Quest Software, Inc. Q2 2009 Earnings Call Transcript

Quest Software, Inc. (QSFT)

Q2 2009 Earnings Call Transcript

August 10, 2009 5:00 pm ET

Executives

Steven Wideman – Treasurer

Doug Garn – President and CEO

Scott Davidson – SVP and CFO

Vinny Smith – Executive Chairman

Analysts

Aaron Schwartz – Ladenburg

Walter Pritchard – Cowen & Co.

Tim Klasell – Thomas Weisel Partners

John DiFucci – JP Morgan

Philip Winslow – Credit Suisse

Derek Bingham – Goldman Sachs

Gregg Moskowitz – Auriga

Brian Schwartz – Piper Jaffray

Todd Raker – Deutsche Bank

Presentation

Operator

Good day and welcome to the Quest Software’s second quarter earnings release conference call. Today's conference is being recorded. With us today are Vinny Smith; Executive Chairman; Doug Garn, President and Chief Executive Officer; and Scott Davidson, Senior Vice President and Chief Financial Officer. At this time, I would like to turn the conference over to Mr. Steven Wideman, Treasurer. Please go ahead sir.

Steven Wideman

Thanks. Welcome everyone to Quest Software’s second quarter 2009 earnings call. Doug, Scott, and Vinny are going to offer some color on the quarter that ended June 30, 2009 and then we'll have some Q&A after that. Our call is being web cast from our investor relations website, and you can get a copy of the press release put out just a short while ago on this website as well. A replay of the call is available on the site using the instructions that we provide in our release.

Just quickly, let me turn our Safe Harbor statement. Some of the statements we make Toad ay may be considered forward-looking, including statements regarding our anticipated revenue and operating margins in future periods, other statements about our plans, prospects and strategies. These statements involve a number of risks and uncertainties that could cause actual results to differ materially. Please also note that these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events.

Please refer to our SEC filings including our annual report on Form 10-K for the year ended December 31, 2008; our quarterly report on Form 10-Q for the quarter ended March 31, 2009; as well our Q2 earnings release for a more detailed description of the risk factors that may affect our results. Copies of these docs can be obtained from the SEC at sec.gov or by visiting the investor relations section of our website.

Also please note that certain of these financial measures we use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis, and have been adjusted to exclude various charges including the after tax effects of amortization of intangible assets acquired with business combinations, share-based compensation expenses, acquisition-related costs, and ongoing expenses related to our stock option investigation. We report our GAAP results as well as provide a GAAP to non-GAAP reconciliation in our earnings press release, a copy of which is available in the investor relations area of our website at quest.com.

And with that, I am happy to turn the call over to Doug.

Doug Garn

Thanks, Steven. Good afternoon everyone and thank you for joining our call.

I will first cover our Q2 results at a high level and then address my perspective for the quarter, and provide a sense of what we expect going forward.

At a high level, our total revenues were $164.3 million and the pro forma operating margins was 20.6%. There were clearly some headwinds within the quarter from a license perspective, but I am pleased that we delivered strong margins and income by maintaining our costs discipline despite the license revenue declines.

As always, Scott will review the financials in much greater details here in a moment. As a company, we are continuing to evolve at Quest from what was previously a sales driven, license booking oriented company to a balanced company, where we are equally focused on license, margin and cash flow growth.

On an annual basis, we are committed to delivering strong operating margins. With license growth, our operating margins could be accelerated going forward. In early Q2, we undertook a key project to identify lower potential products and reduce their run rate expenses. This was a careful process and was aimed at striking a balance between cost-cutting and revenue maximization. The primary goal was to enable us to increase our focus on our core product areas, and added benefit is that we also expect to achieve run rate cost reductions, which will be offset in part by revenue reductions over time.

Another key benefit was that we were able to reallocate budget dollars for our high potential product areas, including virtualization management and VDI, where there are just tremendous growth opportunities for Quest. Together with the product fees for this project, we also reduced our sales force by approximately 3%, and marketing was cut by close $1 million.

From a geographic perspective for Q2, on a relative basis North America aided by public sector contributed 65% of total revenues and the rest of the world contributed 35% of total revenues. This compares to 58% and 42% last year. North American commercial, our largest sales group by revenues was flat year-over-year in license bookings. North American public sector, however, was very strong delivering 24% year-over-year growth. They took clear advantage of the many state and local government fiscal year-ends and the increased federal spending that we are seeing.

Our Asia-Pacific region also performed relatively well, delivering flats licensing bookings year-over-year despite a 20% currency hit. We truly believe Asia-Pacific remains a major opportunity for growth for Quest. Europe, Germany in particular struggled. If you took out our total revenues, excluding EMEA, we actually increased revenues by 5% versus 2Q of 2008. So the majority of the businesses are performing better, and we are just very focused right in making sure Europe, again to pick it up.

From a transaction perspective, we completed 160 deals over $100,000 in Q2 09 as compared to 185 deals last year, a 14% decrease. However, the average deal size of over $100,000 increased to 265,000 from 221,000 last year. We had three deals, which exceeded $1 million versus two in Q2 of 08. We also did $10.3 million in term deals, which I think is very much a direct reflection of customer demand.

