Websense, Inc. Q2 2009 Earnings Call Transcript

Aug. 5.09 | About: Websense, Inc. (WBSN)

Websense, Inc. (NASDAQ:WBSN)

Q2 2009 Earnings Call Transcript

July 28, 2009 5:00 pm ET

Executives

Kate Patterson – VP, Corporate Communications and IR

Doug Wride – COO

Gene Hodges – CEO

Analysts

Dan Ives – FBR

Phil Winslow – Credit Suisse

Eric Martinuzzi – Craig-Hallum

Rob Owens – Pacific Crest

Alan Weinfeld – CapStone Investments

Todd Raker – Deutsche Bank

Samuel Wilson – JMP Securities

Lauren Ye – JPMorgan

Walter Pritchard – Cowen and Company

Justin Cable – Global Hunter Securities

Operator

Good afternoon, ladies and gentlemen, and welcome to the Websense conference call. (Operator instructions) As a reminder, ladies and gentlemen, this conference is being recorded today. I would now like to introduce your host, Kate Patterson, Websense's Vice President of Corporate Communications and Investor Relations.

Miss Patterson, please go ahead.

Kate Patterson

Thank you. Good afternoon, everyone, and thank you for joining me and the Websense management team to discuss our second quarter results. Joining me today are Gene Hodges, Websense's CEO; Doug Wride, Websense's COO, and Avelina Ibarra, Investor Relations Manager.

Just quickly, our conference calendar in Q3 includes the Pacific Crest Conference in Vail, Colorado on August 10th and the Deutsche Bank Technology Conference in San Francisco in mid September. We will also be hosting a series of meetings to introduce you to our Art Locke, our new CFO announced today. Stay tuned for more details.

Before turning the call over to Doug, let me remind you that during this conference call management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties, and other factors that may cause the company's actual results to be materially different from historical results or any expected results expressed or implied during the call.

The potential risks and uncertainties which contribute to the uncertain nature of the statements include, among others, risks associated with integrating acquired businesses and launching new product offerings; customer acceptance of the company's services, products, fee structures in a changing market; the success of the Websense brand development effort; the volatile and competitive nature of the Internet and security industries; changes in domestic and international market conditions; volatility in currency exchange rates; risks relating to the required use of cash for debt services; the risks associated of ongoing compliance through the covenants in the senior credit facility; risks related to changes in accounting interpretations; and other risks and uncertainties described in Websense's public offerings with the Securities and Exchange Commission.

The information in this call related to financial results, projections, and other forward-looking statements is based on current expectations; and we expressly disclaim any responsibility to update forward-looking statements should circumstances change. Our discussion also includes financial measures that are numerical measures that can't be calculated in accordance with Generally Accepted Accounting Principles.

The company believes these non-GAAP financial measures enhance investors' ability to evaluate the company's operating results and compare current operating results with historic operating results. For more information, please consult the press release that was issued this afternoon and which is also posted on the Investor Relations portion of the company's website.

I will now turn the call over to Doug Wride.

Doug Wride

Thank you, Kate. Before we start talking about numbers, I'm pleased to let you know that Art Locke has agreed to Websense as our new CFO. Art was most recently Executive Vice President and CFO of MicroStrategy Inc. in McLean, Virginia and brings a wealth of software experience to Websense. He will officially join us on July 31st and you will be meeting him soon.

For the remainder of 2009, I'll be transitioning many of my operational responsibilities to Art, Didier Guibal, and Jay Mac. After that, I intend to remain with Websense for many years to come in whatever role my experience adds most value.

Now, turning to the Q2 results, I think there are two key takeaways. One, our billings shortfall in Q2 was driven by customers under pressure from the recession. And two, our strategy of driving incremental billings is working and we are finding customers willing to upgrade, as well as new named customers even in these tough times.

Gene will talk you through our plans to maximize our performance in the second half by leveraging the strength of our new product offerings. I will focus my comments on a few specific areas, a more detailed analysis of how we have changed our forward guidance to reflect the current business realities. Immediate additional measures will be taken to align our expenses with our current growth forecast and what this means for our financial model through the end of the year.

