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Aruba Networks, Inc. (NASDAQ:ARUN)

F3Q09 Earnings Call

May 21, 2009 5:00 pm ET

Executives

Jill Isenstadt – Blueshirt Group

Dominic P. Orr – Chairman of the Board, President & Chief Executive Officer

Steffan Tomlinson – Chief Financial Officer

Keerti Melkote – Chief Technology Officer & Director

Analysts

Mark Sue – RBC Capital Markets

Jeffrey Kvaal – Barclays Capital Market

Erik Suppiger – Signal Hill Group

Thomas Lee – Goldman Sachs

Sanjiv Wadhwani – Stifel Nicolaus & Company

Bill Choi – Jefferies & Co.

Ehud Gelblum – JP Morgan

Greg Mesniaeff – Needham & Company

Rohit Chopra – Wedbush Morgan Securities, Inc.

Blaine Carroll – FTN Equity Capital Markets

Operator

Welcome to the Aruba Networks third quarter 2009 conference call. During today’s presentation all parties will be in a listen only mode. Following the presentation the conference will be opened for questions. (Operator Instructions) This conference call is being recorded today, Thursday, May 21, 2009. I would like to turn the call over to Jill Isenstadt of the Blueshirt Group.

Jill Isenstadt

Thank you for joining us on today’s conference call to discuss Aruba Networks fiscal third quarter 2009 results. This call is also being broadcast live over the Internet and can be accessed in the investor relations section of the Aruba Networks website at www.ArubaNetworks.com. With me on this call are Dominic Orr, Aruba’s Chief Executive Officer, Steffan Thomlinson, Chief Financial Officer and Keerti Melkote, Aruba’s Co-founder and Chief Technology Officer.

After the market closed today, Aruba Networks issued a press release announcing the results for the fiscal third quarter ended April 30, 2009. If you’d like a copy of the release you can access it online at the company’s website or you can call the Blueshirt Group at 415-217-7722 and we will fax or email you a copy.

We’d like to remind you that during the course of this conference call, Aruba Networks may make forward-looking statements including statements regarding expected revenue, gross margins, non-GAAP EPS and tax rate for the fourth quarter of fiscal 2009, expected operating expense reductions in the second half of fiscal 2009 resulting from the company’s cost reduction efforts. Expected changes in the development in the networking industry, the company’s belief that demand for its products will continue in the education market, the company’s belief that demand for its products and for its new virtual branch network solution will grow across other verticals as a means to save money while improving performance and increasing workforce mobility and other statements as to the company’s future economic performance, financial condition or results or operations.

These forward-looking statements are not historical facts but rather based on the company’s current expectations and beliefs. These statements involve a number of risks and uncertainties, some of which are beyond our control that could cause actual results to differ materially from those anticipated by these forward-looking statements. These forward-looking statements apply as of today and you should not relay on them as representing our views in the future and we undertake no obligation to update these statements after this call.

For a more detailed description of these risks and uncertainties that may affect our results, please refer to the risks and uncertainties described under the captions risk factors and managements’ discussion and analysis of financial conditions and results of operations in our quarterly report on Form 10K filed with the SEC on March 10, 2009 as well as our earnings release posted a few minutes ago on our website.

Copies of these documents may be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges including non-cash stock based expenses, amortization expense of acquired intangible assets and restructuring expenses. We have provided reconciliations of these non-GAAP measures to GAAP financial measures in the investor relations section of our website located at www.ArubaNetworks.com and in our earnings press release.

Now, I’d like to introduce Dominic Orr, President and Chief Executive Officer of Aruba Networks.

Dominic P. Orr

Thank you for taking the time to attend our fiscal third quarter conference call. Overall, we had a strong quarter with 8% year-over-year revenue growth to $45.8 million. As expected, [inaudible] in the first half of March were tough especially as many companies still had not set the IT budgets. April was much stronger and we enter our fourth quarter with some momentum and expect to grow revenues on both a sequential and year-over-year basis.

During the third quarter we also reduced operating expenses by continuing to position the company for future growth with targeted investments in key areas. Overall, we reported non-GAAP gross margins of 67.6% and non-GAAP net income of $0.01 per share. During the quarter we added over 500 new customers and now have over 7,000 total customers spread across a wide range of industries and geographies.

New customers in the third quarter included one of the world’s largest mobile operator, a major medical center in Boston, a leading global software company, one of the biggest luxury hotel chains in the world, one of the largest steel producers in the world, higher education institutions across the world and one of the largest secondary school districts in Australia. The Australian deal was won jointly with IBM and is a program to implement our secure wireless solution in to 463 secondary schools. With limited IT support available at most individual schools, our centralized management solution, ease of implementation and proven security provide and ideal solution for many school districts and high education institutions.

Despite the reduction in endowments and cuts in school spending, we believe that wireless is a necessity in the education market and are pleased with the continued demand that our comprehensive solution including our management capabilities is successfully addressing. During the quarter, we also won a number of strategic accounts in other important verticals both domestically and internationally. We expect these customers to grow in to some of our bigger contributors over the next year.