The falloff in deals under $100,000 was similar with last quarter. We have analyzed this trend thoroughly and this is opposite of what we experienced in the 2001 to 2003 tech downturn, when our smaller deals held up very well. We believe a key difference is that the 2001 to 2003 economic downturn was concentrated within the technology companies, the current environment, although improving, is much deeper and is widespread across most vertical sectors, and certainly all global economies. We believe many more companies are operating under new purchasing rules that postpone or preclude the smaller individual purchases that got through last summer.

Customers as still spending significant amounts of dollars on our products, and our ability to close larger deals are solid statements that our products are delivering value, and our customers will pay for them in the midst of wholesale cost-cutting program. It also tells me that tech budgets are showing resiliency and IT departments may be returning to more normal operations. We are seeing very early signs of budgets going up slightly in Q3, which is a good sign.

Our renewal side of the business, let me talk about that. Our renewals continue to grow albeit at a slower pace. There are three reasons for this. One, lower licensing in first-year bookings. Two, the growth in the term deals, and three, currency. We continue to focus on maintenance renewals, and while in the quarter we were impacted by currency, we also noticed that customers are scrutinizing renewals more closely, requiring us to work extra hard for each renewal dollar. In the quarter, we also noticed that while transaction volumes for renewals increased, the average dollar size of the renewals decreased slightly. This is the complete opposite phenomenon on what we are experiencing on the licensing side of our business.

Now I'm going to transition into talking about product highlights in certain transactions that took place during the quarter. I first want to start out with our application management business unit, which is primarily made up of our Foglight products. Foglight received a new web 2.0 customizable dashboard interface, which continues to be a major differentiator in almost every deal providing everything from compelling executive dashboards to complex diagnostic dashboards for IT administrators.

Now we're starting to see Foglight’s use expand from the physical to the growing virtual environments. The complete revision of Foglight will correlate end user transactions through the physical peers to the virtual infrastructure supporting the critical application service.

A top global systems integrator selected Foglight based on our tremendous strength in this area in Q2. This quarter a major online reservation system provider selected Foglight to manage their web-based online ticket reservation system for airlines. This customer was very excited about what they feel is Foglight’s unique ability to enable them to monitor real-time adoption of on-the-fly airfare changes, and then adjust prices based on near real-time user conversion data. This customer said that their previous web analytics solution required closer to a full day or longer to receive the results of fare changes, price fare changes, and adjust prices to maximize revenues. Again, now they are able to do it virtually real-time as a result of using Foglight.

Let me move on to the database business, which is obviously comprised primarily of our Toad product, and one of the very exciting things that we have seen over the recent months in quarters with Toad is the increase of our Toad freeware product. We have seen an increase of 88% in the downloads of the freeware product, which I think is a reflection of the challenging economic times. What is great about though is that increase in free downloads will, once the economy begins to free up, should lead to a significant increase in the availability to convert those free users into paying customers, which is something that we have certainly proven that we are very skilled at doing over the past few years.

Toad World, our unique Toad website, has hosted 300,000 unique visitors, which is up 71% over the year earlier 12- month period. Another real positive sign was that roughly one-third of the Toad deals over the past 12 months have been with new customers. One of our new Toad database product that we introduced in the market recently is showing tremendous strength. A US-based university purchased 250 seats of our Toad for Data Analysts, which is roughly a $140,000 to enable multiple areas of the university to run ad hoc queries and produce reports against real-time data. This is significant in that we are now addressing a new market of users with Toad.

Another product within the database arena that had a really strong quarter was SharePlex, which is very good news as SharePlex has been a product that we have benefited from for the past 10 years, and it just continues to show solid strength within the market.

Now let me talk about our Windows business, which is broken up into two categories, one being Exchange, SharePoint in unified communications, the other being the Active Directory management group. From an Exchange, SharePoint unified communications perspective, our SharePoint business grew nicely year-over-year. We believe we are an early leader in SharePoint management and migration products, which are natural extensions of our Exchange and SQL server business. Of note, we recently closed a deal worth over $700,000 at a major pharmaceutical company. The majority of that purchase was to help them move from notes to Microsoft SharePoint online, and as you can appreciate we worked very closely with Microsoft in making this opportunity a reality.

From an Active Directory management perspective, our Active Directory tools business was very strong in Q2. ActiveRoles Server continues to deliver on the promise of providing a secure way to manage AD and provision users across the enterprise. AD management continues to be the core of our growing identity in access management products family, which we term the QuestOne strategy.

A large US school district with 250,000 staff personnel and 175,000 students, they purchased over $1 million of our ActiveRoles products in the quarter to upgrade their AD automation and provisioning systems. With the Quest solution they were able to meet the short timelines mandated by their upcoming IS consolidation with a strong out of the box solution as opposed to their larger identity management platforms they had evaluated.

Another part of Windows business is our Script Logic business, which – we targeted towards servicing our SMB Windows market and also our desktop management products and solutions. Script actually had a very solid quarter. It is proved that it is an efficient marketing and sales model are able to hold up in this challenging economic environment. Script had new releases of both its Desktop Authority and Help Desk Authority products. These products will prove to be key contributors in Q3 and going forward.

Now I'm going to move to our virtualization business, which is again comprised of two areas, which is our desktop component and our server component. Our desktop piece, which is referred to as either VDI or VWorkstation is truly an emerging market with tons of upside. We continue to see many pilot projects that will eventually turn into full-blown VDI deployment.

Based on how big the VDI market is and the growth of our pipeline, we continue to invest heavily in this market opportunity, which is some of the market dollars that we took from other parts of the business and we moved it into this VDI desktop area.