Billings. As previously announced, billings for the quarter were $82.2 million. Compared with the second quarter of 2008, this is down 6% from $87.3 million. The underlying trends, however, remained essentially positive over the longer term. First, if you look at billings for the quarter, but use the same foreign exchange rates that prevailed in Q2 2008, second quarter billings would have been approximately $87.2 million, $5 million more and flat compared with a year ago.

As we suggested on our July 7th call, we witnessed widely divergent buying patterns by our customers this quarter. While these buying patterns were largely limited to basic web filtering and e-mail security customers, they do explain the vast majority of our shortfall.

On the one hand, there were customers in financial distress who either did not renew on a timely basis or reduce their contract duration for their seats. This impacted our renewal billings. We estimate that the combined effect on billings in Q2 from these behaviors by distressed customers was about $11.5 million with duration the largest factor and representing about 60% of this shortfall, followed by decreased pricing and seats.

Our analysis suggests that in this distressed subset of the renewal base, duration shortened by six to seven months. This point may seem counter-intuitive because overall, our average duration lengthened to 23.2 months from 21.8 months a year ago. However, the extension was due almost entirely to customers committing to the WSG and appliance platform for longer terms. This divergence in contract duration means that the blended contract duration that we've used in the past no longer describes the business today.

Of the customers who were scheduled to renew, but did not renew before quarter end or what I'll refer to late renewals, we expect that ultimately about half of those will close in this quarter. We believe that a substantial number of the customers who were not going to renew are customers who are simply not buying any solution.

In other words, based on what we are seeing, this does not indicate a shift in market share and our competitive loss rate remains constant. But the financial hardship influence on non-renewals, a factor we've talked about for years, looms larger in economies such as the one we are in now.

To be clear, we do not expect to these late renewals bump our Q3 number. As we expect this buying behavior by distressed customers, we will continue and repeat until the economic environment changes significantly. Finally, as you might expect, financially distressed customers also purchased fewer seats. And overall, our product seat count declined modestly by about 800,000 seats on a sequential basis, although it is still up on a year-over-year basis.

We expect the current environment to persist to at least the end of the year and as a result, we are revising our 2009 billings guidance to a range of $340 million to $350 million. This compares to the range of our guidance that we issued earlier in the year of $365 million to $375 million. This revised guidance for billings, when compared with our 2008 billings of $343 million range, represents a level of change over ’08 that is essentially flat or slightly up and absorbs an estimated $12 million to $13 million of comparative FX pressure for the 2009 year.

This guidance implies growth in the second half, primarily in Q4. We expect Q3 billings to be roughly flat with Q2 instead of down like last year and then see the typical seasonal increase in Q4. The good news is that our analysis shows that the weakness in our billings was heavily concentrated among companies that are facing financial distress and it was limited to a sub-segment of our renewal base. It does not appear to represent a change in our competitive position or execution.

In fact, the buying patterns of financially distressed customers are partially offset by the strong performance in the incremental business. This included customers upgrading to the Web Security Gateway and V10000 Appliance, which exceeded our forecast. Overall, incremental billings were up 18% year-over-year. Our success in generating incremental business is an important early indicator of our ability to resume growth when the economy improves. Gene will speak more to this in his remarks.

Turning to the rest of the financial model, we are also revising our 2009 non-GAAP revenue guidance to a range of $334 million to $338 million from $342 million to $350 million and our non-GAAP earnings per share guidance to a range of $1.23 to $1.27 with the midpoint near the lower end of our previous guidance range.

At the beginning of this year, we said that if the growth did not materialize as we expected we would manage our costs appropriately. We've been aggressively managing our costs throughout the year and we are preparing to further reduce our planned spend by several million dollars in Q3 and Q4.

We already run a very lean organization as demonstrated by our operating margins. About half of the expense savings versus our original plan will come from lower commission expenses, deferring incremental hiring, and slowing or deferring non-critical projects. In addition, we will be reducing our current personnel costs worldwide by about 5%.