We are pleased with the growing mind share and traction among customers outside the education market who are looking at our technology as a way to save money while improving network performance and increasing the mobility of the workforce. The current economic environment has forced enterprises and organizations to rethink their whole approach to networking at the Edge. By virtualization, cloud computing and software as a service are driving down data center costs, the enterprise Network Edge has not changed.

The wire LAN is still typically over built with excess capacity and unused ports. Traditional parameter based network security cannot easily manage the proliferation of mobile devices and remote workers. Complicating the challenge for IT professionals, IT departments often have to replicate complex network infrastructures at multiple remote locations just to manage and control users and devices. At Aruba our mission is to help solve this fundamental problem.

In today’s environment, we believe there’s a clear market for right sizing the Network Edge to deliver immediate cost savings and reduce carbon footprints through more resource utilization. With the increasing adoption of 802.11n wireless can now provide the same user experience as the wired network and introduce mobility in to the work office. With greater security and traditional parameter based wireless secured then the traditional parameter based wired networks. This is why leading industry analyst like the Yankee Group are predicting that wired switch port sales will decline for the first time in history.

They also predict that wireless access will rival Internet access resulting in cost savings and productivity improvement. For example, in a port-by-port analysis of Ethernet use, the California State University realized that at no time were more than 50% of the ports being used. By reducing ports and eliminating 2,500 switches this customer calculated that they would be able to save $30 million over five years in capital and operation costs. This is just one example of the way in which customer are realizing cost savings through the wireless LAN roll outs.

Beyond right sizing the Network Edge, one of the key problems facing IT professionals today is dealing with tens, or hundreds or even thousands of remote offices. Today, networking solutions must replicate routing, switching, firewall and other services at each remote location. Equipment required is expensive and the services are complex to set up and manage and consuming IT resources and money.

We have taken on the challenge of remote networking and last week introduced our virtual branch networking or VBN solution that at once lowers the cost, complexity and IT overhead associated with deploying and managing branch office, teleworker and other remote networking applications. Our VBN solution just won the best of [inaudible] award in the wireless and mobility category. VBN includes powerful new software that virtualizes complex networking tasks traditionally implemented at the branch in to the data center.

At the Edge we have developed three new [inaudible] family of wireless branch office controls and remote access points which we call RAPs. The RAP II has US list price of just $99 making it the least expensive centrally managed enterprise branch networking solution on the market. The high end 600 branch officer controller family is designed to be a branch network in a box and features network attached storage support and wired and wireless WAN connectivity.

Since our solution is centrally managed and disseminated from the controller branch office setup is quick and easy. The one click installation allows a non-technical person to provision a branch office in minutes. So far the feedback has been encouraging. For example, a major retail customer recently deployed our VBN solution at nearly 100 sites. Our customer was able to use our technology in suburban locations over 3G or DSL without any additional customization requirements allowing them to choose the most effective method of connection at each site.

Now, I want to stress that we are at the very early stage of the market for VBN but we do not believe that it has the potential to add additional revenue growth in this quarter but we believe that it will add additional revenue growth in fiscal 2010 and significantly increases our [TAM] over the longer term.

To summarize, while it remains a tough and highly competitive market, we are clearly excited about the long term growth opportunities for our product and believe that both right sizing the Network Edge and virtual branch networking can drive incremental revenue growth in the future. We are offering our customer solutions that save money, increase productivity and solve problems by revolutionalizing access of the Network Edge. We executed on track in the third quarter and believe we can grow in the fourth quarter.

While immediate focus is on generating short term revenues and profits, we are not losing sight of the longer term company objective which is to be the leading provider of secure mobile access for the largest enterprises and organizations in the world. We believe that the vast majority of our new customer and design wins today will lead to additional revenues in the future.

A little later in the call I will be happy to answer any questions you may have and we will now turn it over to Steffan to go over the financials in more detail.

Steffan Tomlinson

In Q3 total revenue of $45.8 million increased 8% year-over-year. Product revenue of $35.8 million increased 1% year-over-year. Professional services and support revenue of $9.7 million increased 54% year-over-year. As expected, ratable products and related services revenue declined on a sequential basis. In Q3 approximately 83% of our revenue came from indirect channels while 17% was direct.

As a reminder, our indirect channels represent sales through our distributors as well as our strategic OEM partner Alcatel Lucent. Additionally, during the quarter, existing customers accounted for 64% of sales down seven percentage points from last quarter. Alcatel Lucent was a 10% partner. Approximately 60% of our sales were generated in the US with the remaining 40% coming from international theaters.

When we headed in to Q3 we believed that the quarter would be back end loaded. True to these expectations, bookings in February were light, March improved and 54% of our bookings came in April. Bookings overall and for our major theaters grew year-over-year. Non-GAAP gross margins in Q3 were 67.6% compared to 70.2% in the prior quarter and within our targeted range of non-GAAP gross margins of 65% to 68%.

