SonicWALL Q2 2009 Earnings Call Transcript

| About: Sonic WALL (SNWL)

SonicWALL (SNWL) Q2 2009 Earnings Call July 23, 2009 5:00 PM ET

Executives

Kelly Blough - VP, Investor Relations

Matt Medeiros - President and CEO

Robert D. Selvi - Chief Financial Officer

Analysts

Sterling Auty - J.P. Morgan

Joel Fishbein - Lazard Capital Markets

Matt Hedberg - RBC Capital Markets

Craig Nankervis - First Analysis

Operator

Good day and welcome to the SonicWALL Second Quarter 2009 Conference Call. As a reminder, today's conference is being recorded. At this time I would like to turn the conference over to Ms. Kelly Blough. Please go ahead, ma'am.

Kelly Blough

Thank you, Shea, and thank you, everyone, for joining us. Welcome to our second quarter 2009 earnings conference call. With us today are Matt Medeiros, President and CEO of SonicWALL and Robert Selvi, CFO.

Before we begin I'd like to remind everyone that during this conference call we'll be making forward looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended. Forward looking statements include, without limitation, revenue, GAAP, and non-GAAP earnings per share, and gross margin guidance for the third quarter of 2009, expected operating expense increases for the third quarter of 2009, the impact of our continuing commitment to operating efficiency on our financial performance, the benefits associated with new products and services, the security and performance characteristics of our product and service offerings, the impact of economic factors on our ability to generate revenue growth, and the impact of our GSA listing our ability to take advantage of government sales opportunities in the future.

All forward looking statements made on this call are subject to risks, uncertainties, and assumptions, that could cause actual results or events to differ materially from those contained in the forward looking statements. For a detailed description of the risk and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward looking statements, as well as the risks related to our business in general, we refer you to the period reports that the company has filed from time to time with the SEC, including discussion in the risk factor section of the company's annual report on Form 10-K for the year ended December 31st, 2008.

The company undertakes no obligation to update forward looking statements at any time or for any reason. In addition, the following information includes non-GAAP results which exclude amortization of purchase technology in the cost of goods sold, amortization of intangible assets and operating expenses, and stock based compensation expense. Please see our website and our Form 8-K filed with the SEC earlier today for reconciliation of non-GAAP to GAAP results. I will now turn the call over to Matt Medeiros.

Matt Medeiros

Thank you, Kelly. Good afternoon, everyone, and thank you for joining our call. In general, we're pleased with our accomplishments in the second quarter which was characterized by sequential improvement across a number of areas. SonicWALL's total revenue in the second quarter grew to $48.6 million. Units sold grew to 39,000 units, a sequential increase of 7% contributing to an improvement in product revenue. So while we remain cautious regarding the demand environment, Q2 represented a step in the right direction.

In the second quarter, non-GAAP earnings per share were $0.10, well above our guidance range of $0.06-0.07. Gross margin performance remains strong and our operating margin was 16% versus 7% one year ago. These results demonstrate the effect of our continued commitment to operational efficiency and achieving mid-teen operating margins.

Operational efficiencies continued to benefit our balance sheet as well. We reported over $11 million in operating cash flow in the second quarter, representing over 20% of our total revenue. We ended the quarter with $189 million in cash, cash equivalents, and total investments, approximately $3.50 per share with no debt.

Our bundling and promotional strategy in North America continued to drive demand in the second quarter, winning competitive displacements for our UTM product lines. This program contributed to unit growth in the quarter and to increases in deferred revenue.

In the second quarter we were encouraged to see some significant customer wins spanning across multiple product lines, indicating that our investments made are paying off. In the second quarter our clean VPN solutions that combine our E-Class SSL-VPN technology and our E-Class UTM products were selected by government agencies, both domestic and international.

These deals were directly competitive against Cisco and Fortinet with SonicWALL winning based on our breadth of enterprise features and price-performance advantage. A number of enterprise customers in the US and Europe purchased our E-Class products in the second quarter with specific intent of running full UTM services. Customer examples include large financial institutions in the US and the UK and domestic and international educational institutions.