On the server side, Garner has just rated Quest as the number two player in the server virtualization management market, which as you can appreciate is very exciting. Our virtualization management products are evolving from point products to enterprise solutions. We closed a $400,000 deal with a Big 3Accounting Firm for our vEssentials product suite. It is validating our complete solutions strategy. A large media firm purchased over $300,000 on vOptimizer Pro to achieve immediate savings of over $1 million in storage hardware costs, by reclaiming unused desks and being able to reallocate it.

We had several major virtualization product releases in Q2. vRanger Pro 4.0 is a significantly enhanced version of our market leading vRanger data protection solution. We were pleased to see 8500 downloads of vRanger Pro 4.0 in its first 20 days of availability.

Following up on the successful launch of our award-winning vOptimizer Pro product last quarter, it proved to be faster ramping virtualization product to date. vOptimizer Pro is a key part of the bundled solution of vEssentials. A product that we released about a year ago and you have heard us talk about in occasion is on vFoglight. vFoglight continues to be an extremely exciting new product within our virtualization business, and is truly experiencing very significant growth.

As you can imagine, the opportunity within the virtualization is something that within Quest has of how we are very excited about. And is really beginning to touch on many different parts of our business, and Vinny will probably touch on some of that when the talks here in a moment.

One final piece of information that I'm very excited to announce that was just posted on our website here a little but ago is the fact that Alan Fudge has just joined Quest today per se as the Senior VP of worldwide sales. Alan comes to us from – he had previous experience in Tivoli (inaudible), BEA, VMware and recently GuardianEdge, and what we are really excited about is Alan is the guy that is going to help us truly maximize and take advantage of our commitment to growing our license component of our business, but also be completely sensitive to the margin and cash flow growth.

I will say on a personal level I am extremely excited about having Alan here, and it is just going to be a great contribution to Quest.

So all in all, a challenging quarter from a revenue perspective, although we did a good job at the higher end of our business, and we are strong in places like public sector. We expect a slow but gradual improvement within our markets, but in the meantime we are continuing to focus on managing costs, driving focus, and taking the opportunity to refine our business model during these times.

And with that I would like to turn it over to Scott, and Scott will give you incredible detail on our financials.

Scott Davidson

Thanks, Doug, and good afternoon everyone. So the Q3 results were as follows. Total revenues were $164. Non-GAAP operating income was approximately $34 million in the quarter, which is an 81% increase over the second quarter of 2008.

Cash flow from operations was approximately $24 million, and deferred revenue was $325 million, which is a $30 million or 10% increase over last year. The non-GAAP diluted earnings per share was $0.29.

On June 30the, we closed a tender offering for 6.8 million shares, the impact of which will be reflected starting in Q3. Including the previous tender close in December 2008, and the results of our open market buyback in Q1, we have repurchased over 18.6 million shares or 17% of the previously outstanding shares. Toad we announce a $100 million repurchase authorization enabling us to acquire incremental shares on a go forward basis.

Now I'll get into the quarter in a little bit more detail. The second quarter revenues continue to be shaped by the macroeconomic environment particularly in EMEA and by currency. Total revenues were approximately $164 million or 5% lower than Q2 of 2008. Excluding the impact from currency, total revenues would have been down 2%.

We continued to see stress among the smaller deal size volume. Some of these deals have been aggregated into larger deals, while others have not closed.

Q2 license revenues decreased 18% year-over-year to $62 million or down 11.6%, excluding the impact from currency. Similar to Q1, we saw a noticeable increase in the volume of term license deals, which was about 10% of new business generated in the quarter. Had these term deals have been structured as perpetual licenses, license revenues would have been down – which would have been approximately $8 million higher. It bears mentioning again that the term deals, while recognized within revenue over time have similar characteristics to perpetual deals from a cash flow perspective in that we collect the cash upfront.

So taking into account currency and the effect from term licenses, license revenues would have been down approximately 1% during the quarter versus the 18% decrease as reported. Service revenues comprised primarily of maintenance and renewal were up 5% in the second quarter to $103 million. Our renewal activity has been relatively consistent, and our renewals continue to grow, albeit at a slower pace as Doug mentioned. We continue to focus on maintenance renewals, and in the quarter we were impacted by currency, we also noticed that customers are scrutinizing renewals more closely.

In the quarter, we noted that transaction volumes of renewals increased for the average dollar size and the middle transaction decreased. Along product lines, license revenues for virtualization management products were up approximately 14%, but we saw declines across the rest of our products. Our maintenance revenue growth was driven primarily by Windows management and virtualization management products.

Looking at the revenue mix for the quarter, license revenues were approximately 38% of the total revenues, while services generated the 62% balance. This compares to a 43% license, 57% services mix in the second quarter of 2008. Moving to expenses, I would like to remind you that to Q2 09 non-GAAP results presented exclude the after-tax effects of amortization, and the intangible assets acquired with the business combinations, share based comp expenses, acquisition related costs and ongoing expenses related to the stock option investigation. Our earnings release provides that reconciliation for you.

Non-GAAP expenses in the quarter were down 16% on a year-over-year basis to approximately $130 million or down 8% excluding the impact from currency. We continue to contain headcount and discretionary expenses, while also benefiting from the strength in the US dollar. During the quarter, our expenses were approximately $12 million lower due to the impact from foreign exchange. This represents about half of the reduction in total expenses. The other half is related to tighten management of headcount related expenses, travel and outside service fees and other discretionary spend.

