty nice numbers that are renewed in Q2 and Q3. Of course, we continue to sell these solutions together with new products that we are selling. That happens all the time.

Dino Diana – UBS Securities LLC

Okay. Thanks.

Operator

Thank you. Your next question is coming from Edward Maguire of Merrill Lynch. Please go ahead.

Edward Maguire - Merrill Lynch

Yes. Good afternoon. Could you talk about any regional differences, particularly in Europe? What you’re seeing on the ground there in terms of the spending environment?

Jerry Ungerman

You know, we saw strengths in Asia again. We saw strength in the United States, and I think it’s a little bit softer in Europe right now. The only thing – it’s not meant to be facetious, but I saw it one time before is the impact of the World Cup with the activity in Europe. It does have an impact on business, which is interesting.

But I think overall the market is just a little bit softer in Europe right now than it is in the other parts, although we still struggle with Japan, which hopefully with our change there in August 1 that will help us revitalize that business unit. So, I hope that explains it.

Edward Maguire - Merrill Lynch

Okay. And just moving onto your product mix, could you comment a bit on what you’re seeing on the consumer market? Are you happy with what you see in terms of the Zone Labs product?

Gil Shwed

We are very happy with the product line that we have. We are receiving excellent reviews. We also continue to produce good results on the consumer. This is one opportunity that we have which is much bigger than where we are today and we can grow it and we’re looking forward to continuing to do that.

Edward Maguire - Merrill Lynch

Okay. Thanks very much.

Gil Shwed

You’re welcome.

Jerry Ungerman

Thanks, Ed.

Operator

Thank you. Your next question is coming from Phil Winslow of Credit Suisse. Please go ahead.

Philip Winslow – Credit Suisse First Boston, Inc.

Hi, guys. Just wanted to dig in just a little bit further on the deferred revenue line. Eyal, just wondering if you could give us a sense for what your expectations would be for the back half as far as deferred revenue growth and should we think of it as being sequentially up as well in the September quarter?

Eyal Desheh

Yes, I think that if you look at our records for the past few years, the September quarter is always somewhat down on deferred revenues and we make it up and more than that in the fourth quarter. I don’t expect this to be any different this year.

Philip Winslow – Credit Suisse First Boston, Inc.

Have you seen any changes, just when you guys go out renewing subscriptions to the pricing environment on the maintenance side or has it remained pretty stable?

Gil Shwed

It’s remained pretty stable. Large customers with large contracts always want to get better price. That’s not something surprising. We did raise the price of our subscription this year for the first time and the general acceptance of that is okay. They [inaudible] got that.

We’re also coming up with new subscription programs that add more value, buying more support services and others, which we continue to sell very well. You can see from the support line that we have been growing in a faster way, both together with the subscription, that’s something that’s getting more acceptance.

So we kind of balance those two trends and so far its done – again, it’s very hard to judge it in a single quarter because we are talking here about the year-long contract, but so far the acceptance seems relatively positive and that you can see for the last few quarters and even few years, we consistently keep growing the subscription element of our business.

Philip Winslow – Credit Suisse First Boston, Inc.

Just one last question. Eyal, what are you using for share count for Q3?

Eyal Desheh

Share count? Well, we continue to buy shares and as you’ve seen we’ve bought this quarter more shares than in any other single quarter in the past and we plan to continue to do that.

I don’t think that I can really accurately forecast a number as there are a lot of parameters all being influenced by the stock price, as you know. So I’m not going to even try to forecast. But anywhere between 235 to 240 million shares would be a good number.

Philip Winslow – Credit Suisse First Boston, Inc.

Okay. Thanks, guys.

Operator

Thank you. You next question is coming from Georgy Grigoriyants of Thomas Weisel Partners. Please go ahead.

Georgy Grigoriyants - Thomas Weisel Partners LLC

Hi, guys. A couple of questions. First of all, on pricing, what do you see? It seems like there’s a pricing pressure increasing in some of the segments, like UTM appliances, for instance, have been picking up. Can you give us any color? What do you see in terms of pricing pressures. Is it stable, increasing, et cetera?

Gil Shwed

I don’t see a big pricing pressure. What I do see is a very competitive market, and that’s two different things. I think what we are focusing is on improving our position about that and improving our position about that is not necessarily, by the way, reducing prices. In many cases, it is offering more price points so we can compete in more and more segments.