As a result, we believe we will be able to generate non-GAAP profitability very close to our original guidance ranges even at a slightly lower revenue number without jeopardizing our ability to ramp billings when the global economy improves. Therefore, our guidance excludes an estimated $2 million of cost we will incur in the third quarter associated with this action, the majority of which are related to severance.

Taking a closer look at how the model shapes up to the remainder of the year based on the guidance ranges and the quarter's results, we find that Q2 non-GAAP revenue was $84.1 million and included $4.6 million of surf control add-back revenue. For the first half of the year, we generated $170.6 million including $10.1 million of surf control add-back.

Based on our revised guidance, this suggests non-GAAP revenue of between $162 million and $168 million, divided approximately equally between the two quarters and including about $6 million in surf control add-back.

Non-GAAP operating expenses for the quarter Q2 were $51.6 million, up about $400,000 sequentially on higher billings number, but down approximately $850,000 from Q2 a year ago as we continue to carefully manage our expense structure. The operating margin for the second quarter was 28%, in line with our target range for the year.

We had planned to increase our second half by $10 million to $12 million compared to the first half of the year and we are now planning to increase expenses by about half of that amount, weighted a little heavier to Q4 to account for the commission expense associated with the seasonal increase in billings.

We expect cost of goods to remain approximately flat with Q2 run rate and gross margin to remain just slightly under 90%. The largest variable influence on cost of goods in the second half of 2009 will be the volume of appliance we shipped, but this influence should be small as a percentage influence.

Interest expense will likely continue to decline modestly as we pay down debt with expense cash flow. We expect our non-GAAP tax rate to decrease slightly to the 33% to 34% range. Speaking of cash flow, we generated $6.7 million of it during the quarter, slightly ahead of our expectations and ahead of Q2 2008. For the full year, we are adjusting our expectations for cash flow down to account for the lower billings number and cash severance related outlays. We are now expecting to generate approximately $80 million of cash flow from operations this year.

We ended the quarter with about $78 million in cash, higher than our target range of $60 million to $65 million. We did not pay down during the quarter due to the seasonal patterns in our cash flow, but will resume early principal payments in Q3. During the quarter, we did repurchase approximately 447,000 shares for a total of approximately $7.5 million. Our share repurchase plan is restricted by our credit facility.

Let me conclude by saying that we have demonstrated financial discipline so far this year and we'll continue to do so in the coming months. While this quarter ended up being a challenging one, we are taking steps we can to address the weakness we saw in the renewal base, but we expect the distress caused by the economic environment to continue. The economy will improve at some point and we intend to emerge in a strong position.

The early indications on our new products based on incremental business, new customers, and larger deals globally suggest we are on the right track. The steps we are taking to align our cost structure with our revised growth outlook are consistent with this view.

With that, let me turn the call over to Gene.

Gene Hodges

Thank you, Doug and thank you, all for your time today. As you heard earlier, we have two main messages. First, our Q2 billings shortfall was driven by customers under pressure from the recession, predominantly decreasing billings through shortened subscriptions. And second, our strategy of driving incremental billings is working. We are finding customers willing to upgrade, as well as new named customers even in these tough times.

As Doug discussed, the billings shortfall from distressed customers in Q2 was disappointing, but it shows the flexibility of our business model in recessionary times. Customers who shortened their subscriptions or shaved seats are still our customers. Most will be up for renewal again in 2010 and as economic conditions improve, they will be candidates for upgrades and will probably lengthen their subscriptions and gradually begin to add seats back.

We could react to this significant shortening by much more aggressive pricing to inset customers to stay on their longer-term subscriptions, but this would lower long-term cash flow and profits and so it's not the way we choose to go. We'll maximize our billings performance in the second half of 2009 by advantage of our new products to gradually improve our customer retention and to continue to drive good growth in incremental business.

Our renewal billings retention rate in Q2 were at the lower end of our historical range of 75% to 80%. As you know, we've been in this range for several years. We believe at this point, however, our new products should allow us to gradually improve this renewal billings retention rate.