Expense management is a theme that will continue. In addition we continue to perform a broader portfolio review of the products to identify incremental cost savings and free up dollars to redeploy in several other areas of the business. This effort will ultimately lead to more focus and the reduction in the sources associated with building, selling and supporting certain products, which may be partially offset by a reduction in revenue from these products.

Turning to the individual expense line items, the sales and marketing expenses for Q2 were $64 million or 39% of total revenue as compared to $79 million of 46% of total revenues in the same quarter a year ago. In the aggregate, the year-over-year changes related to headcount related expenses, including lower commissions on reduced bookings, travel and the benefit from foreign exchange.

R&D expenses in the second quarter were $34 million or approximately 21% of total revenue. This compared to $38 million and 22% of total revenues in the year ago quarter. Increases in core labor costs primarily in our virtualization group were offset by benefits in foreign exchange and decreased travel.

General and administrative expenses were $16 million or approximately 10% of total revenue in the quarter as compared to $20 million, which was approximately 12% of total revenue in Q2 last year. The reduction in G&A was related to lower fees for outside services, the benefits from foreign exchange and reduced headcount related costs.

Looking at income, the GAAP operating income margins were 13% in the quarter and GAAP operating income was $21 million. The non-GAAP operating income was $34 million during the quarter generating operating margin of 20.6%.

Our Q2 non-GAAP operating income was up 81%. Beyond expense management, favorable currency changes reduced our total non-GAAP expenses by approximately $12 million compared to the negative impact from currency on the revenue line of about $6 million.

Other income was $4.8 million versus $3 million in the second quarter of 2008. In March we initiated a limited balance sheet hedging program, which was designed to and in fact did reduce some of the currency volatility within OI&E although we did see a larger than normal sequential change.

With the recently closed mortgage and line fees on our undrawn line of credit, interest income and expense are essentially neutral. Now we are working on reducing the volatility as we build out our balance sheet hedging program. We will first focus on a few currencies and then broaden into the rest of them for the coming quarters.

The GAAP effective income tax rate for Q2 was 22% compared to 11% in second quarter of 2008. The comparative difference, the increase is primarily related to the results in the mix of pre-tax income between high and low tax jurisdictions, the impact from net operating losses, and the associated valuation allowances in certain foreign jurisdictions, and the resolution of income tax audits in the US and France, and the discreet impact of such items in the quarter respectively.

The Q2 non-GAAP tax rate was 27.1% compared to 18.7% in Q2 of 08, primarily resulting from the change in the projected mix of net income before taxes in the high and low tax jurisdictions, the impact from net operating losses and associated valuation allowances in certain foreign jurisdictions, and the resolution of the income tax audits in the US and France. The closure of the IRS examination of income tax returns through December 2004 discreetly resulted in a tax benefit for the reversal of income tax and related interests incurred for the period June 30, 2008, while the resolution of the France tax authority examination resulted in a net tax detriment for the period ended June 30, 2009.

GAAP net income in the quarter was $20 million and GAAP EPS was a diluted $0.21. Non-GAAP net income was $28 million and non-GAAP diluted EPS was $0.29. The fully diluted weighted average shares outstanding were approximately 96 million shares.

Now turning to the cash flow statement and the balance sheet, as of June 30, cash and investment balances were approximately $331 million. However, on July 7, we acquired the shares associated with the tender offer and spending approximately 96 million of our cash balances. From a liquidity standpoint, we also recently closed on the mortgage of our principal property in the amount of 34 million and $100 million line of credit remains undrawn.

CapEx for the quarter was about $2million. Cash flow from operations was strong at $24 million.

The day sales outstanding was 61 days, which was a three day increase over Q2 of 2008. Deferred revenues increased 10% to approximately $325 million, which was up $30 million year-over-year.

So in summary, while Q2 was challenging on the revenue front we did a good job continuing to manage the expenses and also benefit favorable currency impacts thereby enabling us to further increase the operating margin. For the reminder of the year, we intend to be diligent on expenses, however, we are not expecting as much benefit from currency. We anticipate entering some severance costs related to the product review that Doug mentioned before and expect like little strategic hiring, while making both the necessary and opportunistic investments to position ourselves for the revenue upturn.

This concludes my remarks, and I'll turn it over to Vinny.

Vinny Smith

Thanks, Scott. I just wanted to bring up two topics I think you'll be interested to hearing from me on. One is use of cash and how we view our utilization that, and the other is how we are looking at forward markets. When I think about cash, we are currently running with $270 million with $100 million credit facility, and we expect absent of any acquisitions to have about $450 million of cash and still $100 million credit facility.

That will be at the end of Q1 2010. So we are a cash generating machine as most software companies are. We are in a great industry that provides a steady revenue stream and can produce decent margins. So if we keep our margin pictured where it is, around 20%, we're going to continue to generate large amounts of cash. So that leaves us with the challenge of what to you do with the cash. And really what comes to my mind is three uses. You can acquire companies; you can pay out dividends, or you can buyback stock.

And so we balanced and reviewed those three options, and for us we anticipate continuing to do smaller acquisitions. We do look at time to time at larger acquisitions that cost hundreds of millions of dollars. We haven't done any to date, but we know that we're going to do smaller deals, and we need to keep enough powder dry and cash to be able to do those stock. So far us, we know we can draw down our cash, and still continue with our acquisition strategy that we have used in past years.