Q3 non-GAAP product gross margins were 63.3% compared to 67.8% in the prior quarter due in part to product mix, reserves related to inventory transitions and increased overhead absorption. The number of 802.11n access points as a percentage of total access points was flat with the prior quarter at approximately 28%. Q3 non-GAAP service gross margins of 83.6% compared to 81.3% in the prior quarter benefitted from the increase in service renewals. Going forward, we expect total non-GAAP gross margins to be within our target range.

Moving on to operating expenses, we have proactively aligned our cost structure to reflect the current challenging economic environment without impacting our long term growth and are pleased with our progress so far. Non-GAAP research and development expense was flat with the prior quarter and increased slightly as a percentage of revenue from 17.1% in Q2 ’09 to 17.9% in Q3 ’09.

Non-GAAP sales and marketing expenses were down $1.2 million from the prior quarter and decreased as a percentage of revenue from 39.1% in Q2 ’09 to 38.1% in Q3 ’09. Non-GAAP G&A expenses decreased by $300,000 in the prior quarter and relative to Q2 ’09 were down as a percentage of revenue to 9.8% in Q3 ’09. As we move deeper in to the discovery phase of our lawsuit with Motorola, legal expenses for Q3 continue to impact our G&A line and totaled approximately $900,000 or $0.01 per share.

Headcount at the end of Q3 was 531, flat with the prior quarter and down 21 heads from the prior year. Even with the ongoing legal costs, I’m pleased that we lowered operating expenses by approximately $1.5 million during the quarter down 4.7% from Q2. Relative to our fiscal Q1 operating expense run rate of $35 million, our operating expense reduction in Q3 resulted in an op ex reduction of approximately $4.8 million.

Through our focus on cost reduction efforts we are well ahead of schedule to achieve planned operating expense reductions of $5 to $6 million over the second half of fiscal 2009. Our non-GAAP tax rate was 17.5% in Q3 compared to 9% in Q2. We expect our tax rate in Q4 to be approximately 15%. Non-GAAP net income for the quarter was approximately $1 million or $0.01 per share. This compares to non-GAAP net income of $2 million or $0.02 in Q2 ’09 and non-GAAP net loss of $1.1 million or $0.01 per share in Q3 ’08.

GAAP and non-GAAP net income include approximately $0.01 per share worth of expenses related to the Motorola lawsuit. Q3 ’09 non-GAAP weighted shares outstanding were 88.6 million shares on a diluted basis. The GAAP net loss for the quarter was $5.8 million or $0.07 per share compared to a GAAP net loss of $6.8 million or $0.08 per share in Q2 ’09 and a GAAP net loss of $6.2 million or $0.08 per share in Q3 ’08. Our third quarter of 2009 GAAP results included $5.5 million of non-cash stock based expenses and $1.2 million of amortization expenses of acquired intangible assets.

Turning to the balance sheet we finished April with $11.8 million of cash and short term investments. This represented a decrease of $3.4 million from the last quarter. Cash flow from operations declined by $4 million compared to the prior quarter due in part to linearity and the back end loaded nature of the quarter. Year-to-date we are pleased with our performance with operating cash flow which is approximately $9.2 million and we expect to be cash flow positive in Q4 ’09.

Given our strength in April we ended Q3 with $30.7 million of accounts receivable up from Q2 ’09 balance of $23.6 million. Moving down the balance sheet, short term deferred revenue was $24.6 million at quarter end compared to $28 million at the end of Q2 ’09 and $22.5 million at the end of Q3 ’08. Days sales outstanding were 60 days, flat year-over-year and an increase of 16 days from an exceptionally strong fiscal Q2 and above our long term DSO target of between 50 and 55 days due to a primarily back end loaded quarter. We believe the quality of our receivables remains excellent.

Inventory totaled $12.3 million at the end of Q3 down by $1.6 million from the end of Q2. Inventory turns decreased sequentially to 2.8 from 3.2. Global economic conditions continued to impact our business and the level of competition in our market remains high. At the same time we had a solid third quarter, our win rate has remained consistent and our visibility has improved over the last three months with a number of multi quarter contact wins in Q3.

Balancing all these factors we expect revenues in our fourth quarter of fiscal 2009 to be in the range of $48 to $50 million. We expect non-GAAP EPS of $0.01 to $0.02 per share using a 15% tax rate and 88 million and 95 million shares on a basic and fully diluted basis respectively. With that, let me turn the call back over to Dominic.

Dominic P. Orr

Steffan, Keerti and I would now be happy to answer any question you may have. Operator, now you can open up the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Sue – RBC Capital Markets.

Mark Sue – RBC Capital Markets

Maybe some further comments on the month of May which followed a strong April, maybe comments just on overall pipeline and how you feel deal sizes and closure rates and also whether or not we should expect a return to normal linearity for the July quarter?

Dominic P. Orr

As we pick up momentum in April in terms of bookings we also picked up momentum in terms of the building of the pipeline and off our pipeline if you could recall about a year ago kind of understanding the softness of the enterprise market coming, we announced that we were going to focus our market development and lead generation effort in to the government, healthcare and education market. I’m actually very happy to report that part of the strength for April and also in our pipeline is a significant increase of such opportunities.