Most of our competitive losses are to appliance vendors like Bluecoat, Cisco, and MacAfee in enterprise accounts and Barracuda in SMB. We are just starting to leverage the impact of our appliance-based solutions in our enterprise accounts. We doubled our initial target for appliance-based WSG sales in the second quarter. We achieved this performance even though the appliance was only available for two months out of the quarter. We believe our pipeline shows we can continue strong performance in this area over the rest of the year.

We discussed specifically how the competitive environment changes in our favor against Bluecoat on the July 7th call, but this improved competitiveness isn't just against Bluecoat. It strengthens our hands against all of these appliance-based competitors. To be clear, the large majority of the upside billings impact we expect to achieve here doesn’t come from the appliances themselves, but rather from being able to sell more of our industry-leading software at good price points and being able to retain more customers than we have in the past.

Our SMB competitors like Barracuda, Marshal, Sonic Wall and Watch Guard are also selling appliances, but at very low price points and low margins. Rather than adopt a low-margin appliance approach in SMB, we will focus on the next generation of solutions with our security as a service web and e-mal offerings.

Over the last year, we've improved product functionality in these offerings, but more importantly, we significantly lowered our cost of service delivery. As a result, we can now deliver FAS profitability at price points closer to the appliance solution providers in SMB. We estimate the positive impact of these efforts to be a few million dollars a quarter in the second half, but growing over the course of 2010.

As you heard on the July 7th call, incremental business or sales to new named customers plus upgrades to our installed base were almost $20 million in the second quarter. This performance was driven by over $11 million of WSG sales. Incremental business in the U.S. was up especially strongly, 63%. We take this as a leading indicator of our global incremental business opportunity in the second half. The U.S. market is usually the first to be receptive to newer technologies, but that receptiveness seems to be growing rapidly now in Europe and Asia.

Incremental pipelines were up nicely again for the third quarter with the strongest increases being in Europe and Asia. Generating a growing stream of incremental business has been Websense's core challenge for years. The results of the first half we are finally making progress. But of course just having these great products isn't enough. We have to sell them effectively and ensure that we invest for maximum return in these tough times.

To do this, we’ve added two key executives to our leadership team. Art Locke joins us as our new CFO. Art has a great background in business intelligence at his old home at MicroStrategy and this more detailed understanding of our business will help us optimize investment, improve operational efficiency, and continue to tightly control costs.

Didier Guibal joins us as the head of our Worldwide Sales. Didier has delivered results in both large companies and in startups. He has extensive experience, both in the U.S. and international markets. Didier will help us improve the processes in sales discipline that are so important to our success.

Doug will be with us here fulltime into 2010. He'll reduce the time he spends on operational responsibilities sometime in the first half of 2010, but we expect he will still be working with us for a long time to come.

The results from the first half show our strategy is working although we are feeling impact from the recession certainly. Our new products are highly competitive and are driving increased incremental business. Our new sales reps are generating pipeline and have started to close deals. Our ongoing sales force is having similar success with our new products.

Improvement in product competitiveness will gradually allow us to improve our billings renewal retention rates. We expect the recessionary impact from the distressed customers to continue through the second half of 2009 and into 2010. But as the recession gradually lifts, these are still our customers and they will be candidates for upgrades. We are expanding our management team to help us improve execution across all aspects of our business. The recessionary impact is large, but it is transitory and we remain bullish about Websense's future.

And now, I'll turn the call over to the operator for your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We’ll take our first question from Dan Ives with FBR.

Dan Ives – FBR

Yes, a few questions. First, what gives you confidence that you are going to close 50% of those customers this quarter? Can you just elaborate on that on what you are seeing?

Gene Hodges

Yes, we've already closed a good number of them and are as you would expect very much on top of those deals. So they are fairly qualified.

Dan Ives – FBR

Okay. And then, can you talk about – I mean, if you can remember, last quarter you guys beat guys and this quarter you missed. When you think about the next few quarters in terms of costs, what are the sorts of levers on the cost side? I mean, you said you are expecting $5 million increase second half. Could that be ratcheted down based on what you see? Just kind of walk us through how you look at expenses second half.

Doug Wride

Well, it could be ratcheted down further, but that’s not our intention, Daniel. It's important to us to continue to be prepared for the opportunities and to continue the strength of our product offering and sales force investments that we've made.

