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Acme Packet, Inc. (NASDAQ:APKT)

Q2 2009 Earnings Call

July 30, 2009 5:00 pm ET

Executives

Brian Norris - Director of IR

Andy Ory - President and CEO

Peter Minihane - CFO and Treasurer

Analysts

Simona Jankowski - Analyst

Paul Silverstein - Credit Suisse

Catharine Trebnick - Avian Securities

John Marchetti - Cowen

Sanjiv Wadhwani - Stifel Nicolaus

Ted Jackson - Cantor Fitzgerald

Operator

Good afternoon ladies and gentlemen and welcome to Acme Packet's Conference Call. At this time, all participants are in a listen-only mode. (Operator Instructions). As a reminder, ladies and gentlemen, this conference is being recorded.

I would now like to introduce your host for today's call, Brian Norris, Director of Investor Relations for Acme Packet.

Brian Norris

Thank you, Mary. Good afternoon, everyone. With me on the call are Andy Ory our President and Chief Executive Officer and Peter Minihane, our Chief Financial Officer and Treasurer.

The format for today's call is as follows. Andy will begin with an overview of our financial results and an update on the key growth drivers in our business. Peter will then follow with a detailed financial review and a discussion of our outlook for the second half of the year. We will then open the call up to Q&A.

The press release announcing our second quarter results along with our financial statements, and a reconciliation of non-GAAP financial measures to the most directly comparable GAAP measure, is available on the Investor Relations section of our website at www.ir.acmepacket.com. Please note that all results and projections we review this evening are on a non-GAAP basis, unless we otherwise and explicitly describe them as GAAP.

During this afternoon's call, we'll be referring to non-GAAP net income and non-GAAP net income per share, which are non-GAAP financial measures that exclude stock-based compensation expense for all periods presented. Non-GAAP net income and non-GAAP net income per share for the three-month period ended June 30, 2009, also excludes the amortization of intangible assets and integration and merger-related expenses related to the company's acquisition of Covergence during the second quarter of 2009.

Statements made during this call that are not historical facts, maybe forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such forward-looking statements may relate among other things to expected financial operating results and to future business prospects and market conditions. Such forward-looking statements do not constitute guarantees of future performance, and are subject to a variety of risks and uncertainties that could cause our actual results to differ materially from those anticipated.

A discussion of these risks and uncertainties and additional factors that could cause actual results to differ materially from those projected or suggested in any forward-looking statements is contained in our recent filings with the SEC, including those factors discussed under the caption 'Risk Factors' in such filings. Investors should not place undue reliance on these statements, which are current only as of the date they are made and we disclaim any obligation to update them.

Finally before I turn the call over to Andy, please mark down August 12th, when we'll be in New York for the Morgan Keegan Technology Conference and October 29, when at 5 pm Eastern Time, we'll be hosting our third quarter earnings release conference call. For more details on our IR outreach plan for the third quarter, please feel free to contact me at 781-328-4790.

With that, I'd like to turn the call over to Andy.

Andy Ory

Thank you, Brian and good afternoon, everyone. We are excited to be reporting strong financial results for the second quarter, which again reflects solid momentum in all areas of the business.

Revenues increased to a record $32.9 million, reflecting growth of 6% sequentially. This is the fourth consecutive quarter that we achieved sequential revenue growth. Our top line results in the second quarter were strengthened by the addition of over 40 new customers, and the continued expansion of existing deployment within our customer base.

Gross margin expanded to a record 83%, as a greater percentage of our product sales came from our high performance Net-Net 4500, which was introduced in the second half of 2008. Our higher gross margins enabled us to deliver operating margins of 20%.

We reported second quarter non-GAAP EPS ahead of First Call consensus at $0.07. We ended the quarter with a record $155.6 million in cash, further improving our already strong balance sheet.

We also acquired Covergence, an innovative provider of software-based SBCs for Fortune 1000 enterprises for $22.8 million.

While many others have struggled in arguable the worst economic conditions in the last 100 years, our company has continued to perform very well. We are seeing growing demand from enterprises, service providers, contact centers, government agencies and universities, recession-oriented IT-based communications powered by session boarder controllers. Based on the growing strength of the overall business, the growth drivers we are seeing in our key markets and the visibility we have for the remainder of the year, we are again raising our outlook for 2009.

Let me start with what's happening in the enterprise market. Our overall addressable market is growing as enterprises are migrating to IP-based connections for their communication services. SIP trunking and IP connectivity are strong growth trends that are fundamentally changing the way enterprises communicate. For nearly two years, we have been strategically investing to develop a dominant position in this emerging market. That effort is clearly paying off.

Infonetics Research, a leading research firm, recently released their Enterprise SBC Market Outlook, which highlighted Acme Packet as one of the two market leaders by revenue share in the enterprise SBC market.

More and more enterprise customers are deploying our solutions to control four critical IP network borders -- the IP trunking border, the private network border, the Internet border and the hosted services interconnect border. The IP trunking border is the connection from service provider IP network linking the enterprise to the outside world of PSTN and IP end-points.

The private network border is the connection to internal employees located on the enterprise campus land and in remote offices connected by a private land server.