So that leaves us with we should do either a dividend or a buyback. And about a year ago I spent some time with some several shareholders and they are really advocating that we do one of these two, and so we went and did that. We spent a little over $250,000 million or so buying back stock, and that was the choice for we deployed versus dividend, and that was primarily because of the tax benefit of doing buybacks versus dividends. So when we announced $100 million stock buyback this time, it is along the same lines. We're keeping enough powder dry into the acquisitions, the way we have done them historically, but also returned something back to the shareholders, and at this point it looks like buybacks are more effective than dividends.

Now moving on to thinking about our forward markets, the way I view the businesses, we have got three principal businesses. We have the database business, which is our first business. It is a more mature business, and having said that there is some value in that, in that we have got intensely valuable solutions for our customers along with an enormous installed base.

And for me that means opportunity, and that you can continue to evolve your products to solve problems in a more effective manner so that the huge installed base you have will be with you in three, five, ten years from now. And so the database business is also a great cash flow engine for us and that allows us to generate our profits, and invest back in the business.

So we will be able to continue to innovate in the database world, but we don't anticipate huge growth there. Second business I want to comment on is Windows. Windows has been a great growth for us over the last five years or so. We're a server management company in this area, where we have very complete solutions for Active Directory, Exchange, SharePoint, and general Windows Server management. And each of those categories, both AD and Exchange were quite substantial amounts, which SharePoint being younger and a faster grower.

What is interesting about the Windows market is it is large. I mean, the Windows market is just absolutely enormous because of Microsoft's penetration in the market, and they also lead into bigger markets, because when you are managing AD, Exchange and SharePoint, you are all delving into identity management and security and compliance. So our products are morphing into more comprehensive complete solutions for identity management, security and compliance, which is very exciting for us. There are even larger segments than our traditional AD exchange and SharePoint.

So we think that as we invest in Windows, in Windows management, we will be able to continue building and growing the nice license business. The third category, bucket of products, our market segment is virtualization. And when I think about virtualization, I think about it from a point of server virtualization and client virtualization. And in the Sir virtualization world, obviously VMware’s ESX have been the market dominant force in the market, and that is where we have brought about products to market and we have brought products for backup, compression, movement, monitoring and provisioning.

So we have a very comprehensive ESX Management line in the market today with over 20,000 customers already. We think that the market is going to bifurcate, and Hyper-V is going to get a reasonable share, and that has started to happen in 2010, because in the fall Microsoft is going to be releasing a substantially upgraded version of Hyper-V.

We are holding on zen [ph]. We do have some zen products in the market, but we don't know if zen is going to create a big enough base to have a reasonable management market for part of that. So we have got a great start in ESX with lots of customers and we have got a great opportunity with Hyper-V, and so we also believe that there is going to be new categories of products that we can bring to market. So this area is going to be a nice growth area for us in future years.

The other side of virtualization is the client. And what is going on there is the current rate demand client is troublesome. It costs a lot, it is unreliable, and there's not much IP protection and that we are running around with great too much data with our client, and we're having people like me or Scott managing our own PCs, once I go back, which I am not the greatest IT guy involved.

So we know that we need to modernize how we manage our clients, for security reasons, reliability and for cost. And so we brought some companies and we're investing in this area, because we think that we can merge or utilize virtualization techniques to address these concerns around reliability, IP protection, and cost. And so it is a great opportunity for us as server virtualization management is.

So those are our three buckets: database, windows and virtualization. And then there is another opportunity that we are looking at that is staring us right in the face, as the datacenter moves and more and more of their servers being virtualized, there is going to be new techniques to do better management. Also where traditional application is and what we do very well needs to meet virtualization, and utilize those now virtualized servers in ways that couldn't have been dreamt of hope before. So we have an opportunity to advance all of our products, almost all of them, from SQL to Oracle to AD, Exchange, and SharePoint, so that they move forward and incorporate and utilize virtualization to offer a more effective management.

So for me this is really exciting, because we have got these three market segments that we play in. We have the opportunity to now move our products forward, and let them embrace and adopt virtualization to offer better solutions, much like I just talked about in the client management side. That is true in every category. So we're looking at a lot of opportunity and we are very excited about that.

So that concludes my comments and now we want to open up to now question and answers.

Question-and-Answer Session

Operator

(Operator instructions) And our first question will be from Aaron Schwartz of Ladenburg.

Aaron Schwartz – Ladenburg

Good afternoon. I had a question on your cost structure given that headcount was roughly flat sequentially in the quarter. If this is the base cost structure we should think about if revenue stays at this level or can you take sort of the non-variable cost structure down, down lower from this level?

Doug Garn

I think this should probably what you would assume to be the baseline cost structure. You know, we've got been some benefits as I talked about from currency in the cost structure. Those are going to be offset, you know, in the coming quarters by a couple things that I had mentioned. One, we don't think that we are going to get the same benefits on the currency side going forward, at least the magnitude we've seen in the first half of the year.

The second thing is as we have gone through the portfolio review that we touched on there is, you know, there are some products that we're going to be sort of be powering down if you will, and others which will get more, sort of drastic cuts to them, but there is going to be in the next couple of quarters, there is going to be costs associated with that in terms of severance, for example. And you know, I'll call those out in future calls, but typically we don't pro forma that out. So that'll be embedded in there. That is the second thing.