In competition with Symantec and Checkpoint for these deals, our ability to run our full security suite, gateway anti-virus, intrusion prevention, anti-spyware, and content filtering at gigabit speeds, gave us the competitive advantage that tipped the scales in our favor.

We also finalized our GSA schedule requirements, resulting in a large order from another government US agency for 23 of our E-Class UTM appliances. With our recent investment in federal government business, along with our presence on the GSA schedule, we are optimistic and intend to take advantage of more government opportunities in the future.

We continue to develop industry leading award-winning technology to expand our market presence. At the end of the second quarter we ship two new UTM offerings; the TZ 200 and the TZ 100. These products introduce a series of mission critical innovations, important to small businesses and distributed enterprise including integrated SSL VPN, 82.11n gigabit interface, and intelligent failover to 3G networks.

Perhaps more importantly in this tough economy, we believe that we've reshaped the competitive landscape by introducing these feature rich products with an entry US list price of $295. At the end of the second quarter we also introduced a strategically important new subscription service, comprehensive anti-spam. This subscription services offers enterprised calibre spam defense delivered through our cloud infrastructure on all UTM appliances, including our new TZ 200 and TZ 100.

Looking ahead, while SonicWALL's business showed some encouraging signs in the second quarter, we remain cautious with respect to our outlook. External factors still point to recessionary conditions. Unemployment remains high, bankruptcy filings are on the rise, and the availability of credit continues to be a major impediment. The risk of a double-dip recession remains significant.

With that in mind and the consideration of seasonality of Q3, our guidance for the third quarter does not assume sequential revenue growth.

Now let me hand it over to Rob to review our financial results.

Robert D. Selvi

Okay. Thanks, Matt, and good afternoon, everyone. Of the $48.6 million in total second quarter revenue, UTM solutions contributed 77%, secured content management solutions contributed 10%, SSL-VPN solutions contributed 8%, and CDP contributed 5%. Total revenue in units shipped in the quarter, as Matt mentioned, was 39,000.

Product revenue was $16.5 million up 7% sequentially and down 31% year over year. As a percent of total product revenue, 81% was generated from products with average net revenue per unit below $1,500. 16% was generated from products with average net revenue per unit of $1,500-5,000 and 3% was generated from products with average net revenue per unit above $5,000.

License and services revenue of $32 million grew about $400,000 over Q1 and was level with the same period last year. License and services revenue represented 66% of total revenue in the quarter, compared to 67% in the prior quarter and 57% in the same period last year.

License revenue represented 9% of total license and services revenue during the quarter, compared to 8% in the prior quarter and 9% in the same period last year.

Total subscription services billings increased to $34.4 million, up 2% from the first quarter and 8% from the same period last year. Multiyear subscriptions accounted for approximately 43% of subscription service billings in the second quarter, an increase attributable to our ongoing three-year competitive displacement promotion.

On a percentage basis, North America represented 67% and international represented 33% of total revenue. Europe, the Middle East, and Africa, contributed 21%. Asia Pacific and Japan contributed 10%, and Latin America contributed 2%.

Non-GAAP gross margin was level sequentially at 74% compared to 71% in the second quarter of last year. Product gross margin was 46% compared to 47% in the first quarter, due primarily to the mix of products sold.

Non-GAAP operating expenses declined again in the quarter to $28.2 million from $29.4 million in Q1, and $35.5 million in the same period last year. The year-over-year decrease in operating expense was the result of reductions in every functional area. The sequential decrease in operating expenses was primarily reflective of payroll reductions, efficiencies, travel to meetings, and third-party fees.

Total non-GAAP operating expenses represented approximately 58% of total revenue for the quarter compared to 62% in the prior quarter and 64% in the second quarter of 2008. Operating expenses for research and development represented 17% of revenue. Sales and marketing expenses represented 34% of revenue, and general and administrative expenses represented 7% of revenue.

At the end of the second quarter, total regular employee headcount was 788 compared to 810 at the end of the first quarter. Interest income net in the second quarter was $1 million compared to $800,000 in the prior quarter and $1.6 million in the same period last year.