The Internet border is the connection to small offices, users working from home and mobile employees over the public Internet.

And finally, the hosted services interconnect border is the private connection to service providers or application service providers that offer hosted IP-based audio and video conferencing services, IP contact center services, IP Centrex to augment premise-based systems for certain sites, business groups or divisions and VoIP-enabled business applications such as Salesforce.com.

SIP trunking has received a lot of attention and budget support because of the compelling payback it can offer in a very short investment horizon. By converting from a TDM trunk to one or more IP trunk, an enterprise can reduce call termination costs by letting IP trunks route each call over to the service provider IP backbone to the remote media gateway closest to the call's destination; reduce capital and operating costs by eliminating media gateways and TDM trunks, and by supporting voice applications on the existing data network; add network geo-redundancy by provisioning multiple IP trunks to diverse PoPs and/or diverse service providers; simplify operations by relegating media gateway and PSTN interconnection management to the service provider; and cut the time to provision and deploy IP interconnects to a matter of days, as opposed to the months typically needed to provision and deploy TDM-based services.

The rapid payback of SIP trunking is driving growth for the enterprise SBC market. Infonetics Research forecasts that the enterprise SBC market will grow by an average of 49% annually to nearly $300 million by 2013. Infonetics Research also forecasts that the number of IP trunks deployed globally will grow from 7 million to over 38 million in that same period. Each of these trunks represents the potential for SBC sessions on the enterprise and SBC sessions on the service provider accesses.

In other words, growth in this emerging market is driving growth in our core service provider market.

To meet this opportunity head on, we have made investments to develop both our position and our product set. Perhaps the most exciting of these investments was a recent acquisition of Massachusetts-based Covergence. Covergence was a privately held, innovative provider of software-based SBCs for Fortune 1000 enterprises. We announced and closed the acquisition back on April 30th. What was interesting and intriguing during the due diligence process has turned into genuine excitement 90 days later.

The original rationale for acquiring Covergence, as we outlined on our last call, was very straightforward. To deepen our expertise in the enterprise market with a talented and dedicated workforce of 39 employees, including 23 engineers; to strengthen our value proposition to enterprise customers, distributors, and access service providers by adding Covergence's unique, proven, low-end software-based, enterprise focused solutions; and to add approximately 100 customers and meaningfully expand our presence in the enterprise market.

The integration of Covergence has gone very well. We achieved virtually all of our operational and financial performance targets for the second quarter. The service and support of the Covergence customers is proceeding well. The employee integration went well with several new hires assuming key roles in our extended leadership team. We are well down the path of cross-training employees in all functional areas.

We've also made excellent progress on the product integration effort. We've launched the new Acme Packet Net-Net 2600, which is based on the Covergence product line. It is an integrated SBC platform for enterprises and IP contact centers requiring control for 150 to 4,000 simultaneous sessions.

We've also launched the new Acme Packet Net-Net OS Enterprise or OSE, which is also based on the Covergence product line. It features a software-only integrated SBC platform for Acme Packet certified third-party servers. The available server options provides enterprise focus, Acme Packet OEM and solution integration partners with the flexibility to choose a system that best matches the performance, capacity and price requirement for their service or application. This acquisition provided us with another focus and an immediate critical mass in the enterprise market.

Covergence is a great fit given its similar technology, market geography and mind share. Just a quarter removed from the acquisition, the lines of separation between what was Acme Packet and what was Covergence have significantly diminished.

Turning to the service provider market, we are seeing several interesting demand drivers across our wire line, wireless and cable customers. First, we are seeing demand for SIP trunking as enterprises drive demand for our solutions on the access side of our service provider market.

We are also continuing to see signs that the pool of global IPv4 addresses will be exhausted by 2010, which in turn is driving demand for IPv4 to IPv6 interwork. We are delivering solutions to enable seamless SIP interactive communications among end-points and service elements located in networks using different version of IP addresses.

Our customers are responding favorably to our IPv4 and IPv6 interworking offering as a way to both yield significant cost savings and roll out in services. Additionally, we are seeing growing demand for higher performance solutions.

Our Net-Net 4500 platform, which we introduced last year, increases the performance and capacity of our Net-Net 4250 platform by more than 100%. This additional speed and capacity is critical as our customers support an ever increasing number of users and increasing functionality.

Revenue from the Net-Net 4500 increased approximately 100% sequentially from the first quarter. We believe this is a very important product cycle for the company, and that the Net-Net 4500 will be a significant revenue contributor in 2009 and beyond.

Infonetics Research recently projected that the total addressable market for SBCs in the service provider market to grow from approximately $209 million in 2008 to over $370 million by 2013. According to the same research report, our share of the global SBC market had grown from 46% in the first quarter of 2008 to 52% at the end of the first quarter of 2009.

As the clear market leader, we believe we can continue to drive market share gains and leverage this long-term growth opportunity.

By the end of the second quarter of 2009, we had nearly 8,000 session border controllers deployed in 95 countries around the world. We also have more than 835 customers, including over 700 service provider customers. Our presence among the very largest of these service providers continues to be very strong. It includes 48 of the top 50 and 89 of the top 100 service providers in the world.