And I think third, when we talk about certain key markets, specifically around virtualization, you know we're going to do some very specific strategic hiring there, and that business has still grown for us fairly well in light of everything else, and so I don't think that we are going to see any sort of down, you know, down step from here on the expense side at all.

Aaron Schwartz – Ladenburg

Okay, in the comment when you made about a 20% margin, is that, I know you're not giving guidance but is that what we should think to for sort of an annual margin here or was that just talked about and sort of what you are talking for the cash flow going forward?

Vinny Smith

No, what we have talked about you know, and we have been pretty consistent on this all years, we said you know we expect to get improvement over last year's operating margin, which was around you know, 18.5% or so. So you know yes, you could probably get to the 20% range on an annual basis, right. In Q2 having gone from 10.5% to 20.6% was a dramatic increase. We don't expect such a dramatic increase in the back half of the year, but again we are pretty consistent on focusing at the margin, and we think that the guidance we have always talked about is still upper teens to 20% or so. So that hasn't changed.

Aaron Schwartz – Ladenburg

Okay…

Doug Garn

There will be some puts and takes to get us there, but we still feel pretty good about that.

Aaron Schwartz – Ladenburg

Understood and last question from me, the shift to term deals, is that being driven by you or is that more so being driven by the customer?

Doug Garn

You know, I think there is a little bit of both. You know, there were a couple of deals that I was personally was engaged in during the quarter, and it so happened for example, the customer had four different deals that they wanted aggregated amongst four different business units or divisions. And what they did was they were trying to control purchasing and effectively get a better price or better terms. So what they did was they took these four smaller deals aggregate them up into one larger deal and then after we went through the negotiation process it turned out, in that case a term deal was one that made sense for them.

In another deal that I wasn't directly involved in but got the details on, it was a public utility that happened to be publicly traded and they had debt covenants, and so in order for them to maintain their debt covenants, one of the limitations that they had was on their capital expenditures. So, they opted to take a term deal, which is accounted for not as a capital expense, as an operating expense and they were able to manage around their debt covenants for it. So those were just two particular cases. I think the truth be told in certain cases, you know, we'll sell a term deal, but it's a little of both.

Aaron Schwartz – Ladenburg

Okay, that's helpful, Scott. Thanks for taking my questions.

Scott Davidson

Sure.

Operator

We'll go next to Walter Pritchard with Cowen & Co.

Walter Pritchard – Cowen & Co.

Hi, Scott. I'm wondering if you could just talk a bit about sort of following on the Aaron's question. Looks like you guys have seen you know, even 5 or, 5% or 6% increase in your margins from say Q2 to Q4, just based on a higher revenue ramp. I'm wondering, I know you're not giving guidance but just wondering if you guys are expecting to see that kind of ramps as we head into the fourth quarter again this year?

Scott Davidson

You know, the largest factor on that you all know is coming from the license growth rate. So, if we see the license growth rate, we always show the best operating margin in the fourth quarter. The third quarter, so it's interesting going into the second quarter we have always talked about that, you know, the second quarter sort of the licenses as well, as the margins go down. We were pleasantly surprised, you know, from the benefit of currency in the cost reductions we made, they actually went up a lot more than we thought that they would. One other thing that concerns me a little bit specifically on the third quarter is Europe.

You know, Europe was weak in the second quarter. We do know that the third quarter EMEA is a slower quarter and that's partially offset by, you know the strength that we see in public sector, which has their strong third quarter. So there's a lot of balancing if you will, but suffice to say that if you do see license revenue growth and yes, you should see margin improvement, but we're not sort of claiming victory in that area anywhere near at this point.

Walter Pritchard – Cowen & Co.

And are you planning Scott for an up sequential Q3. It looks like you've done at the last three of four years in terms of license?

Scott Davidson

Yes, without getting into guidance I'd say you know, at this point we're not planning for anything dramatic either way.

Walter Pritchard – Cowen & Co.

Okay. And then just last question around the products that you're talking about winding down, can you just give us an order of magnitude in terms of, you know, $700 million or so in revenue you know, right now what we should expect from those products and how do they impact license as well as maintenance?

Scott Davidson

Not yet. We are still sort of working through that process right now Walter. So it's premature there.

Walter Pritchard – Cowen & Co.

Okay, great. Thanks a lot guys.

Operator

And our next question comes from Tim Klasell of TWP.

Tim Klasell – Thomas Weisel Partners

Yes, good afternoon everybody. So, first question, you mentioned that already into Q3 you are beginning to see some falling off the budget process. How do you think about the shape of this year? Will it be the – do you think there will be the typical hockey stick or in Q4 from how the customers are acting or do you think it may be a little bit more muted, given the macroeconomic environment?

Doug Garn

Yes, this is Doug. I mean that's, you know, obviously all this is hard to predict but we are, you know, we do sense that because people have been so tightfisted with their budgets through the first two quarters, and we expect to see some of that here as well in Q3. But we are getting a sense, again we do hope that public sector this quarter sees a nice loosening of the purse strings, but we do – we're kind of getting the sense that many of the companies we talk to that this buildup, we could see a little bit freeing up of those budgets in Q4.

I mean, you know, I'm certainly not making any commitment to that but we are hearing those that drumbeat a little bit louder than we have in any other quarter up to this point. So, yes, I do expect, I'm hopeful that in Q4 we'll see a bit of a flood of budget dollars that – and that's one of the reasons why we're keeping our headcount pretty solid in most regards as we don't want to go to lose the opportunity that might be out there going into Q4 and maybe even in the next year.