The year-over-year decline in interest income is due to a reduction in available yields on investment vehicles. And the sequential increase is due to foreign exchange translation gains.

For the quarter, non-GAAP tax expense was $3.2 million against non-GAAP income before taxes of $8.6 million. Non-GAAP net earnings for the second quarter were $5.3 million or $0.10 per diluted share. Non-GAAP net earnings for the second quarter exclude $1 million amortization of purchase and tangible assets, and $2.2 million of stock-based compensation expense. GAAP earnings for the second quarter were $3.2 million or $0.06 per diluted share.

And now I'll review the balance sheet and cash flow statement. We had another solid cash flow quarter, generating operating cash flow of $11.1 million. At the end of the quarter, total cash, cash equivalents, and short-term investments were $174 million compared to $117 million at the end of the first quarter. Growth in cash in short-term investments is attributed to the strong cash flow I just mentioned as well as a reclassification of approximately $45 million of option-rate securities which are subject to a repurchase rate with UBS. This right is exercise beginning in June 2010.

Net accounts receivable were $17.5 million in the second quarter compared to $19.2 million in the prior quarter and DSO was 33 days compared to 37 days in the prior quarter. Net inventories were $6.1 million in the second quarter compared to $6.5 million in the previous quarter and $7.5 million in the same period last year. Net inventories consist of inventory to our largest distributors and finished good inventory at our third-party manufacturers and logistics provider.

Total annualized inventory turns on a non-GAAP basis were eight times compared to seven times in the prior quarter. Deferred revenue increased $3 million to $111 million up 3% sequentially and 5% year-over-year. The increase in total deferred revenue is related primarily to an increase in subscription deferred revenue.

Deferred revenue attributable to subscription services was $96 million, up 4% sequentially and up 10% in comparison the same period last year.

And now I'll complete my comments with guidance for the third quarter of 2009. As Matt mentioned, we remained cautious due to uncertainty in the overall demand environment, and third quarter seasonality. We expect third quarter revenue in the range of $46-49 million. Our forecast for gross margin in the quarter is in the range of 72.5-73.5%. We expect non-GAAP earnings in the third quarter to be in the range of $0.08-0.09 per diluted share, and this guidance reflects increases in operating expenses including increased third-party fees primarily in accounting and legal, increased depreciation and amortization expense, and moving costs. We expect GAAP earnings of $0.05-0.06 per diluted share. And now we'll turn it back over to Matt

Matt Medeiros

Hey. Thanks, Rob. Historically there's been a tradeoff between network performance and security. SonicWALL solutions eliminate that tradeoff. Every product we design today starts with the premise that great security has to be accompanied by great network performance, whether you're a small business or a large financial or government institution.

This quarter's customer wins helped demonstrate our progress in delivering on that promise, regardless of size or type of business. I'm pleased that we've been able to show great improvement and profitability and business efficiency, while simultaneously keeping our focus on delivering an expanded array of new products and new securities subscription services that are more competitive and relevant for today's market.

With these innovative award-winning solutions, improving operating performance, and a solid balance sheet, SonicWALL is stronger now than ever. I'd like to thank our employees and our partners for their hard work in the second quarter. And now we'll take your questions. Kelly?

Question-and-Answer Session

Kelly Blough

Operator, could you please poll for questions?

Operator

Sure. (Operator's Instructions) We'll take our first question from Sterling Auty with J.P. Morgan.

Sterling Auty - J.P. Morgan

Hi, thanks. Sorry about the background noise. Two quick questions, one, can you give us some color about geographics? Were any regions particularly strong or particularly challenging? And then when looking at September quarter, the followup question is on cash flow, what are you thinking here sequentially should happen with the cash flow?

Matt Medeiros

So thank you for the question, Sterling. North America sales out an also sales overall are very encouraging. You see continued issues with EMEA, China, Asia, look to be continuing to maintain their pace. Let me have Rob answer your question regarding cash flow.