We recently announced a number of service provider customers including Telefónica O2 Germany, Telenor Sweden, PCCW, Belgacom International Carrier Services and Kabel Deutschland.

Telefónica O2 Germany, which belongs to Telefónica Europe and is part of the Spanish telecommunications group, Telefónica S.A., is deploying Acme Packet SBCs to provide key IMS functionalities at its access and interconnect work.

Telenor Sweden, the second largest service provider in Sweden, has chosen Acme Packet SBCs to control the access and IP interconnect borders with its IMS data centers.

Belgacom International Carrier Services, the wholesale voice service provider with offices in Brussels, Bern, Dubai, Singapore and New York, has deployed Acme Packet Net-Net 4500 SBC to supplement its existing network of Acme Packet Net-Net 4250 SBC. The addition of the Net-Net 4500 will provide Belgacom with significant cost savings, while doubling subscriber capacity at its (inaudible) location.

Kabel Deutschland, Germany's largest triple-play provider, has deployed Acme Packet's Net-Net SBCs on multiple hardware platforms. The SBCs are used to deliver first class IP interactive communications to Kabel Deutschland's residential customers and secure IP interconnect to other service providers.

As we've outlined with you this afternoon, we are well positioned to take advantage of the key growth drivers fueling our market. After careful consideration of the strength of our business, we are tonight raising our outlook for 2009. We are raising our full year revenue outlook from our previous estimate of $128 million to $132 million, up to $130 million to $134 million.

We are also raising our estimate of full year non-GAAP EPS from our previous estimate of $0.24 to $0.28 per share up to $0.28 to $0.30 per share.

We have a business plan in place to drive revenue growth of between 12 and 15% in 2009. During the balance of the year, we will be focused on executing against this plan, expanding our addressable market opportunities, building additional predictability into our business, extending our technology in market leadership and extending our focus on profitable growth.

Let me now turn the call over to Peter for a closer look at our second quarter results and our outlook for the balance of the year. Peter?

Peter Minihane

Thank you, Andy. This afternoon I'll take a few minutes to review our financial results for the second quarter and then discuss our updated outlook for the remainder of 2009.

As a reminder, all financial results and projections we review this afternoon related to our statement of income are on a non-GAAP basis unless otherwise and explicitly described as GAAP. Our discussion of sequential changes in our financial results compares the second quarter of 2009 to the first quarter of 2009.

Finally, please note that all earnings per share results we review this afternoon are on a fully diluted basis. With that, I'll begin with a brief review of our second quarter results.

Revenues were $32.9 million, an increase of 6% sequentially. Product revenues were $24.2 million, an increase of 5% sequentially, reflecting a modest increase in both the total number of systems sold and their average selling price. Maintenance, support and service revenues were $8.6 million, an increase of 9% sequentially, reflecting the continued growth in our installed product base.

The distribution of revenues in the second quarter is 40% direct and 60% indirect. No direct customers accounted for 10% or more of revenue in the second quarter. Two channel partners accounted for 10% or more of our revenue and those partners were Nokia Siemens Networks at 14% and Alcatel-Lucent at 13%. Both of these channel partners represent dozens of end user customers.

Geographically, 54% of our total revenues came from the United States and Canada, and 46% came from our international customers. Gross margin was a record 83% in the second quarter of 2009, which is higher than our most recent quarters, reflecting favorable product mix as well as an increase in revenues from software upgrades.

Total operating expenses in the second quarter were $20.6 million, an increase of 11% sequentially, primarily as a result of the Covergence acquisition.

Other income net was $55,000 in the second quarter compared to $66,000 in the first quarter of 2009. We continue to maintain a conservative investment policy, and are invested primarily in money market funds, which are focused on high-grade U.S. government securities.

Our effective non-GAAP tax rate in the second quarter of 2009 was approximately 32% compared to approximately 34% in the first quarter of 2009, reflecting certain R&D tax credits associated with the Covergence acquisition.

Net income for the second quarter on a non-GAAP basis was $4.5 million or $0.07 per share, compared to $4.3 million or $0.07 per share in the first quarter of 2009. Net income for second quarter on a GAAP basis was $1.7 million or $0.03 per share compared to $2.8 million or $0.05 per share in the first quarter of 2009.

Non-GAAP net income differs from GAAP net income in the second quarter of 2009, as it excludes stock-based compensation expense, amortization of acquired intangible assets, and merger and integration related costs, all net of tax, of $2.8 million or approximately $0.04 per share.

Non-GAAP net income differs from GAAP net income in the first quarter of 2009, as it excludes stock-based compensation expense net of tax of $1.6 million or approximately $0.02 per share.

We added 48 new employees in the quarter, ending the second quarter at 432 employees. The Covergence acquisition added 39 of these new hires, and the remaining nine were consistent with our 2009 hiring plan.

Taking a look at the balance sheet, we ended of the second quarter of 2009 with record cash and cash equivalents of $155.6 million, compared to $135.9 million at the end of the first quarter of 2009. We generated record cash flow from operations of $14 million during the quarter.