I think that’s generally been the situation for a long time. We are in a competitive market. Customers do want the right value. But customers are also very much willing to pay.

If I try to summarize what we are seeing it’s in the low price points, the pressure – or not the pressure, the competition, is a little bit tougher. In the high priced ones that we have, customers are fully willing to pay for getting the full value for what we offer. I think there again, the way we address that is having more price points on the lower part of the scale.

Georgy Grigoriyants - Thomas Weisel Partners LLC

Then you last made a comment that you were increasing sales and R&D headcount. Can you give us any numbers around that? What does that mean?

Eyal Desheh

You can see the overall headcount. In the sales, I don’t know how many, how much we increased the sales headcount this quarter?

Jerry Ungerman

It was increased by about 30 salespeople, which is –

Eyal Desheh

Net additional 30 positions.

Georgy Grigoriyants - Thomas Weisel Partners LLC

And R&D?

Eyal Desheh

R&D hasn’t grown in a huge way this quarter I think. It’s grown only a little bit this quarter and it’s about, year over year it’s 10, 15 people more this year compared to last year.

Georgy Grigoriyants - Thomas Weisel Partners LLC

Gil, on the share buyback, have you guys considered at all just stepping in a major way and maybe making a tender offer and buying a lot of shares back? Has that been a subject of discussion at all?

Gil Shwed

Well, first of all I think we stepped up our program substantially last quarter when the Board approved a $600 million program. As you can see, we began to execute this quickly. We added a 10b 5 program also, that we buy throughout the quarter using that. All the other options are open. So let’s not make any statement now, only that we have accelerated the share buyback and we will continue to buy at least similar quantities in Q3.

Georgy Grigoriyants - Thomas Weisel Partners LLC

And the last question, how many gateways have you guys shipped this quarter?

Eyal Desheh

Oh, a lot.

Jerry Ungerman

23,000.

Eyal Desheh

23,000 and that’s a record number for –

Jerry Ungerman

The last two or three or years.

Eyal Desheh

The strongest we have on our sheets, yes.

Georgy Grigoriyants - Thomas Weisel Partners LLC

Thank you.

Operator

Thank you. Your next question is coming from Horacio Zambrano of

Wedbush. Please go ahead.

Horacio Zambrano - Wedbush Morgan Securities Inc.

Thank you. Just a question on the geopolitical environment. Obviously with the attacks going on in your part of the world in Israel, what do you guys, in terms of your shipping or use of ports, I mean, are you concerned about how far this could escalate and what sort of issues could happen, could disrupt business in your minds if this were to escalate any further?

Gil Shwed

Well, we clearly hope the political environment settles down and we get more peace. But so far we haven’t seen any effects of the situation on our operation. As you know, Eyal and I live in Israel. We’ve been there two days ago. Our colleagues and families are there and life is very usual where we live. Jerry’s been to Tel Aviv, actually, last week, as well as the rest of the management. They can testify about that.

And let’s remember that most of the Check Point business activity, sales, marketing, support, is done outside of Israel. 98% of our sales and these kinds of business activities are out of the region. But we feel pretty well about, I mean, the way we operate the business and these kinds of things.

Horacio Zambrano - Wedbush Morgan Securities Inc.

Okay. Just a real quick question. Between license and subscriptions, as I look at the first half of the year sort of down, double, in the mid teens on the license line but up in the higher single digits. How does that shift for the second half of the year or do you expect from the growth year over year on subscriptions to maintain itself and the license growth, to continue on the current trend line it’s on?

Eyal Desheh

We expect to grow both. But if you look at our guidance and see, we have improvements in our license revenue in Q2 as compared to Q1. As we said, we believe that some of it has to do with the new products but not a lot as we only introduced them.

We expect this to be a more dominant factor in the second half of the year and I would hope to sell more licenses. At the same time, grow our subscriptions, add more new subscriptions, new programs, new combined services and subscription programs that we believe and we hope that will be more meaningful in the second half of the year.

So we believe that both will grow. We have to remember that the revenue line that we are reporting on the subscription, most of it is created in the earlier quarter because this is something that we recognize over the lifetime of the program.

Since we are increasing our booking of EBS and subscription and support almost every quarter from one to another, then this is expected to grow also in the second half of the year.

These numbers are already in; most of them are already in.

Horacio Zambrano - Wedbush Morgan Securities Inc.