So what we are looking at this point is reevaluating aggressively what we have been spending and making changes in that and then evaluating what we have intended to add and about cutting that in half. So – and most of that’s labor driven, whether it's compensation, benefits, officing, you name it. As a software company, that’s our big variable.

Dan Ives – FBR

Okay, thanks.

Kate Patterson

Next question, please?

Operator

Next, we'll go to Phil Winslow with Credit Suisse.

Phil Winslow – Credit Suisse

Hi guys. I was just wondering if you could give us a little more detail, just volume by geography. Obviously, you talked about some business over in Europe, but Gene, kind of when you think about the covert of your business, obviously unemployment has increased here in the U.S., it's been increasing in Europe. Which geography do you see as recovering faster than – sort of any indication of sort of lulls of shelf out there that we might need to worry about? Thanks.

Gene Hodges

I think we would see what's fairly consistent demographically. Asia is in much better shape than the other two regions economically. The U.S. might be a little bit ahead of Europe. The main difference in our own execution is we are a little bit more mature in selling our new products in the U.S. So I think we've been able to perform a little bit better in the recessionary environment. We think we have a good chance of bring more type of behavior out of Europe and Asia in the second half.

Phil Winslow – Credit Suisse

Thanks guys.

Operator

Next, we'll go to Eric Martinuzzi from Craig-Hallum.

Eric Martinuzzi – Craig-Hallum

Thanks. Doug, you just took on the COO role there in January. So we are six months into this. Just curious to know why the change in roles.

Doug Wride

I think it's a continued evolution of our management team. We've done a good job here at Websense of succession planning. We did a good job at the CEO level from John Carrington to Gene. I think we did a good job at the CFO level from me to Dudley Mendenhall, back to me to Art. And now, it's a matter of finding what is the right role for me. How can we leverage we as a company, leverage me and my experience and knowledge of Websense in a non-CFO role. And that's what we are looking to do. We are just being upfront with the transition that we see.

Eric Martinuzzi – Craig-Hallum

Thanks. I mean, that – it is clear that CFO role is not the right role for you, just hired a new CFO. Give me some idea of where you might be going.

Doug Wride

Well, when I became COO, I was also President and with the promotion and the changes – expansion responsibilities for John McCormack, some of those operational responsibilities go with that. At that time, I was also doing a fair amount of emphasis on our partners globally and with the addition of a Didier to our worldwide team. Some of those responsibilities just need to be transitioned. So that sort of adds the question, so what's left and that's what we are working on, how can I apply my skills and experience in a positive way.

Gene Hodges

And this is Gene. Let me be clear, Doug does want to spend more time with his family, maybe work some 30-hour weeks rather than 80-hour weeks and we definitely want to have him involved in as deep a way as he can be involved. So we have been working on this transition actually for quite a long time. Dudley Mendenhall's departure made us scramble a little bit harder to get ready for the first half of 2010.

Eric Martinuzzi – Craig-Hallum

Okay. Vertically, financials had – it's safe to say that – well, maybe they don't get any worse, but it's always been an important vertical for you guys. Do you see any signs of them coming back or is stabilization about as good as it gets?

Doug Wride

We have not seen a pop-back in financials. We are seeing good activity in health care and North America may be the leading edge of the Obama stimulus funds. But I think that's probably the only vertical that had an extraordinarily good quarter. State and local governments in the second quarter, as you might expect, didn’t have such a good time.

Eric Martinuzzi – Craig-Hallum

Thank you.

Kate Patterson

Next question, please?

Operator

Next we'll go to Rob Owens from Pacific Crest.

Rob Owens – Pacific Crest

Yes, good afternoon, everyone. So as you look at the progress in throughout the year, I think you saw some of this in Q1 with regard to renewals and then obviously in Q2. What gives us confidence that this impact doesn’t get even just by the current recession? And what's – what have you taken into your guidance from a conservative standpoint to give us a sense that those numbers are good, those billings numbers?