Cash flows provided by investing activities was $4.8 million, reflecting $6 million of net cash acquired in the Covergence transaction offset by capital expenditures of approximately $1.1 million. Cash flow provided by financing activities was approximately $900,000, primarily reflecting proceeds from stock option exercises.

Accounts receivable net decreased to $20 million on $22.9 million at the end of the first quarter of 2009. This decrease is reflected in our improved days sales outstanding or DSOs. DSOs were at 55 days as of June 30, 2009 down from 66 days at March 31, 2009. This improvement reflects several trends we've been speaking about for the last four quarters. They are improved visibility, improved revenue linearity, and continued strength in our collection efforts. Due to the standard terms and conditions of our customer contracts, our targeted DSO range continues to be between 60 and 70 days.

Inventory at the end of the second quarter of 2009 was $7.9 million, compared to $7.6 million at the end of the first quarter of 2009. Inventory at the end of the second quarter included approximately $400,000 of inventory related to the Covergence acquisition.

We had an increase in finished goods at customers of approximately another $300,000. Therefore, operating inventory controlled by our manufacturing organization actually decreased by approximately $400,000 sequentially.

Finally, deferred revenue was a record $25.8 million at the end of the second quarter of 2009, compared to $20.2 million at the end of the first quarter of 2009. This increase reflected an increase of approximately $4.5 million in deferred product revenue related to one very large transaction, as well as the addition of approximately $1 million of deferred revenue related to Covergence.

I want to take just a moment to review a few key highlights from our recent filings related to the historical financial results of Covergence, which we acquired during the second quarter for $22.8 million. Please keep in mind that Covergence operated under a December 31st year-end and that all the following details of Covergence's historical financial results are on a GAAP-basis.

With regard to their full year statement of operations, Covergence had revenues of approximately $7.9 million in 2008 and $6.7 million in 2007. The company's gross margins were 73% in 2008, 71% in 2007. The company had a net loss of $11.4 million in 2008 and $11 million in 2007.

With regard to their statement of operations for the first quarter of 2009, Covergence had revenues of $6.3 million compared to $1.8 million in the first quarter of 2008. This increase was due to the timing of one large transaction in excess of $4.5 million, which was booked by Covergence in the first quarter of 2008. This had an unusual and unsustainable impact on both the company's gross margins and profitability in the first quarter.

Looking at the Covergence balance sheet of March 31, 2009, they had cash of $7.8 million, accounts receivable of $1.7 million and total assets of $11.1 million.

Finally with regard to the preliminary allocation of the $22.8 million purchase price, we recognized $7.8 million in tangible assets; again largely related to the acquired cash and receivables. We had $8.2 million of deferred tax assets, $11 million in intangible assets and $4.2 million in deferred tax liability.

Pursuant to the accounting rules and regulations, we have until April 30, 2010 to finalize any purchase price allocation related to this transaction.

To help you better understand how we are looking at our growth plan let me close with a few forward-looking comments. I'll remind you that the comments I'm about to make are based on the current indications of our business, which may change at any time. We undertake no obligation to update these comments.

For the second time this year, we are raising our full year outlook, both revenue and earnings. We now expect revenues to range between $130 million to $134 million, with sequential revenue growth in both the third and fourth quarters.

This compares favorably to the outlook we provided on April 30th, which called for full year revenues of between $128 million to $132 million. And the outlook we issued on February 5th, which called for full year revenues of between $120 million and $125 million.

The increase in our full year outlook reflects the improving demand environment within our service provider market, as well as growing demand for SIP interconnects from our enterprise market customers.

We now expect non-GAAP EPS to range between $0.28 and $0.30 per share. This compares favorably to the outlook we provided on April 30th, which called for a full year non-GAAP EPS of $0.24 to $0.28 per share, and the outlook we issued on February 5th, which called for full year non-GAAP EPS of $0.22 to $0.26 per share. Our improved outlook for the full year non-GAAP EPS is based on our expectation for higher full year revenues and gross profit.

For purposes of modeling non-GAAP EPS, we expect non-GAAP earnings to differ from GAAP earnings in subsequent quarters by approximately $2 million or $0.03 per share. This includes approximately $1.9 million net of tax for stock-based compensation, and a new non-cash charge of approximately $100,000 net of tax for the amortization of acquired intangible assets related to the Covergence acquisition.

Our earnings projections assume a non-GAAP effective tax rate of approximately 35%. And we expect our weighted average diluted shares outstanding to be approximately 62 million shares.

To summarize, we had a strong second quarter highlighted by record revenues, gross margins, cash flows from operations and ending cash. We announced and completed our first acquisition. The business is performing very well and has been for four consecutive quarters. Our visibility continues to improve, and our outlook for the business is strong.

During our next earnings release conference call, which will be held on Thursday, October 29th, we will share with you the highlights from the third quarter of 2009. We look forward to updating you on our progress during future calls.

With that, I'll turn the call back over to Brian.

Brian Norris

Thank you, Peter. Mary, at this time, I'd like to open a call up for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And our first question comes from the line of Simona Jankowski with Goldman Sachs.

Simona Jankowski - Analyst

I just wanted to find out if you're seeing any evidence of revenue synergy so far, and I realize it might be early, but it just struck me that you added 40 new customers, which is about how much you normally add, and so it didn't seem like you had yet tapped into a new customer base through Covergence.