Okay. Thank you.

Operator

Thank you. Your next question is coming from Michael Turits from Prudential. Please go ahead.

Michael Turits - Prudential

Hi, guys. You did bring down both revenue and EPS guidance slowly relative to what you were guiding to last quarter. You said that the environment is relatively the same. What’s changed that caused you to trimmed guidance a bit?

Eyal Desheh

I don’t remember. I don’t think that we gave guidance for Q3 last quarter. We usually give one quarter ahead.

Michael Turits - Prudential

No, I just meant for the full year.

Eyal Desheh

First, for the full year what has changed is we got the results for this quarter and they do narrow the guideline moving forward. We did operate in a challenging environment and I think we are acknowledging that, and the environment is still challenging. I think we have high hopes out of the second half of the year and out of 2007, but right now we do have to take into consideration the run rate that we are in and the general seasonality that occurs in Q3.

Michael Turits - Prudential

The days sales outstanding dropped, I don’t know, five or six days I think this quarter and the contribution of working capital from that reduction. Is this the right level going forward or actually look at DSOs for the rest of the year?

Eyal Desheh

I think generally, we have a range. I think our DSOs are relatively stable between 50 to 60 days. I think that’s what we should expect. Sometimes, I mean, high DSO means that we got a lot of business at the end of the quarter. Low DSO might mean that we actually had a lot of collection from the previous quarter. So I don’t think that you can attribute too much value to these numbers.

Michael Turits - Prudential

Okay. Last question. You had two fairly significant executive changes, both Kevin Maloney, I believe, left this quarter and so did Ken Fitzpatrick, so both a sales and a marketing change. What can you tell us about what precipitated those and what the transition plans are?

Gil Shwed

I think our policy is never to discuss any personnel issue. We treat them as internal, and that’s why we won’t comment except for saying both for Ken and Kevin, that I value them and they are great guys. I don’t think that you’ll hear much more from us about that.

About the transition plan, I think Jerry did talk a little bit about the process that we started long ago, which is the restructuring of our sales and marketing operation. In the sales organization, which is the bigger and a very important organization that we have, we’ve created the worldwide field operations and we’ve nominated Amnon Barlow, who’s been with us for about a year, to head that organization. I think it’s going to have a good impact on our ability to drive more programs, more changes, same or better organization.

For the marketing department, Jerry’s acting as the head of marketing and he has done that for many, many years so he’s very well-valued and has a great contribution to the activities in marketing and provides now a lot of energy to the marketing stuff and we are looking for a new VP of Marketing.

Michael Turits - Prudential

Okay. Thanks, Gil.

Gil Shwed

You’re welcome.

Operator

Thank you. Your next question is coming from Ehud Eisenstein of Oscar Gruss. Please go ahead.

Ehud Eisenstein - Oscar Gruss & Son

Yes, hi and congrats on a nice buyback in the quarter. Can you just give us some color on the slight decline in the gross margin? Is this part of the new 4Ps initiative?

Eyal Desheh

No I think that the gross margin, again, is not a target on its own. We do have one of the highest operating and I think gross margins in the technology sector and hopefully we’ll keep to that.

I think the main change in margin this quarter is the fact that we invested in the business. We hired more people and that hopefully will have a good effect moving forward and growing revenue.

Gil Shwed

Most of the costs in our cost of sales that implicate gross margin is the cost of technical services and I will mention at the beginning we added people in the product services group. This is the majority of the increase that you see over there.

Eyal Desheh

You also can see, actually, from that perspective that we did grow our services business nicely from a year ago and with deferred revenue we’ll even grow further moving forward. So we are setting up the right stock levels to continue and drive support and service programs to our customers.

Ehud Eisenstein - Oscar Gruss & Son

Very good. Thank you so much.

Operator

Thank you. Your next question is coming from Sean Jackson of Avondale Partners. Please go ahead.

Sean Jackson – Avondale Partners, LLC

Yeah, I just wanted to drill down a little bit on Europe again. The weakness that you said, was it a function of deals that just didn’t close at the end of June or did you see a weakness in your pipeline overall?

Jerry Ungerman

Just to remind everyone on the line, we did grow our revenues in Europe from Q1 to Q2, so the direction is the right direction. We had I think a $2 or $3 million increase in revenues so that’s a positive.