Gene Hodges

Rob, it certainly could get worse. It also certainly could get a little bit better. So as we've done all year, we are basing our guidance on the Q2 performance at a detailed level and that will, I think, give the most accurate picture for the second half.

Rob Owens – Pacific Crest

Okay. So, if your renewals worsen from here, we will see probably a further guide down?

Gene Hodges

I think we have sufficient range in guidance and sufficient opportunity and upside on both incremental business and on billings retention rates that we are comfortable with the guidance range.

Rob Owens – Pacific Crest

Okay. And then with customers just opting not to run anything at all, I guess what does that say about this market opportunity going forward? Do you think you are going to have to start to transition people more to the value proposition around Web 2.0 protection or do you get a sense that these customers will really come back if the economy comes back?

Gene Hodges

We think they will. When we look at the customers who absolutely went away, the majority were from bankruptcies and from mergers, the people who went – let me call it naked, was probably about $1 million and you would expect those guys to come back. Obviously, companies that are bankrupt are not going to come back.

Rob Owens – Pacific Crest

Okay, great. Thanks.

Kate Patterson

Next question, please?

Operator

Next, we'll go to Alan Weinfeld of CapStone Investments.

Alan Weinfeld – CapStone Investments

Hi guys. I was wondering when you talked about these new products, the Web Security Gateway the loss prevention hosted security. Did you put those all in the same basket when you said those were the products that were $20 million in the second quarter?

Gene Hodges

That's correct. The incremental business number would also include lower level Web Security, our legacy products such as Websense Web Security Suite sold to new named customers. So the incremental business number captures all revenue to new named customers – or excuse me, billings and billings that has come from upgrading any existing customer with new products.

Alan Weinfeld – CapStone Investments

And so, the appliances of that business are growing by a few million a quarter or they were a few million in the second quarter?

Gene Hodges

Our appliances were about $2 million in the second quarter.

Alan Weinfeld – CapStone Investments

And do you expect them to grow to $4 million in the third quarter or –?

Gene Hodges

I don’t want to guide to product volumes. I think it's important because we talked about the appliances, the platform is important. But in the deals, the appliance is not the dominant part of what the customer pays for. We de-bundle, if you will, the appliance and the software subscription and something in the order of two-thirds, 80% of what a customer pays is for software.

Alan Weinfeld – CapStone Investments

Right. And if you think the economy just stays where it is and doesn’t get any worse, you can hold this average contract value at $7,300 or do you think that that still goes lower because I don’t remember in the current history of your company that number going much lower than $7,000?

Doug Wride

Average contract value, I think it's important to understand it is affected by foreign exchange and when we look at pricing patterns, we look at the currency we sell our products in. So for example, as the pound and the euro have weakened, we generally don't change pricing. So the contract value is depressed by foreign exchange. In local currency, it is actually slightly up.

So we do not see a decay in pricing. We would expect medium term as the distressed customer base is stable and the incremental billings increase that average contract value and the cash flow with it will go up because most of our new products are tending to be sold at $540 and up to larger enterprises.

Alan Weinfeld – CapStone Investments

All right. Good luck and congratulations to the new people.

Doug Wride

Thanks.

Kate Patterson

Next question, please?

Operator

Next, we'll go to Todd Raker with Deutsche Bank.

Todd Raker – Deutsche Bank

Hi guys, can you hear me?

Gene Hodges

Yes, Todd.

Todd Raker – Deutsche Bank

Doug made some interesting comments talking about how contract length is not really apples to apples anymore. Can you guys give us some sense if you backed out the Gateway in DOP, what was contract length in kind of the legacy business versus kind of what it's historically been?

Gene Hodges

Gosh, we didn't calculate that, but it would have been down significantly. As Doug mentioned, when we looked at these distressed orders, which were in the low $20 million, they had dropped by six or seven months. So that definitely would have driven it down in a way that we have not seen before.

Todd Raker – Deutsche Bank

Okay. And you've talked about Gene, some of the deals that slipped that have closed, can you just give us a sense – you look at the deals that have slipped, what percentage of them have you closed? How many are still kind of outstanding?