Robert D. Selvi

Yeah. I mean in general we would expect cash flow to normalize in the 10-20% of revenue range and we're a little bit above the high end of that range this quarter based on strong contribution from profitability as well as good contribution from accounts receivable which as I mentioned was very efficient in the quarter, and inventory, as well as deferred revenue.

Sterling Auty - J.P. Morgan

Alright thanks, guys.

Operator

We'll take our next question from Joel Fishbein with Lazard.

Joel Fishbein - Lazard Capital Markets

Good afternoon, everybody. I just have a few quick questions. First, Matt, on the product side, license side, we saw a nice uptake this quarter. Can you give us a little bit more color around the overall environment and the buying patterns? I know you want to stay cautious. It was clear in your commentary, but any thought there would be helpful.

Matt Medeiros

Well you know, Joel, in North America we saw a pretty good demand market and some encouraging signs that at all ranges of our product, both the low end and also the enterprise product. So North America we definitely feel that there was some decent traction in Q2. Our pipeline for Q3 looks good, but again the pipeline I think everyone's pipeline is judged on its ability to close within a quarter.

In Europe as I mentioned I do think that there's still suffering in trying to understand how this recession is really affecting the business environment there. So I'm having a difficult time reading how bad seasonality along with just the uncertainty of the economy in Europe is really going to affect us.

Joel Fishbein - Lazard Capital Markets

Alright, two more quick ones, in terms of subscriptions can you talk about the renewal environment and has that pattern changed? And then I have one more.

Matt Medeiros

Yeah, okay. No, the renewal environment hasn't changed. In fact, we're putting more resources on it. A part of renewal is also upgrading and I think that we're being able to show evidence that that's working very well for us. Our existing customer base is extremely loyal and I feel comfortable that we'll continue to be able to actually improve our renewal environment.

Joel Fishbein - Lazard Capital Markets

And then the last one is in terms of — I guess one of the challenges you guys have is sometimes your products work so well that they don't get upgraded very often and I'm just trying to understand with the Microsoft operating system coming out and people upgrading servers, does that open up an opportunity for you guys to get in there and upgrade from a product perspective?

Matt Medeiros

Yeah. No doubt that anytime Microsoft changes its OS or whenever they make some sort of massive change like they're intending to do here I think everybody looks at their overall comprehensive IT solutions and understands how that impacts it and how we have to potentially improve the performance.


But let add though that I really do believe that if you start looking at our new products, when we're starting to demonstrate literally 10X to type of performance on our own product to product — higher than 10X even with competitive products from Cisco and Fortinet, that's where the real advantage of convincing the customer to upgrade is, that we can truly improve their network performance and also the security at the same time. And with the type of applications and with the type of use of the Internet where video is becoming far more prevalent, where voice is becoming far more prevalent that 10X performance, that throughput is really required in today's networks.

Joel Fishbein - Lazard Capital Markets

Great, thanks a lot, Matt.

Operator

We'll take our next question from Robert Breza with RBC Capital Markets.

Matt Hedberg - RBC Capital Markets

Hey, guys. This is actually Matt Hedberg sitting in for Rob. First off, nice job with quite a few competitive wins in the quarter which is always good to see. Can you talk a little bit about — I assume it's some of the new products, obviously the E-Class had a lot of nice wins. How soon do you expect some of the new TZ products to ramp? And I guess one competitor I didn't hear about was Secure Computing. I'm wondering how them being under Mac could be affecting the environment?

Matt Medeiros

Well, Matt, thank you again for the questions. I do think that our new products are really taking shape. The TZ 200, 100, they were just introduced at the end of the quarter. They are TZ products. The channel is very familiar with our operating system. There is no substantialness of change in our operating system. We just have additional features and we have it at a price point that we think is very important for the current market conditions.

With that said we've always said you have to train, train, and retrain your channel and your sales team and I think that that's what the opportunities that we have this summer to really take advantage of training environments and we're putting together quite a few road shows to make that happen, both here domestically and also internationally.