All in all we have very strong momentum in terms of our pipeline and obviously we’re going to moderate it with the caution that is applicable for the general macroeconomic environment where the procurement cycle could be lengthened and procurement can come in phases and all that.

Mark Sue – RBC Capital Markets

Dominic maybe if you could share with us the moving parts whether it relates to whether you might come in at the low end of your guidance or the high end? Also, the thought that you’re tightening the range, what are you pointing to there in terms of how we should be thinking about the guidance going forward?

Dominic P. Orr

The way I am thinking about the pipeline is that I feel the government, healthcare, education deals worldwide we have a better handle on the closing dates. On the other market segments we’re focusing on design wins and that would be whatever times that the procurement ends when the project lands, when the budget is there is really somewhat beyond our control. The tightening of the ranges is somewhat reflective of our rapidly increased proportion of the government, healthcare, education sector, the pipeline in those sectors.

Operator

Your next question comes from Jeffrey Kvaal – Barclays Capital Market.

Jeffrey Kvaal – Barclays Capital Market

Dominic of the enterprise based checks or networking checks that we’ve had over the course of the past few months, you folks are the first to really indicate that you’ve seen a bit of an uptick in the market. Why do you suppose that is? Is it a function of markets or is it your particular product set? Any thoughts that you may be able to share would be helpful.

Dominic P. Orr

From a market perspective, first of all in the healthcare and education market we believe that wireless is now becoming a necessity and so it’s somewhat secured in terms of the business and growth. The second is we believe that in terms of our pipeline at least that under this tough economic environment the usage of 11n as a Network Edge technology is very appealing to a lot of large enterprises with tight budgets as compared to the traditional way of using kind of port based wired Ethernet.

Thirdly, I think within the wireless LAN market we believe we are gaining market share. As you probably noticed, two of our large publicly listed competitors have reported their wireless LAN business has shrunk double digit year-over-year and we just reported that we have grown 8% year-over-year so that also contributed to the growth.

Jeffrey Kvaal – Barclays Capital Market

Steffan, of [inaudible] the services mix, should we think about both lines being up then in the upcoming quarter?

Steffan Tomlinson

Correct.

Jeffrey Kvaal – Barclays Capital Market

If I’m reading this right there’s a bit of deferred revenue, anything we should make of that?

Steffan Tomlinson

There’s seasonality in our deferred revenue and if you look back to Q3 ’08, that would be a relative comparison and we’re actually up year-on-year but there is seasonality in the deferred revenue. We’re primarily a book and ship business and we feel comfortable with the deferred revenues where they are.

Jeffrey Kvaal – Barclays Capital Market

Would we expect then deferred revenues to be up again in the July quarter?

Steffan Tomlinson

We don’t forecast deferred revenues but I will tell you as a proxy with increasing revenues, deferred revenue tends to increase.

Operator

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

Erik Suppiger – Signal Hill Group

Can you give us any details on the IBM deal? I think IBM announced that it was about $70 million. Can you give us any frame of reference of what portion of that will you see? Secondly, what opportunity you have to expand on that relationship because I don’t think you’ve done a lot with them historically?

Dominic P. Orr

Well actually, over the last 12 months we have quite a number of engagements with IBM in multiple theaters particularly the international theaters. But obviously, this recent win in Australia is the most notable. As you may have noted from the IBM press release, this is a multiyear product service project connecting 225,000 laptops in 400 plus schools and IBM is the system integrator.

That same press release stated that the target implementation time is 12 months from the announcement which was April so clearly the supporting this whole wireless network roll out is one of our big tasks here and we are still actively working with IBM to stage out the implementation and roll out plans. So, that’s the framework I can give you.

Erik Suppiger – Signal Hill Group

Can you suggest whether this is one of your biggest deployments?

Dominic P. Orr

We certainly look at this as one of our top 25 accounts. We also share with you about the statistic of our top 25 accounts and how to repeat buying pattern so this deal has definitely has made it on that list.

Erik Suppiger – Signal Hill Group

You has said that you have a number of engagements with IBM, do you see IBM working more effectively with partners like yourself in light of competitive issues with CISCO?

Dominic P. Orr

Well, I cannot comment from the IBM perspective but I certainly can let you know that they’re worldwide footprint and their target account list is very complementary to our technology and product offering and hence like I mentioned starting 12 months ago we have started to engage in multiple countries, multiple theaters along our targeted list. We certainly would not let any opportunity be missed out given any new impetus to a tighter working relationship. It certainly has not escaped our attention.

Erik Suppiger – Signal Hill Group

Last thing, the percentage of shipments that were 802.11n was flat. I would have expected that to continue to increase. Any reason that didn’t increase and would you expect that to continue increasing going forward?