Andy Ory

We absolutely are. You know, we closed the transaction on April 30th, and the mean time sell of our product, the lifecycle of the sale is usually longer than 60 days. So we might not see the revenue impact or the acquisition of new customers that we talk about. But in terms of activity, excitement and what we believe will lead to increased revenue in Q3 and beyond, the synergies are very, very real. Not only are we addressing a new market, but we are driving demand for our access service providers, who see us as increasingly strategic as part of them offering their services. So it's really stimulating both markets.

Simona Jankowski - Analyst

Then I know I've asked you this question in the last couple of earnings calls as well, but your deferred revenues are now up over 60%, year-over-year, and I realize there are some elements in there from Covergence, and some large one-time deals, but, you know, compared to your full year guidance of up only 20%, can you just explain the disconnect? Are you just building up more of a backlog, and if that's the case, how is your relationship with your customers changing so that to allow you that kind of control over the timing of shipments and project completion?

Andy Ory

Maybe Peter and I should take a whack at this together. My feeling is, I mean, first of all, we always want to try and improve our visibility, so that we can run the business properly and articulate fairly what is going on in the business. And so part of the goal that I talked about in the closing paragraph I had, one of the goals was to continue to improve visibility. At the same time, our business is moving from a book, ship and bill to a backlog-driven business.

And as it moves that way, the deferred revenue largely is just annualized service revenue being recognized ratably over the period that it's being delivered. And the product element is sort of like a catch all or a buffer for stuff that ends up, you know, where you might have shipped it and received some revenue, but we haven't really been able to satisfy our revenue recognition and that will happen shortly. I wouldn't look at our deferred revenue for the kind of business we run, as necessarily a harbinger of anything other than just business as usual.

Peter Minihane

Right, Andy, and I think, within reason, as I mentioned in my notes, Simona, I think there really was just one transaction in our deferred revenue as related to product revenue. And everything else I think is standard quarter-over-quarter growth, focused on a piece of maintenance service and support revenue and another element from the product [web].

Simona Jankowski - Analyst

That's helpful, but Andy, just to clarify your comment. When you say that your business is moving from a book, ship, and bill to a backlog business, what is it exactly, kind of, underlying that? I mean, what is it that's driving and enabling you to do that?

Andy Ory

Well, I mean, I think that in Peter's section, we talked about improvement linearity. We've talked about being able to become more strategic to our customers. We are investing more in the relationships we have with our business development partners, as well as our key large customers, and that's giving us insight into additional projects. People are not making one quarter or two quarter architectural commitments, but they're starting to involve us into multi-year architectural commitments. And all of those things make a big difference in terms of our ability to have better visibility and manage the business more appropriately.

Simona Jankowski - Analyst

And then just lastly, how do you see your growth margin trajectory going forward, especially as your enterprise business increases as a percent of the total?

Peter Minihane

You know, Simona, I don't think we see any major deviation from what we've had here in the past four quarters. I think our current gross margins of 83% this quarter are slightly higher than we would have anticipated. But other than that, we don't see any substantial mix within the mix affecting the gross margin overall.

Operator

And our next question comes from the line of Paul Silverstein with Credit Suisse.

Paul Silverstein - Credit Suisse

First off, following up the previous question, can you quantify your backlog comment? So you're shifting from a book and ship to a backlog. It begs the question of how much of your business you've already got in the bag coming into the quarter these days?

Andy Ory

No, no, consistent with what we've been saying for the last several quarters, we've been moving from a majority of turns and a small minority of backlog and we've actually been flipping that around. Where we've consistently made gains to run the business as we talked about, a little bit cooler, not quite as hot, and that's a process, that takes time. But I think we did talk about, on the Q1 call that we had tasks where a majority had been backlogged as opposed to turn to book, ship, and bill, and our goal is to just keep running the business that way. It takes a lot of pressure off the business. It lets us think much more strategically, and it lets us start to leverage or scale our business operations over potentially larger amounts of revenue.

Peter Minihane

I think it's a combination, Andy, of items that you mentioned, but when you do increase your visibility, you're also talking about improving AR DSOs, and you've seen that now, Paul, we've gone from 80, 90 days, down to high 70s, to mid 60s, to mid 50s. I think you'll see our inventory turns and our inventory balances continue to have continued improvement. The quality of our product is tremendous. DOAs and things of that nature almost don't exist at this company, because it's not like we are scrambling to make a June 30th date or a March 31st date.

And last, but not least, it makes it easier for us to enforce the terms and conditions on various contracts that we have with somebody showing up saying, I want an extra 30 days on payment terms. And the answer to that, generally speaking, is no and our sales organization does a great job of front-ending it. And then for simply the finance people to be much more of a backstop, but you don't have to be as much of a backstop when the sales guys know that that's just not the way we are going to do business.

Andy Ory

That's right. And the thing I want to add on top of that because you're looking at my comments about backlog, versus book, ship and bill as a level of confidence in our business, and as it relates to Q3. Clearly, we have to have a real high degree of confidence or we would not be raising both elements of revenue and earnings.