We are seeing more wins in the government. I don't know that that's against the Secure Computing environment, but the good news is that with our present on GSA schedules with some new resellers that we've signed up, some very substantial federal government partners that we've signed up, we're feeling that we're capable of being very competitive in that environment whether it's at the cost of secure computing or someone else I'm not sure. What I can tell you is that the federal government is equally as interested in price to performance ratios as any other commercial customer.

Matt Hedberg - RBC Capital Markets

That's helpful. I guess second, linearity looked a little better, DSOs ticked down sequentially and year on year. Can you talk about how — I mean was it sort of better than you expected going into the linearity? Can you kind of talk about how that trended throughout the quarter?

Matt Medeiros

Yeah. I mean over the last couple of quarters we've seen improvements in linearity. Some of that is a function of the mix of revenue so of course within license and services, service revenue is pretty close to perfectly linear because it rolls off the balance sheet. And so I would say in comparison to sort of our historical model where we do approximately 50% of the revenue in the first two months of the quarter and the remaining 50% in the final month of the quarter — we've really improved, in general, to 60% of revenue in the first two months of the quarter and 40% in the last month. And Q1 and Q2 were very similar in that regard.

Matt Hedberg - RBC Capital Markets

That's helpful. I guess on the expense side you guys have shown nice cost management here. I think op ex has ticked down pretty much five quarters in a row or something like that and I think, Rob, you mentioned that it might pick up a little bit. Can you talk about how much slack is in the current model here with your current expense base? I mean if demand returns, what kind of slack is in the model and I guess just kind of that in general?

Robert D. Selvi

So I think the net of your question is can we support higher revenues in roughly the same op-ex footprint, is that right?

Matt Hedberg - RBC Capital Markets

Yeah.

Robert D. Selvi

And I think the answer is yes. I mean I do believe that we have leverage in our model. In Q3 we're going to see some increases that I mentioned. I mean accounting fees were very low in the second quarter which is typical and in line with our normal sort of annual cadence and we have some increases in legal fees and depreciation, amortization, and some moving costs to our new facility are factored into the mix there. But in general I think we have an operating expense structure that can drive higher amounts of revenue than we're experiencing currently.

Matt Hedberg - RBC Capital Markets

That's great. Very helpful. And then one final question on cash, you've got a pretty healthy cash balance on a per share basis. It's been, I think Aventail is maybe about two years anniversary now at this point. Can you kind of give us an update about how you think about M&A or maybe a buyback at this point with that cash balance? Thanks.

Robert D. Selvi

Yeah. I don't think we have any announcements to make with regard to either avenue as it turns out. I mean share repurchase is something that we certainly evaluate pretty consistently along with our board of directors. M&A activities are hard to predict . I think we've always remained active looking at opportunities and a part of question is sort of an ex post facto look at Aventail I think which we regard as a very important strategic acquisition for the company which not only brought us revenue diversity and it's an important new product category, but also enabled our entry in large part into mid-tier and enterprise customer accounts. And that continues to be really important.

Along with the rest of the business in comparison to where we were last year, the performance has been a little bit lackluster, but we did see some improvement in general and we still are very optimistic about our future trajectory there.

Matt Hedberg - RBC Capital Markets

Great. Thanks, guys.

Operator

(Operator's Instructions) We'll now take our next question from Craig Nankervis with First Analysis.

Craig Nankervis - First Analysis

Yes. Thanks very much, nice job, guys. On your E-Class business, did you view that more as sort of catch up from Q1 push outs or do I hear you saying that there's some incremental improvement in the overall market for that product set, maybe we start there?

Matt Medeiros

Yeah. Hey, Craig, I think that the performance of E-Class was very linear. You heard us talk about linearity or Rob talk about linearity through the quarter in sales and E-Class was part of that. It wasn't just the end of Q1 a push, get product out. It was, quite frankly, just a great pipeline and our sales team continued to execute against it.

Craig Nankervis - First Analysis

And I think it was you, Matt, that used a phase that some of this business with the large financial institutions and whatnot was with intent of running full UTM. Does that mean there's subscription revenue to come yet from these sales or how do I understand that phrase?