Europe is kind of, a little sleepy towards the summer months. The World Cup in Germany probably added to that a little bit. There are always some deals that slip from one quarter to another, and that will continue to happen. It’s part of our business.

But I don’t think that there’s anything significant that we can point out and say hey, this is not functioning very well. It is functioning and we believe that we’ll see that and get it on track. And I think there’s a lot of companies that seem to see the same environment in Europe. It’s not bad.

Sean Jackson – Avondale Partners, LLC

On your emerging products, if you had to pinpoint one or two that you felt like were exceeding expectations, which ones would those be?

Gil Shwed

Probably the work security, Connectra product line, is working pretty well. The branch office gateways are doing very well; the VPN-1 Edge family is doing very well just to name two out of the entire sector.

Sean Jackson – Avondale Partners, LLC

All right. Thank you.

Jerry Ungerman

Thank you, Sean.

Gil Shwed

Okay, Sean.

Operator

Thank you. Your next question is coming from Shaul Eyal of CIBC World Markets. Please go ahead.

Shaul Eyal - CIBC World Markets

Thank you. Hi, good afternoon, guys. Just one quick question from me. What’s the current status with Sourcefire? Even though the acquisition was rejected a few months ago, what has been the level of work for this in the past couple of months?

Gil Shwed

We are evaluating different options in that phase of adding signature-based technology for our IPS capabilities and our products in general. Sourcefire remains a candidate, although we also have additional candidates for different levels of technology partnerships.

Shaul Eyal - CIBC World Markets

Okay, thank you very much.

Jerry Ungerman

You’re welcome, Shaul.

Operator

Thank you. Your next question is coming from Sarah Friar of Goldman Sachs. Please go ahead.

Sarah Friar - Goldman Sachs

Good afternoon, guys. I just want to follow up a little bit on Michael’s question around guidance and although you did drop it for the year, if I just take the midpoints, you’re still showing a pretty sharp hockey stick in the fourth quarter. I think it comes out at around $170 million for the fourth quarter, which is about 11% year over year growth.

As you look at your pipeline, do you see the pipeline shaping up that way, where there’s definitely a very backend-loaded nature to the year?

The confidence level, as you think to the fourth quarter, is that increased because there’s naturally more renewals and more maintenance that comes in in that quarter that we should be able to feel more confidence, even though that is a hockey stick for fourth quarter revenue?

Eyal Desheh

The short answer to what you said is yes. The bigger answer is that it’s always hard to predict the future and it’s always hard to predict the market trends, but we do have a healthy pipeline. We did see in the past year and every quarter that business is becoming more backend loaded and those levels of revenue and business are not unreasonable given what we’ve seen in the past year and again, to that I’ll add the regular caveat that predicting the future is always a risky thing.

Sarah Friar - Goldman Sachs

Sure. I totally understand. Then just, in terms of driving new product sales, you talked a little bit about some of the products you’re excited about: Connectra, the branch office gateways, and so on.

Are you making any changes in how you go to market with your channel, your direct sales force, in terms of really trying to drive new product sales over just renewals and maintenance?

Gil Shwed

In terms of driving new product sales, yes, we are making many programs and many things to do, but then actually you can see them working.

We’ve grown this quarter our new license revenues. We’ve implemented many programs internally to drive it and actually they’re working pretty well. I mean, our field organization has met some of our corporate targets for new business so I think we are, we’re pretty happy about that change.

It still depends a lot on the conditions in the general market and not just our execution, but the nature of the execution stems from the sales execution. We’ve made the right incentives. We’ve built a new sales plan with separate targets for new business and subscription renewal. And I think at least the initial indication which we are getting is that these targets are well understood and are staring to work out.

Sarah Friar - Goldman Sachs

Okay, and is that true – you talked a lot about it being an internal sales force, but does the channel also have those new incentives in place?

Gil Shwed

I think the channel wants to grow their business. The question is how we work with them and how we motivate them. We all want – let’s be very clear. We all want to grow the business, both the subscription line and the new business. What we want to make sure is that we set the right focus to both things and not focus on only one part of that.

Sarah Friar - Goldman Sachs

Fair. Okay, and then Eyal, I have a very quick question for you. Just could you give us the FAS-123R impact for the third quarter?

Eyal Desheh

The what?