Paul Silverstein - Credit Suisse

Andy, I appreciate all the qualitative comments, but actually all I'm seeking is, it was over 50% last quarter, clearly, from your comments, so is that much better this quarter, are you adding -- I'm not expecting you to give me the exact number, but have you crossed 60%, is it somewhere in that 50% to 60% range?

Andy Ory

Paul, I respect your question. We haven't really provided any exact range, but what I will say is that it did continue to improve and so if we were already a majority in Q1, We are a majority plus something in Q2.

Paul Silverstein - Credit Suisse

Fair enough, I'll move to the next question. You mentioned your 4500 contribution up 100%, the 4500 began shipping when?

Andy Ory

Second half of 2008.

Paul Silverstein - Credit Suisse

That 100% growth, can you give us some sense of the base, so we can appreciate the comment?

Andy Ory

I don't have the data in front of me, but I'll bet we shipped more than 100 units. I don't know what the number is, I mean, it's a fair bit. It's pretty significant.

Peter Minihane

It's probably 145 units.

Andy Ory

Yeah, there you go, right, in the last 90 days?

Peter Minihane

Q3.

Paul Silverstein - Credit Suisse

Could you be a little more precise? Could you translate that into dollar terms?

Andy Ory

We don't give out [AIP]. We really haven't done that, just for competitive reasons.

Paul Silverstein - Credit Suisse

Andy, you did not give me the damn unit number, you could have given me the dollar number, but --

Andy Ory

Peter's going to take a whack at it with his spreadsheet.

Paul Silverstein - Credit Suisse

I'll move on while you're doing that. Gross margin, Peter, I think you said Covergence had 71% to 73% gross margin and it connects me with the previous question. Peter, I think you also said that over the next four quarters, you're not expecting a meaningful impact. It begs the question.

Given Covergence's margin profile, and I appreciate they're a lot smaller and a somewhat different organization than you are combined, but as we look forward and your enterprise business prospectively growing and perhaps growing faster than your service provider business, over a longer term time horizon, does the enterprise gross margin come up to service provider gross marginal levels, or does that ultimately and eventually hit the overall gross margin?

Peter Minihane

I think it will eventually be 71% to 73%. It was lower than our profile, and we expect that that, as a result of their software portion of the revenue we will continue to increase over the next two to four quarters. Again, they were not a very large piece of our Q2 revenues, so therefore their impact was insignificant as it relates to gross margins in our Q2 quarter, Paul.

Andy Ory

And Paul, if I could add a comment on that there's got to be 100,000 or more addressable (inaudible) in the two markets that We are now looking at and we sell the widest breadth of session border controllers now from software only for people who want 10 or 20 sessions, all the way up to people who want 100,000 or more sessions in a purpose-built piece of high-end carrier grade hardware. And they all have different mixes, based upon what you're going to do, whether there's a lot of transcoding in the high end. That's going to have a very different margin impact.

As it relates to the enterprise, you're going to see Acme Packets continue to invest and, I think, really show tangible results with distributions of software as well, which should offset any lower margins of small boxes.

Paul Silverstein - Credit Suisse

Andy, Covergence brought you how many, not SKUs, but how many chassis came with the Covergence acquisition?

Andy Ory

So Covergence had a few different. Really, what we are doing is, we have the 2600, the 2610, the 2620. We took Covergence's two or three chassis and we said okay this is an enterprise product and it's going to have a couple of different chassis configurations within the 2600 series. And we are going to take their software, and we are going to engage in business development and make that software available through partners with distribution arrangements to large portions of the end user community.

Paul Silverstein - Credit Suisse

Andy, all that being said; and I apologize, it was a good explanation, but I still, I just want to make sure I'm clear. As we go forward in time, not just over the next one or two quarters, but over the longer term, you don't think Covergence, in terms of the impact on the organization, from a gross margin standpoint, you're not expecting it to [threat] me, if We are drag down your current low 80s. Is that not what you're saying?

Andy Ory

We are not changing guidance of long-term growth margins of the upper 70s. We currently don't see any margin crusher that's going to force us there in the short run, nor do we think that there's any business dynamics that we are engaging in, that inevitably lead us there. But we just think from a modeling point of view, an expectation point of view, that's a good way for us to think about our business. But I'm not sitting here with data that I can project three quarters out, that's going to cause me right now to say we need to revisit that.

Peter Minihane

I think it's a combination of we have reviewed the price list that Covergence was operating under. We have made adjustments to that price list. We think we will get reduced costs as a result of our volume benefits. I think it's a combination of a higher ASP going forward and lower cost.

Paul Silverstein - Credit Suisse

Peter, did you give us the enterprise revenue number in the quarter?

Peter Minihane

We didn't, but one way to think about it is between 10% and 20%.

Paul Silverstein - Credit Suisse

Under 20%. All right, and last question. I apologize, I know I'm taking up time here, but last question. On the $4.5 million item, you call that for Covergence, if I heard you correctly, they got the business in Q1 '08 and that's in deferred revenue now, you haven't --

Peter Minihane

No, Paul, that was a booking in, in the Q4 2008. It was from one large customer. They shipped during that quarter and then recognized it as revenue in Q1 of 2009.