Gene Hodges

I actually didn't give an update today, but we closed a significant portion of them. We got a good portion of them in tact in the first week and we do feel pretty confident about that 50% number and we'll give you an update in October.

Todd Raker – Deutsche Bank

And of the deals that slipped that closed, is pricing being with where it would have been have they closed at the end of the quarter or have you guys had to move to economics to get those deals done?

Doug Wride

Yes, we are not moving the economics to get the deals done. And Todd, just to kind of put a bow around that topic, we assume that this holding on to their cash beyond the renewal time is probably going to keep going. We won't see a big upside nor do we expect a downside from that with respect to Q3.

Todd Raker – Deutsche Bank

Okay. Thanks guys.

Kate Patterson

Next question, please?

Operator

Next, we'll go to Samuel Wilson from JMP Securities.

Samuel Wilson – JMP Securities

Hi, good afternoon. Just one quick question and as a follow-up to several other questions, Doug, can you elaborate a little bit more on the commit environment? In your prepared remarks, you stated that you didn’t think you lost any of these based on competitive nature. But several other companies are reporting sort of growth in better business or billings trends. And I just want to know if you can reconcile that a little bit or do you think it's just different markets or what do you think is going on in the competitive landscape?

Doug Wride

Well, first, I don’t think we've ever said we haven’t lost any deals. We have a billings retention renewal rate of 75% to 80%. So we certainly suffer losses. When we look at our competitors' disclosures in Web Security, we have seen Bluecoat dropping consistently and from the best parallax we can do, the secure part of McAfee is also not thriving very much.

So the bottom line is in Web Security, we do not see competitors gaining share. DOP is a very healthy market, although low numbers. We were up 44% year-over-year and we will see what Symantec has to say tomorrow afternoon.

Samuel Wilson – JMP Securities

Got it. Thank you.

Kate Patterson

Next question, please?

Operator

Next, we'll go to Lauren Ye from JP Morgan.

Lauren Ye – JPMorgan

Hi, this is Lauren for Sterling. I was just curious to kind of understand the stickiness of the products because I think it's the first time I've really heard you guys talk about companies going naked. Can you just help me understand what type of companies these are? Are they because they are smaller that they don’t need a web filtering product anymore or is it verticals, certain verticals that don't need it?

Gene Hodges

Well, first of all – and let me repeat the magnitude again. It's about $1 million. So it's not something that frightens us. And they were – as you heard Doug talk about this for a while conjecturing that in – if we say that happened, it would happen in smaller companies and that's what occurred.

Lauren Ye – JPMorgan

Okay. And then just – it sounds like you guys are refocusing on the staff initiative. Can you just elaborate on when that product might introduce timing and I guess it sounds like it's a – like a package?

Gene Hodges

Yes. We've just done an important upgrade to our e-mail product and some important functionality upgrades in the last couple of quarters on the website. We will start using it against the SMB players in the second half of this year. And as I think we've shared previously, our major new product initiative next year is the combination of our SAS and on-premise products into what we call a hybrid deployment model.

Lauren Ye – JPMorgan

Okay. And is this going to be inside your R&D number going forward in terms of the second half?

Gene Hodges

Yes. And we feel comfortable we can get to that.

Lauren Ye – JPMorgan

Okay. And just the last one is, are you planning to run any special promotions or are you running anything in Q3 that might, I guess, close these distressed or delayed renewals?

Gene Hodges

No, we really don't think the way to go after these guys would be is with pricing promotions. That could lead to long-term consequences. So we are going to try to sell the value rather than decay the price.

Lauren Ye – JPMorgan

Okay, great. Thanks.

Kate Patterson

Next question, please?

Operator

(Operator instructions) Next, we'll go to Walter Pritchard of Cowen and Company.

Walter Pritchard – Cowen and Company

Hi, thanks. Gene, I'm wondering just – if you look at the market, you talked about appliances being an area of pressure and I know some of those vendors use more of a – sort of more upfront perpetual type pricing with a smaller subscription on the back end for the content of the web filter.

I’m wondering if you see any pressure – I know you've historically really stuck and have been disciplined to this 100% subscription pricing, but if you see any pressure to go to pricing model that's – it's more in line with what some of those guys are pushing?