Dominic P. Orr

Yes, I expected that to continue to increase going forward for a couple of reasons. First, it’s the relative proportion of 11n in education market is higher because the bandwidth requirement, because the support of capital devices which come only with 11n interfaces and given that education is a big market for us. So, following the seasonality of the education market, I suspect that the 11n product will ramp.

Secondly, as you might have heard the ratification of 11n which was originally recently targeted for January 2010 has actually now been pulled in to November this year. So, I think even though the ratification for people who have committed to do 11n the ratification time is not as important. I think the pulling in of the ratification day actually encouraged people who were kind of sitting on the fence to be more encouraged to start planning on 11n. For those reasons that are relevant to Aruba, I expect the 11n mix to be increasing.

Erik Suppiger – Signal Hill Group

Would you expect it to be over 50% by the time of ratification?

Dominic P. Orr

I actually cannot predict that because of the rule we do not forecast product mix.

Operator

Your next question comes from Thomas Lee – Goldman Sachs.

Thomas Lee – Goldman Sachs

Just a question on the guidance, does your guidance assume that activity or the improvement you saw in April, that continues at that level or do you expect as we go through the quarter that your business or business activity level or revenue trajectory improves on a month-over-month basis?

Dominic P. Orr

Let me just put it this way, we are quite comfortable with the guidance because of the increased momentum as we exit April coming in to this quarter of our pipeline. However, at least for the portion of the pipeline that are not in the government, healthcare, education sector, we are still applying the caution that I think one should in terms of this macroeconomic environment. The closure rate of the pipeline has to be moderate. But, the proportion of our projects in the government, healthcare, education sector is such that we feel comfortable enough to tighten up a little bit of the range of the guidance.

Thomas Lee – Goldman Sachs

So you’re taking a more cautious stance primarily on the government sector?

Dominic P. Orr

No, we think we are more confident of the portion of the pipeline that is in the government, healthcare and education sector and it seems that those two sectors have been doing well for us. That is the portion of the pipeline that gives us better confidence in our guidance and that’s one reason we have tightened up the range.

Thomas Lee – Goldman Sachs

Just on this whole right sizing concept, can you talk about which verticals are you seeing the greatest amount of I guess activity?

Dominic P. Orr

I think as I mentioned we have two new initiatives that we hope in multi quarter fashion will add to our [TAM] and our revenue growth in fiscal 2010. You mentioned one of them which is the right sizing activity and that actually is applicable to particularly North America, large campuses, corporate campuses and large buildings which traditionally are both wired ports and wired switched have been typically three to five times over provision and so that is one area where we’re starting very active dialog to help people to make the best of the existing infrastructure and adding 11n to extend their functionality without totaling refreshing the wired network.

Those typically are two, three quarters, kind of planning and deployment projects so we are happy with the pipeline but we are not expecting a lot of incremental revenue in the current quarter. Secondly, our engine of growth is in the virtual branch network where we have developed a pretty healthy pipeline and again this large corporation primarily in the service industry where there’s a large number of small branches and stressing the IT staff and again, this large corporation they move rev conservatively and we’re dealing with a whole enterprising network architecture so this again is going to be multiple quarter kind of initiatives.

So, while we are very, very encouraged by the pipeline of projects being developed on both fronts we are taking a very realistic view that until several quarters later this will not be meaningfully impacting our top line.

Thomas Lee – Goldman Sachs

Last question maybe for Steffan, just trajectory of kind of new customers versus repeat customers, you saw obviously a big kick on the new customer front. How should we think about next quarter? Do you expect that trend to continue?

Steffan Tomlinson

Typically our Q4 is one of the strongest quarters that we have both in terms of revenue growth and also new customers additions. We’ve been operating in the call it 500 to 600 new customers over the last couple of quarters. I don’t see any reason why we’d deviate from that going in to Q4. The main point that we track internally though is not just the total number of customers, it’s those customers that have strong repeat buying probability and patterns. So, we’re focused on all customers but we also have a specific focus on the global 200 and also government, education and medical.

Operator

Your next question comes from Sanjiv Wadhwani – Stifel Nicolaus & Company.

Sanjiv Wadhwani – Stifel Nicolaus & Company

Two questions, first Steffan it looks like international revenues were up about 1% sequentially, US was down 7%, can you talk about where you saw strength in the international markets? Europe has sort of come up as a geography that seems to be troubled so I was just curious how that faired versus Asia?

Steffan Tomlinson

In Europe we had a little bit of a mix bag. Northern Europe and Southern Europe and France actually were pretty good specifically the Nordic region, the Netherlands we had a number of key wins in those regions. The UK was a little bit challenged but I don’t think that’s a surprise to anyone. In APAC we had nice growth in China, in Australia. On the mixed bag front in Asia PAC, Korea continues to be hampered by currency fluctuations, the devaluation of the Won. But, I would say overall when you look at it at a feeder level, we are very pleased with the overall growth on a year-over-year basis of all our major theaters.

Dominic P. Orr

From a bookings perspective, we have growth on all theaters, APAC, EMEA and Americas.

Sanjiv Wadhwani – Stifel Nicolaus & Company

That’s year-over-year bookings growth?