Tim Klasell – Thomas Weisel Partners

Okay, great. And then just on your Windows division, obviously Microsoft has got a large set of releases on the client and some of the server products. How do expect that will impact your business over the next let us say, two to four quarters?

Scott Davidson

I mean, generally, Tim on the client piece, you know, the ScriptLogic as our other guys had touched the client more than anywhere else, and, you know, the question is what the uptake on the client and generally what we've seen on our Windows business if it is anything, it is a couple of quarters after the introduction. That's number one and then the biggest driver at least on the migration business, isn’t so much the new product introductions as much as it is the, you know, end of life support on existing platforms. So you know, with exchange 2010 coming out, you know, there is still a large constituency of customers that are on 5.5 or exchange of 7. You know, the question is when they will stop our end of life support 5.5 exchange 2007, and then how people migrate to 2010. So, you know, those are usually more, more bang for the buck as it relates to us, and again most of our revenue at least historically has been on the server-side. So, any of the desktop piece will be on Script’s business.

Doug Garn

Well, we were worried at one point that maybe our active directory products would be impacted, and yet we actually saw a nice little piece of growth in that part of our business this quarter or this Q2. So, we were very worried about someone else, Microsoft has been making and did make last year and continue to make. They actually very often speak almost with our words and our language of what our products currently do, and in some cases it's actually helping us a bit. So, you know, the good news is that the, you know, we are still seeing good strength in various areas of our Windows business. So it's at this point doesn't seem to be one of our biggest you know, one of our big worries.

Tim Klasell – Thomas Weisel Partners

Okay, great. Thank you very much guys.

Operator

Our next question comes from John DiFucci with JP Morgan.

John DiFucci – JP Morgan

Thanks. I have a quick follow-up Doug on Tim's, one of his questions there. This quarter, you said looking forward you're hoping you know, to see some kind of budget flood, not sure if you will but something like that. This quarter we actually saw license decline by about 18% versus 21% last quarter. Just curious is this looking at the current environment right now. Is this just a little less bad than it was or is that just in the noise? Are you seeing anything getting better on the margin, getting worse on the margin? Can you comment on that please?

Doug Garn

Well, I think Scott talked to the margins pretty heavily so far. You know, I would, we are not – we are anticipating a significant up-tick in our license revenues for Q3. You know, I don't think that's the case, you know, I've been on the phone with a variety of our sales leaders across the world and generally the theme that I'm hearing, in particular some of the smaller end transactions that have seemed to be experiencing more of the congestion and not getting freed up. They are beginning to see some of those deals begin to happen and that's, you know, for us you know, we've actually not seen much weakness in our $100,000 and above. We've seemed to be doing pretty well there. It's really in our lower-end deals, and so the minor optimism that I'm hearing a little bit about it is that we are beginning to see some of those lower-end deals to go through a little bit more smoothly than they have up to this point.

I, by no means, want the think that as a flood because it is nothing even close to that, but you know, for those guys that are selling more of the lower end markets, it's been a tough year, and so I think they are seeing a bit more optimism on us than they did before.

Scott Davidson

And I think -- John, it is Scott. The other thing I had mentioned on that while your numbers are right. You know, we've got other dynamic at least on the license line of the impact from these term deals. So if you back out just term, not the currency piece, your license line year-over-year was down about 8%. So, you know, that term deals as far as, you know, hitting the revenue line in Q2 you know, was an $8 million swing. The feel of the business if you will in terms of a booking dollar amount seems like it's at least, as you said little bit better at the margin.

Doug Garn

Yes, absolutely.

John DiFucci – JP Morgan

Okay, and it looks here that you guys have done a good job in controlling what you can control, but on those smaller deals obviously there is an issue with macro economy, but we are hearing from some others that actually is sort of come back, and which is not what we are the really hearing. It sounds like it may be getting a little bit better. So I'm just curious, do you think it's possible given the products that are sold in those smaller deals that there is sort of perhaps some kind of secular change happening in your business?

Scott Davidson

Not really. I mean, like I said you know, the early indicators for you know, Q3 are that we are seeing that that's beginning to open up a bit. So I'm not sure if I, you know, I'm seeing that you know, it's not certainly going to be worse than it has been and I am seeing it getting improved in the lower-end deal transaction band, but you know, it's so hard to anticipate to the level of that improvement, you know, at this point in the quarter. You know, in Q2 versus Q1 it was very similar, the depression we experienced in those, in that lower-end deal bandwidth. So, but I certainly don't expect it to be like it was in Q1 and Q2.

John DiFucci – JP Morgan

Okay, thanks a lot guys.

Operator

Our next question will come from Philip Winslow with Credit Suisse.

Philip Winslow – Credit Suisse

Hi, guys. Just first off, congratulations on the new hire to the team, but also just focusing on just the sales organization now with Alan coming in, should we be expecting any changes to just the sales force model, go-to-market, emphasis, et cetera?

Doug Garn

You know, at this point no, but you know, certainly what we are excited about bringing Alan in is that he will have a chance to really bring some of his experience and recommendations on how we can do it better, and so, you know, we are certainly very open and willing to listen to Alan, and take his guidance on what he observes. You know, it's one of the real advantages to bring in a guy in from the outside is, you know, he is bringing his years of experience to us. We are you know, somewhat you know, you can be a little bit insular, and it's nice to bring in a guy from the outside that's going to really challenge us to look at things a bit different, and you know, I can tell you, Vinny, Scott, and I are very excited about getting his perspective, really looking at our products and trying to gain from his experience at VMware and BEA, in particular on how we can be more efficient in these areas, how we can, you know, sell more lower touch products as well as be more competitive in some of the higher-end more solution oriented products.