Andy Ory

Never touched us.

Peter Minihane

Never touched us.

Paul Silverstein - Credit Suisse

So it will have no impact going forward, that's over and done with.

Peter Minihane

That particular transaction is over and done with. We are obviously trying to maintain a relationship with that customer so that we can expand that opportunity.

Paul Silverstein - Credit Suisse

Peter, so that's clearly different than the $4.5 million deferred item you called out earlier in terms of your --

Peter Minihane

Paul, you're absolutely right, and I should have differentiated just to make sure because they were the same number, so sorry.

Operator

(Operator Instructions) And our next question comes from the line of Catharine Trebnick with Avian Securities.

Catharine Trebnick - Avian Securities

So my question is on the enterprise SBC area. Can you discuss like typical deal sizes and then a little bit of color around perhaps the vertical markets? And then how low of a market do you look at going with Covergence now your Net-Net 26 product line, is that like an [SMB] type? So that gives you enough range, Andy?

Andy Ory

No, Catharine, thank you. I mean, first of all, we are very excited about the enterprise market, and we have several different ways that we are attacking the enterprise market and based upon the attack vectors in the market that impacts deal size. So we do a lot of direct touch, largely in the North America and EMEA. If we are going to spend time putting people on the ground, we are talking about sizes anywhere from $50,000 to $2 million, would be the deal size that we'd talking about.

I mean you could think about, right now I'm seeing the deal sizes used to be between $50,000 and $100,000 moving up to $150,000 to $300,000 in terms of average initial opportunity and you could imagine these would be the Fortune 100, Fortune 500s that we'd be talking to. At the same time, we have the service providers. Almost every access service provider in the world uses Acme Packet technology, almost, not every one, to deliver SIP trunking. And so when we show it to enterprise customers, when we show up with that service provider, it helps the service provider feel very, very comfortable that they have such strategic partners that can help them reconcile offer and implement carrier grade IP over their SIP trunk.

Now those folks can take us into much smaller deal sizes. They sometimes take us into very large deal sizes, but they have large sales organizations. We train those sales organizations. We are continuing to field an army that will go out and that allows us to lower our cost of sales, go after slightly lower ASPs, and they could be anywhere from $25,000 to $100,000. And then we are developing relationships with equipment manufacturers that make the infrastructure that these SIP trunks are going to connect to, the IP-PBX companies, the application companies, the contact and call server manufacturers.

They have served some very large opportunities there, but by using our software we can go all the way down to 25 sessions or less. And so we want to go after the entire market. When Acme Packet was without Covergence, and we made our 3800 product, we really had trouble below 500 sessions. With Covergence, we can go all the way down to the smallest SMB opportunities.

And in terms of vertical, clearly the contact center market in the carriers, really a very good market. The financial vertical is a very, very good vertical. Technology companies that offer technology products and services are a very good vertical. We are seeing a big increase across the board in a number of different verticals globally for the enterprise market.

Catharine Trebnick - Avian Securities

All right, and then the last question, and I'll move on. Would you say that perhaps still there isn't enough standards on the different end points that that might be probably slowing down, perhaps some of the momentum?

Andy Ory

Well we are seeing momentum pick up. We are not seeing it slow down. Granted, it's a very small market relative to our other markets, and so I think that the large-small numbers, you'll see large percentage growth. In terms of absolutely growth, our core business is probably going to continue to grow pretty dramatically, relative to that. But when we look in the funnel, Peter and I went to Minnesota and to Ireland, and listened to every field sales person and business development person share with us what they had done for the last six months and what they're going to do for the next six months. And we see activity picking up significantly in the enterprise market, not diminishing.

As far as standards are concerned, Acme Packet is going to help connect, normalize, integrate and secure all of the session-oriented communications in and out of that enterprise and across that enterprise and its end points. And so we are going to make it easier, not harder. I don't believe that you're going to see standards emerge very quickly, that will make interop happen without technology like ours. There are other issues like security that couldn't be solved either, but I don't think the standards issue is going to be a problem.

Operator

And our next question comes from the line of John Marchetti with Cowen.

John Marchetti - Cowen

Thanks, hey, guys. I was just wondering if you could take a second and just clarify for me in terms of revising your guidance for the full year upward, are there any changes to any of the assumptions you made when we talked last quarter about what was coming from Covergence, both on the revenue side and on the hit to EPS for the whole year?

Peter Minihane

No, that's still consistent, John.

John Marchetti - Cowen

Okay, so no changes there. And then lastly, on the 3800 platform, you know, obviously strength this quarter you mentioned coming out of the 45. Any comments on the 3800 platform and how that performed this quarter?

Andy Ory

No, the way we think about it is that the 3800 platform is really the low end of our carrier grade offerings. And the 2600 is actually going to move up to be even higher on our enterprise offering because we've expanded it now to go from less than 50 or 100 sessions all the way up to 4,000 sessions. So in some ways, one is more service provider focused and one is more enterprise focused.

John Marchetti - Cowen

Right, but relative to the 4500, so did you just see more high end strength this quarter, than you did say last quarter when the 3800 performed pretty well for you.