Dominic P. Orr

I believe it was both year-over-year and sequential.

Sanjiv Wadhwani – Stifel Nicolaus & Company

A question for either you Dom or Keerti, it looks like CISCO had some announcements around sort of the branch office also a couple of days ago. Can you just comment on that and sort of contrast what they’re doing with what you’ve announced?

Keerti Melkote

It’s basically the technology that they’ve announced is fundamentally the wireless LAN technology that they’re looking to deploy outside of the enterprise. This is similar to what our remote AP technology enabled a couple of years ago. The difference between what they’re doing and what we have done with our virtual branch networking initiative is basically what we covered on the call which was fundamentally our advantages come in the area of our ability to do secure one click installation of the branch office site as well as being able to do it with all the policies that you would typically do at a headquarter site.

Secondly, we’re also bringing technology at price points that are currently unheard of in the enterprise branch office market especially with the RAP II that is priced at $99 a branch site. So, those differentiate us and hold us in good stead. Just a quick point here, we just won the best of show for our branch office technology competing against CISCO and many other players in the category.

Operator

Your next question comes from Bill Choi – Jefferies & Co.

Bill Choi – Jefferies & Co.

First a question for Steffan, can you quantify the charge you took on the product that hurt gross margins please?

Steffan Tomlinson

We don’t get in to the specifics of the various reserves that we take. But, I’ll tell you that the overall product gross margin mix was impacted by a number of things, the reserves related to the inventory transitions was one part of it. But, in this quarter we actually sold a little bit more access points than controllers and as you know from a gross margin standpoint controllers have a more favorable gross margin profile than access points. So, it was a combination of product mix, the reserves and also a little bit of the overhead absorption.

Bill Choi – Jefferies & Co.

But just given the meaningful shift in product gross margins, can you at least order in size of magnitude which ones has the biggest impacts and where the reserves fall in that?

Steffan Tomlinson

We don’t give the specifics but I will tell you in rank order the product mix was definitely the largest driver of having the product gross margins come down on a sequential basis followed by the reserves and then overhead absorption.

Bill Choi – Jefferies & Co.

It sounds like 802.11n is finally moving in and that’s great news from my perspective. At the analyst day, I think you guys were talking about how the 802.11n group was starting to build in video over Wi-Fi, all these extraneous things that were delaying it. Can you describe why now it’s getting pulled in?

Keerti Melkote

The main reason what’s happening is the problems that are outstanding are getting resolved faster. In other words the folks that had the outstanding questions are basically happy with the comments and therefore, you had about 7,000 comments that were unresolved that is going down substantially over the past couple of meetings. So, that is really what is helping us bring it forward.

Bill Choi – Jefferies & Co.

Does this still have the video over Wi-Fi and those elements still in it?

Keerti Melkote

Yes.

Bill Choi – Jefferies & Co.

Then if you could talk about this trend of it seems to me one of the key things that is giving you greater visibility in this coming quarter is the number of multi quarter contracts you won. Can you either quantify it or compare what happens in the past quarter or in the most recent quarter with prior quarters?

Dominic P. Orr

I think that at any given quarter Bill we always work on a good pipeline of large deals but then you make your numbers depending on the medium sized deals. I think it is just a matter of last quarter some of these deals finally that we won before, the accounts got rolling. I cannot give you a single trend because the type of account, the location, the theaters it happened is pretty widespread so I cannot give you one reason other than state the fact that yes, we have now more multi quarter deals that are in motion.

Bill Choi – Jefferies & Co.

Which verticals is that occurring in? Is that influenced at all by the stimulus money coming from the government?

Dominic P. Orr

No actually, we are working very actively with a couple of our big partners on the stimulus related opportunity but none of this actually has materialized substantially yet.

Bill Choi – Jefferies & Co.

One final question, Steffan can you give us a rough revenue breakout by verticals which you’ve done at various points in the past?

Steffan Tomlinson

We had about a year ago given some breakouts but what we’ve done to be more constructive is actually lumped the verticals together. The government, education and healthcare business was very strong for us, those three combined, we don’t give an exact revenue percentage but it is easily above 10% for those verticals. There is a mixed bag, I will tell you that retail was a little soft or lumpy this quarter relative to how its performed in prior quarters. We also think that the federal business is kind of back on track and we feel comfortable with our fed business.

Bill Choi – Jefferies & Co.

Government, healthcare and education has always been well over 50%, just curious today if it’s a bigger percentage than its been in the past?

Dominic P. Orr

It was I think modestly above but, the trend for the last four quarters is it’s increasingly more of a percentage of our total revenue.

Operator

Your next question comes from Ehud Gelblum – JP Morgan.

Ehud Gelblum – JP Morgan

When you see the strength in orders that came through in April and seems to have continued in to May, how do you parse the difference between pent up demand from people who wanted to buy in January, February and March that were obviously holding off versus new orders for projects that will continue to and sustain and design? How do you get comfortable in knowing the difference?