Sarah Friar - Goldman Sachs

The FAS-123R. Your stock option impact for third quarter in the guidance. You gave us GAAP and non GAAP, but can you give us the portion that’s –

Eyal Desheh

I think you heard you heard me say it’s in the reconciliation table for the [press release. This stock-based or the equity-based compensation expense for Q2 were about $9.3 million. The numbers for Q3 are similar. Always the same, give or take $500,000.

Sarah Friar - Goldman Sachs

Okay. Perfect. Okay, that’s great. Thank you.

Jerry Ungerman

Yes, Sarah.

Operator

Thank you. Your next question is coming from Katherine Egbert of Jefferies. Please go ahead.

Katherine Egbert – Jefferies & Company, Inc.

Hi, good afternoon. Thanks.

So, just back to the margin side. You know, your gross margin has been down a little bit, you said because it was the cost of technical services, i.e. hiring, and the pro forma operating margin was also down.

I know you go through this every quarter but, if you don’t mind again, just talk about where that operating margin can go, say, by the end of the year.

Gil Shwed

Well, first let’s remember we run the highest operating margin in our industry and we’re pretty proud of that. We’re using resources to drive business and that’s the important part of it. We hire when we need to hire. We spend on marketing where we believe that this will generate additional business. We create channel programs to incite the channel where we believe that will add more business coming over and revenues.

You know, we’ve always tried to avoid making long-term predictions on our margins. They are exceptionally high because of our business model, but margin can also change. The important thing is revenue growth, net income growth and earning per share growth and it’s all designed to do this.

Katherine Egbert – Jefferies & Company, Inc.

Maybe a different way to get at this is you’ve been making this transition from product sales to subscriptions. How much more do you think your mix can shift towards subscriptions over time?

Eyal Desheh

That’s a good question. I think we can grow the subscription but we also work very hard to grow the new product line. There’s a target to grow both, it’s not to grow on the expense of the other.

Jerry Ungerman

And by the way, if I could add something to that. I’m expanding off our business model. That mix does not have a major impact on our margin. It’s how many resources we use to drive the business and I think we have a pretty balanced picture.

Katherine Egbert – Jefferies & Company, Inc.

Okay. Thanks, Eyal. Thanks, Gil.

Eyal Desheh

You’re welcome.

Operator

Thank you. Your final question is coming from Gregg Moskowitz of Susquehanna. Please go ahead.

Gregg Moskowitz – Susquehanna Financial Group

Okay, thanks and good evening, guys. I wanted to ask on Zone Labs you talked about consumer and the 6.5 Security Suite product. How did Zone Labs do in the enterprise and more broadly, what are you seeing in the endpoint protection and policy enforcement market?

Gil Shwed

I think we covered the integrity product line. On the enterprise line, we still see a nice pipeline. We see a lot of interest but that’s a market that’s very long-term in that regard.

I think we are a little bit gaining traction there because we don’t have very much competitors that do the kind of capabilities that we have today. But at the same time this market is not producing yet the right level of results that I would expect it to generate.

Gregg Moskowitz – Susquehanna Financial Group

Okay and then I guess as one follow up, Jerry, just getting back to the challenging market environment, I think last quarter you commented on high interest levels, but a longer than expected cycle for customers replacing Point products with broader deployments. Is it more or less a continuation of that that you’ve seen in Q2 or has there been any incremental change one way or another?

Jerry Ungerman

Well, it’s still the same. This is a longer term positioning and that was just reinforced being at the partner conferences in both Europe and U.S. We’re going to go to Asia in a couple of weeks and I think I’ll hear the same thing there. They just basically reinforced or repeated back to me what I had said to you guys just prior to going to the conferences. So it’s a very similar kind of environment that’s still unfolding over time.

Gregg Moskowitz – Susquehanna Financial Group

Thank you very much, guys.

Jerry Ungerman

Thank you, Gregg.

Operator

Thank you. I’ll now turn the call over to your host for any closing statements.

Gil Shwed

All right. Well, thank you very much, everyone for your participation. If you want to speak to management or to our Investor Relations following this call please call our Investor Relations Department in our Redwood City office at 650 628 2050. Again, 650 628 2050. We’ll be very happy to take your calls. Both Jerry and I are in our Redwood City office right now, so we’re here in your time zone and we’ll be very happy to talk to you next quarter.

Jerry Ungerman

Thank you very much, everybody.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Check Point Software Technologies, Ltd. Q2 2006 Earnings Conference Call Transcript (CHKP)
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