Andy Ory

The 3800 is still a solid performer, but the biggest driver of our margins -- and you're correct to point this out, is when people buy systems with more software content, capacity being the biggest driver of that. And so when people are buying 4500s, they're buying a lot more software and a lot more capacity and that tends to have a bigger impact on our margins. And so people are buying bigger systems, so the 4500 seems to be more of what the service providers are looking for though I could point you to a number of service providers that would swear by the 3800.

Operator

Our next question comes from the line of Sanjiv Wadhwani with Stifel Nicolaus.

Sanjiv Wadhwani - Stifel Nicolaus

Peter, I'm a little confused about the $4.5 million in one large transaction. That that number was separate from the Covergence 4Q transaction, right?

Peter Minihane

They're completely separate. There was one transaction from the Covergence books and records that they booked a deal in Q4 of 2008 that they shipped and recognized as revenue in Q1 of 2009 and had no deferred revenue, virtually zero deferred revenue as of the date of acquisition. Our $4.5 million was a completely different transaction with a different company.

Sanjiv Wadhwani - Stifel Nicolaus

Got it. Can you give any color on what's going on there? Is it just sort of revenue recognition, is it a new customer, is it a new project, any color over there?

Peter Minihane

No, no. Its standard business operations, it just happened to occur as of the end of a quarter.

Sanjiv Wadhwani - Stifel Nicolaus

Got it, okay, so just in terms of timing, essentially.

Peter Minihane

That's all it is.

Sanjiv Wadhwani - Stifel Nicolaus

Got it. And then, gross margins, obviously you had a nice upward tick because of the 4500. And the prepared commentary sort of suggested that momentum of the 4500 should continue for I don't know but you said third quarter or for the rest of the year. So I'm presuming at least for the next quarter or two we should see gross margins remaining at a high end level essentially because of the 4500?

Peter Minihane

No, I think what we said, was that it was going to continue to be an important part of revenue contribution in 2009 and beyond, and I think we still look at. And again, this is somewhat of a slanted view on our part that we are always in the high 70s as far as guidance from a gross margin side, again, non-GAAP. And if you take a look at our last four or five quarters, the 83% really is very high by comparison to 81% in Q1, 78% in Q4, 80% in Q3, 78% in Q2 of '08. So we think it's in the high 70s, and occasionally you're going to get a tremendous mix within a mix that will allow us to have or to enjoy an 83% gross margin.

I would not think nor would I think about ever modeling something at 81%, 82%, 83%. I think its high 70s and when we cast a shadow and actually land on 80%, we think that's just a tremendous quarter.

Sanjiv Wadhwani - Stifel Nicolaus

And then one last question, Andy, on the competitive front. Obviously we haven't seen any changing dynamics from Cisco or Juniper over the last six to nine months. I'm just confirming that is still the case, although I did see something coming out from Juniper, I think over the last 30 or 60 days. So I just wanted to check your pulse on the competitive dynamic.

Andy Ory

Yes, I would say that the data that we got at our sales training looking back on the second quarter and looking forward on the third quarter, we don't see any change in the competitive dynamic.

Operator

Thank you, and our next question comes from the line of Ted Jackson with Cantor Fitzgerald.

Ted Jackson - Cantor Fitzgerald

So just touching base on guidance, so relative to the guidance you'd give for the back half of the year, your guidance is assuming that your gross margin is going to be in the high 70s. So just moving down into the operating expense line item, did you take the bulk of the increases in operating expenses as it relates to the acquisition in the June quarter? Are there a more normalized uptick in operating expenses as we look into the third quarter?

Peter Minihane

So once we've expensed all the costs of the acquisition, including severance and things of that nature, for example, as it relates to the merger and integration costs. All have been incurred and are now, as of June 30, 2009 behind us. I think the more "standardized or normalized" OpEx will be reflected in our Q3 and Q4 operating expenses, the only difference being that we only had Covergence for two months of Q2, and we'll have them for the three months for all of Q3. So it will pick up a little bit, Q2 to Q3, as a result of that additional month for Covergence, and again some of our standard adding people and things of that nature, but nothing dramatic.

Mary, are there any other callers in the queue that we can help, or is that it?

Operator

We have no more questions in the queue.

Andy Ory

So again, a very strong quarter for the company with improved visibility, record revenues, record gross margins and record cash flow from operations, very strong balance sheet metrics, including record cash and improved DSOs. We announced and completed our first acquisition in the quarter. Operationally, we added over 40 new customers and introduced several new products to the market, including the Net-Net 2600 and the Net-Net OSE. We are making great progress in building our brand and extending our market leadership across the enterprise and service provider space. We look forward to a strong second half of the year, and we look forward to our next conference call when we can update you on our continuing progress. Good night and thank you.

Operator

Thank you, ladies and gentlemen. This conference will be available for replay today after 7 pm this evening, through August 13, at midnight. You may access the AT&T Teleconference replay system at any time by dialing 1-800-475-6701 and entering the access code 106559. International participants dial 320-365-3844. Once again, those numbers are 1-800-475-6701 and 320-365-3844, access code is 106559.

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Source: Acme Packet, Inc. Q2 2009 Earnings Call Transcript
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