Dominic P. Orr

What we do is we track on our pipeline system the aging of the prospective deals and clearly we’re seeing a lot of the conversion happening in the last month of our last previous quarter and that trend seems to be continuing. Then, we look at the pipeline itself, the ratio of the pipeline over our target and like I mentioned early on for the projects that we have been working on with the government, healthcare, education sectors the projected conversion date seems to be more deterministic. I won’t say deterministic but more likely to not widely deviate.

So, for the other sectors you just have to build a bigger pipeline to account for the fact that in general conversion rates could continue to be like the beginning of the year. I think our guidance reflects the fact that we feel we have the right pipeline to account for the lower conversion rate.

Steffan Tomlinson

One follow on is we’ve had some decent bookings and orders in the first several weeks of the new month.

Ehud Gelblum – JP Morgan

So a lot of the revenue you actually collected – you said the linearity, the 54% of revenue was in April?

Steffan Tomlinson

Bookings.

Ehud Gelblum – JP Morgan

So of the revenue you collected, what percent of that was in April?

Steffan Tomlinson

From a revenue linearity standpoint we typically don’t break that out, we typically give a bookings number but I will tell you in the month of April as compared to the month of January there was call it a 10 point delta in terms of more back end loaded in April than in January.

Ehud Gelblum – JP Morgan

You mentioned another interesting stat, you said that existing customers went down seven points as a percent of revenue so the flip side new customers went from 29%, if I do that math right, to 36% of your revenues this quarter. Was that ratio the same in April as it was for the whole quarter and has that ratio continued in to May?

Dominic P. Orr

Typically this ratio has quite a bit of deviation from quarter-to-quarter. So, even if we have the data I probably won’t correlate it to anything material from month-to-month, it’s hard to correlate.

Ehud Gelblum – JP Morgan

So it’s a nice stat but it doesn’t mean half as much as it sounds?

Dominic P. Orr

No, we don’t want to make it a big deal.

Ehud Gelblum – JP Morgan

At the analyst day you gave us some pricing statistics on where .11n is versus G or A. What’s the pricing differential now and how does that change?

Dominic P. Orr

I think currently in the marketplace in general 11n access points are still roughly slightly over 2x of ABG and there was not significant movement since we met on the analyst day. But, I think on that day also we project that sometime probably in the mid 2010 is when the next generation chips get productized and that is when I think you see a more –

Ehud Gelblum – JP Morgan

Are you expecting the pricing to stay at 2x between now and when the new [inaudible] come out in mid 2010?

Dominic P. Orr

I don’t think I would forecast any industry movement because time is tough and competitors can make moves. But, I can tell you the cost structure of implementing 11n access points is not going to be drastically – there’s nothing happening this quarter that’s drastically changing that.

Ehud Gelblum – JP Morgan

Then finally, are you seeing all verticals moving to 11n equally? You said education is obviously moving quicker I guess because of iPods and iPhones but is it 28% of all – if you’re looking at verticals is 28% of them buying 11n right now or are 28% of your verticals moving to 11n and the other 72% are not?

Dominic P. Orr

I think there are two applications of the 11n, for markets like healthcare and education where mobility is a must and wireless infrastructure is a given, 11n is used to generate more ambiguous coverage and higher throughput to support more applications. Then, you have the general enterprise which has been taking a more conservative approach to mobility just because they don’t have as many laptop carrying employees, users or handheld mobile device users. In those enterprise the incremental traction of 11n is really being applied to a fast Ethernet port replacement discussion.

So, I would say from the pipeline perspective they are increasing more engagement that we have that is in this second category but in terms of large volume of product movement as I mentioned earlier, these are multi quarter projects that we expect the impact will more likely be happening in our fiscal 2010.

Operator

Your next question comes from Greg Mesniaeff – Needham & Company.

Greg Mesniaeff – Needham & Company

Could you comment on the services component of your revenue mix this quarter which appears to have been stronger in the quarter than in previous ones. And, whether that’s just kind of a onetime situation or is that a trend that we should focus on?

Steffan Tomlinson

Our support revenue continues to grow on a sequential basis and it’s driven in large part by the support renewal system that we have in place. This quarter benefited from a number of large renewals that had come in. We anticipate that line item in the P&L to continue to grow.

Greg Mesniaeff – Needham & Company

That being said, what kind of impact on overall gross margins do you see that having over time?

Steffan Tomlinson

Well, our services gross margins are actually very robust and they’ve been tracking the last couple of quarters in the low to mid 80s. We will continue to make investments in the service and support organization to support our now well over 7,000 customers worldwide. One of our key differentiators against all the other wired competitors who are trying to do wireless LAN as an offshoot is that we are 100% focused on delivering the best in class service to all of our customers and it is absolutely a competitive differentiator. So, in short we will continue to make investments in that organization but, we’ll see the overall gross margins in the services business at these levels for a while.

Operator

Your next question comes from Rohit Chopra – Wedbush Morgan Securities, Inc.

Rohit Chopra – Wedbush Morgan Securities, Inc.