Matt Medeiros

Well yes, there's some subscription revenue yet to come from these sales, but most often we do sell our E-Class product fully with our services. The question is how does an end customer choose to deploy and implement the product? Will they buy the hardware, if you will the appliance, in one quarter, and get that up and running, debug the appliance or provide the appliance the right environment in the datacenter and then move forward the next quarter with solutions incrementally.

So that does happen and I don't have any data on which way the majority of our E-Class products were sold, but from our perspective we're doing a very good job at attach rates in our E-Class products. Some of it is just the definition of the product. Again you wouldn't buy our E-Class email solution if you didn't buy the spam and the compliance factors. Our UTM solution is what's selling. People are no longer looking at UTM as a novel technology. It's mainstream, it's mainstream in enterprise, and we've got the best performing product from the standpoint of being able to provide throughput without compromise.

Craig Nankervis - First Analysis

Right. So it's with these E-Class sales it's some mix of buying the subscription with the hardware and some mix of doing it later like you say?

Matt Medeiros


That's correct.

Craig Nankervis - First Analysis

On your promotion that looks, I think this is now the second full quarter of the promotion for converting to SonicWALL's in what is it a three-year service subscription that you're promoting. I think it's helping your cash generation. Is that promotion to continue here in Q3, and so wouldn't that buy the upper end of your cash generation range that Rob was talking about?

Robert D. Selvi

Promotion does continue into Q3. Although it is a promotion, it is a limited time offer and we're evaluating the performance of that. I think we represented that promotion as a bit of a market test last quarter. That continues to be true. We did make some modifications to the program last quarter. We were evaluating other ways on improving the promotion, although as you mentioned it's been quite popular and successful.

Craig Nankervis - First Analysis

I mean that's high, right? 43% of your billings were multi (inaudible). I mean that's —

Robert D. Selvi

That's exactly right. But it was very beneficial as you mentioned. You may have to make some assumptions about what part of the total volume that you do in a program like that is purely incremental versus regular activity that's foregone in order to take advantage of a program like that? So it tends to be additive to differed revenue in cash flow in the current period. It tends to detract from in period revenue. So that's a balance obviously and it's a balance for us in the marketplace with customers and it's a balance for us financially. And I guess what I'm telling you net-net is it's likely that we'll continue to evaluate the program and we may make some changes that change it and then that makes the trajectory hard to predict.

Matt Medeiros

And Craig, I'd like to add just one more time that Rob did say that 33 days of DSO is pretty outstanding and we've only hit that mark once before. And Q3 does usually represent a larger DSO component so historically we just have DSO against us in Q3.

Craig Nankervis - First Analysis

Right. The 33 in Q2 was a great metric. I guess lastly, on op ex, I was just surprised to see how R&D could decline so significantly when you guys are such an R&D focused organization and what are you saying about is this some new sustainable level or was there an anomaly here? I just want to understand what's going on there.

Matt Medeiros

Yeah sure, and I appreciate the question. Listen, in Q1 we were doing an awful lot of prototyping for the new products that we were releasing here in Q2 and those expenses clearly generate some expense levels within R&D.

We also had our 401(k) match which causes a lot of, if you will, the payroll costs. We had an engineering training event that we did both in Shanghai and India so a lot of my engineering leadership team was traveling in the quarter. And as Rob pointed out that we had some benefit of lesser travel if you will, this quarter.

So look, I mean our engineering levels have always been in the higher teen levels and I don't think that that's changing. I think we're getting the benefit of a little lift in revenue. That helped us. The denominator was a little bit bigger. We had some efficiencies because we weren't introducing as many new products from a hardware prototyping and a beta delivery standpoint as we needed to, to confirm the success, or if you will, the working ability and our engineering effort on the TZ 200 and 100.

Craig Nankervis - First Analysis

Okay. Good enough. That does it for me.

Matt Medeiros

Well thank you, Craig.

Operator

It appears at this time that there are no further questions so I would like to turn the call back over to our speakers for any additional or closing remarks.

Kelly Blough

Thank you, everyone, for joining us today and we look forward to speaking with you throughout the quarter.

Operator


That concludes today's conference. Thank you for your participation.

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