Gene Hodges

No, we haven't. And I really think it's because the appliance deals are almost all three years and that's a reasonable amount of time to amortize the appliance and when you look at the other appliance vendors, that's about a lifecycle time when they start pushing for upgrades. So I believe the optics of total costs look about the same regardless of the licensing model to the customers.

Walter Pritchard – Cowen and Company

Got it. And then just, relative to a new head of sales coming in, I guess the obvious question would be is there any expected turnover change in the organization mid-year? Would that be something that you do sort of during the typical time around the first half of 2010?

Gene Hodges

Well, I don’t think we foresee big turnover, we certainly have to reduce sales costs like other functional costs. Didier's key focus is really going to be getting people trained in a very disciplined way. We have a lot of new stuff and our ability to sell multiple products to multiple people is what's going to make the difference medium and long term for the company. So what we need to do on the slightly reduced spend is make our current people much more effective.

Walter Pritchard – Cowen and Company

Great. And then just last question, Doug. I may have missed the employee headcount on – at the end of the quarter. And then also, could you give us a sense of how many people you have in China?

Doug Wride

The employee headcount in the quarter was just under 1,400 I believe. China is about 240 – 245. China is 245.

Walter Pritchard – Cowen and Company

Great. Thanks a lot.

Doug Wride

Yes.

Kate Patterson

Next question, please?

Operator

Next, we'll go to Justin Cable of Global Hunter Securities.

Justin Cable – Global Hunter Securities

Yes, just a couple of quick questions. On recapturing renewals, at what do you start to recognize those revenues? Do you put – do you sort of catch up on the period of their – when the renewal was supposed to start or do you start it from their signing of their agreement?

Doug Wride

So the question I believe – because were a little bit hard to hear, when do we – at what point do we start recognizing revenue on an expired subscription. And the answer is it will vary based upon the contract, but in general it goes back to the date of expiration and many of the – a little bit of the different phenomena for us is concept of late.

Someone – a customer whose subscription has expired and in many cases, it's a matter of the company couldn't get the transaction done, tighter controls, more sign-offs, et cetera and those would tend to be the customers that Gene was referring to that we've already closed in July. In many of those instances, those customers ask for and were given extensions of their key, even after it had expired. So clearly, that customer was using our product throughout that period of time and we would catch up, if you will, that revenue here in July. So the revenue would be in July, exactly what it would have been had they renewed timely.

Gene Hodges

To keep it within focus, however, since we are recognizing daily, it's a relatively small amount of the billings. We had $6 million of late; assuming we close $3 million, it will be very small revenue impact. So don't model a big revenue impact.

Justin Cable – Global Hunter Securities

Okay. And then last question is on your guidance. I know you – it's a very limited guidance for 2010, but the comment of substantial growth in non-GAAP earnings per share for 2010 on basically sort of a flat year-over-year billings outlook for 2009, can you give us a little color, is that just simply from cost-cutting initiatives or is there anything else that would impact earnings or benefit earnings next year, most of them this year?

Gene Hodges

Well, at this point I believe we need to suspend our estimation of 2010. It's a very volatile environment and we certainly didn't foresee this billings impact. So we'll look again at those numbers and reassess and give you new 2010 guidance in January. Everything will depend obviously on what the recovery looks like and we are planning on an L [ph]. Hopefully, we are fairly near the bottom and it isn't going to go up very fast.

Justin Cable – Global Hunter Securities

Okay. But in the press release, the paragraph that states the substantial growth in non-GAAP earnings if you achieve your 2009 billings, I was curious if there was any – what assumptions were baked into that color, if you will, for 2010?

Kate Patterson

We are not prepared to provide color at this point. We'll do that when we have the call in January.

Justin Cable – Global Hunter Securities

Okay, got it. Thank you.

Operator

And there are no further questions at this time.

Kate Patterson

All right. Thank you all for joining us on the call. We'll be available for call-backs in our office today, tomorrow, and later this week. Thank you.

Operator

Ladies and gentlemen, that does conclude today's call. Thank you all for your participation.

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