Can we just come back to the IBM deal for a second. I just wanted to get a sense for the size, could you maybe say if it is a seven or eight figure deal?

Steffan Tomlinson

We don’t comment on particular deals especially at their early stage of where it is. What we will tell you though is given the projected roll out we feel like it will be in the top 25 customers. If you remember, from our analyst day we had given folks the update that in order to crack in to the top 25, a customer would have to spend over $1.8 million and we feel that this deal will definitely be able to crack in to the top 25.

Rohit Chopra – Wedbush Morgan Securities, Inc.

Then the other thing I wanted to ask is are there any other system integrators that you’re working with other than IBM?

Dominic P. Orr

Definitely we have a nice relationship with AT&T, with Bell Canada, with Verizon, NTT Data, [inaudible] in Hong Kong and so on. So, we have a pretty robust number of large system integrators with a good footprint.

Rohit Chopra – Wedbush Morgan Securities, Inc.

I wanted to ask about AirWave contributing to some of these multi quarter wins? Are they part of this or how are you winning these deals?

Dominic P. Orr

Certainly AirWave is a competitive advantage for us because it allows a centralized management staff to be able to deploy, monitor, troubleshoot and in some cases remediate issues in remote sites where most of this large multisite customers would not have the proper level of IT staff. So, you could say that for the larger and the more distributed the customer, the more valuable is AirWave a feature in Aruba portfolio.

Another thing is if our customer is focusing on not only wireless connectivity but mobility, it is very important, mobile devices is very important. We have extended capability through AirWave on managing not just the devices but the user and the end devices not just the networking devices and those are invaluable capabilities that help us to provide a one stop solution for our larger customers.

Rohit Chopra – Wedbush Morgan Securities, Inc.

Can you talk a little bit about the competitive environment? We talked to a few of your resellers who said that CISCO had become a little more aggressive over the last couple of quarters as far as pricing and they were really saying that the pricing on the services component they were trying to get a little bit more aggressive rather than on the product side. Could you talk a little bit about that?

Dominic P. Orr

I can tell you that definitely the market has become more competitive but it is in the sense of CISCO because on the smaller private company side we definitely see a quieting down of competition, the noise level has been very clear that tactical engagement we’re seeing CISCO and CISCO I can confirm is getting increasingly more aggressive particularly with the pricing strategy. In certain situations we’re seeing very aggressive discount but because of our value proposition is so strong and the total cost of ownership, in most situations we do not need to meet them there.

So, other than CISCO in the retail and logistics space obviously Motorola continues to be incumbent but because this retail is lumpy in the last quarter there was not a lot of large lump deals out there so I think in that respect the competitive energy against Motorola actually has calmed down a bit.

One area that has changed slightly is before we never run in to HP ProCurve but now in the area of K to 12 and in some area of hospitality we are seeing occasionally some HP competition but I would say in many more cases we actually complement one another because the same customer who is looking for best in class wireless LAN is also looking for best in class and best value per dollar in edge switches to complement the wireless LAN so in those situations we actually are complementing the HP ProCurve wired switch line is actually complementing the Aruba wireless LAN solutions. So, we’re seeing those situations a lot more than actually we’re seeing them coming up to the wireless LAN layer.

Operator

Your final question comes from Blaine Carroll – FTN Equity Capital Markets.

Blaine Carroll – FTN Equity Capital Markets

Steffan if your business continues to recover like we’re sort of seeing the early signs right now, as you look out to 2010 would you expect to see sequential growth from quarter-to-quarter or would you expect to see more that normal seasonality within your quarters?

Steffan Tomlinson

Well, we’re not giving guidance yet on 2010 but I can tell you that given the last couple of years worth of data I think that it wouldn’t be a stretch to say that there’s going to be some seasonality in the quarters. Our approach has always been to drive the top line, see growth and also deliver results to the bottom line so that will be operating principles that we’re going to adhere to going forward. But, given some of the prior year’s data we just do see some seasonality in the business.

Operator

Management at this time we’ll turn the conference back over to you for any closing comments you might have.

Dominic P. Orr

Again, I thank you for being on the call today and appreciate your support. I am pleased with our performance in Q3 and our outlook for Q4. While we are realistic about how hard it is to grow in the current market, we believe that our value proposition is resonating with customers and they are rethinking their approach to the Network Edge. I believe our competitive position has never been stronger and the long term value of our growing customer base is highly encouraging for the future.

Finally, I would like to conclude this call by expressly thanking all of our employees for their hard work, dedication and competitive spirit. We believe we have the right technology and vision and we also demonstrated this quarter that we all can execute well in a tough market and that is a high testament to you, our employees’ effort. Thank you very much.

Operator

Ladies and gentlemen that will conclude today’s teleconference. If you would like to listen to a replay of today’s conference please dial in to 303-590-3030 or 1-800-406-7325 and enter the access code of 4070876. We thank you again for your participation and at this time you may disconnect.

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Source: Aruba Networks, Inc. F3Q09 (Qtr End 04/30/09) Earnings Call Transcript
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