He has got a lot of experience with managing PSO organizations which is a, you know, always a big part of what we do here. So I really am looking forward to Alan taking a fresh perspective and so, you know, right today I would not expect any changes. I would expect 2010 when we go into that that some of his fingerprint will be on that, and I would expect that we would see some changes. So that would be a good question in our 2010 first quarter call, because I'm sure by then he will have had a chance to make some changes.

Philip Winslow – Credit Suisse

Great,

Doug Garn

(inaudible)

Philip Winslow – Credit Suisse

All right, thank you. And then Scott also just a quick housekeeping item, I'm just interested in other income that has been hoping around a fair amount. Quarter to quarter, past several quarters one of you quantify just any sort of one-time impact for this quarter and then where do you expect that kind of going forward Q3, Q4?

Scott Davidson

There is no particular one-time impact in this quarter. You know one of the things that even if you look at what's in that other income number, you know, the expense associated with the line and line fees and the mortgage, offset by interest income from the investment portfolio. They get swing in their typically foreign exchange that's generated on our positions overseas. We’ve started to hedge some of that balance and even though that the number was pretty big; we took some of the bite out of that actually in the quarter.

We're not providing sort of the forward number on there, but I don't believe it's going to be as big of a swing as what we saw, you know, this year. I think you know, you should just assume it's going to be somewhere between where it was last couple of quarters. You know, the one other thing you know, I want to mention on the call, just so everybody sort of has light of this is, you know when you have 3 to 4 quarters of down license bookings and license revenue on a year-over-year basis that will eventually figure into the impact of your maintenance revenues as well. So, as you guys think about you know, sort of the go forward basis you know, maintenance or services revenue does not just continue to go straight up. You know, it's eventually recouped but that also has impact on the model as well. Something you guys need to think about.

Philip Winslow – Credit Suisse

Great. Thanks guys.

Operator

Our next question comes from Derek Bingham with Goldman Sachs.

Derek Bingham – Goldman Sachs

Hi gentlemen. Scott, on thinking about just third quarter last year was kind of an unusually strong up-tick in license over second-quarter, and I think it was driven in large part by federal business. Can – you talked about a little bit about what you're currently seeing in your federal pipeline and how that might compare to what it looked like last year?

Doug Garn

Yes, I'd probably be better to answer that. I mean the facts are that the federal piece, you know has the potential to be a tremendous swing for us you know, one way or the other. The pipeline is quite significant, but it's, you know, we are very dependent on Obama, and you know, and the level of loosening up of the federal dollars. You know we are very hopeful that will happen because you know, certainly the pipeline – it is significant, but, you know, we are managing to the lowest possible member with the hope that they will bring in considerable upside as a result of tremendous, you know, of significant freeing up of the budget dollars you know, over the next – we should expect to see it over the next three or four weeks.

Derek Bingham – Goldman Sachs

Okay, and then on the kind of deal structure when you're thinking about kind of the increase in term deals that you've seen. I mean is there any part of it that you think is going to last for any reason in terms of you know, maybe making some changes to how you go-to-market in the future or is this only temporary, given the environment and I would go back to the way it always was afterwards.

Doug Garn

I don't think this is going to be the way it'll be long term, no. You know, certainly in certain scenarios, we are in favor of doing them but it's, I would say in Q1 it was reasonable, Q2 it got a little ahead of us, but it also has been driven frankly, you know, I would say a large portion of it was driven by customer requirement. So I think that's going to be an ongoing trend that we are going to see for the next x number of years, I don't. In fact, if we were to look at the pipeline for term deals for Q2 or Q3, which we do track pretty closely, it's significantly smaller than what it was in Q2.

Derek Bingham – Goldman Sachs

Okay, great, and Scott I do have one just for you, which is on buybacks. Is there any kind of additional color that you could give in terms of you know, how you go about in the near term in terms of thinking about when that cash is put to use or what happens to the share count, I mean is it, any thought on open market purchases versus the tenders you've done and anything else like that?

Scott Davidson

Yes, the structure this particular $100 million buyback that we announced today is going to be sort of a 10b-5 equivalent variety. So what we will do is we will put a pricing matrix in place with, you know, with breakpoints on the number of shares that are purchased based on where the stock trades, it's sort of predetermined levels. By doing it that way we are able to continue to buy during blackout periods, and it becomes sort of an auto pilot plan, if you will.

It's difficult to provide guidance so on, you know, what the share count would be because depending upon where the levels are preset, we may or may not execute. So I wouldn't at this point build anything into a model that has any sort of predetermined number on, you know, what we may have purchase over the coming quarters. It's a lot different than the tender offers were. That's a bit early for Q3. You know, you can take those you know, 6.8 million shares out of the weighted average shares outstanding when you're coming up with your EPS number for this year and for 2010.

Derek Bingham – Goldman Sachs

And the 10b-5 will get going though in this quarter, and then it just depends on I mean if the stock price is too high then you will have to reset at some point. How does that work?

Scott Davidson

Yes, we'll kick it off very shortly and then depending upon where the stock price may be relative to where the price points are, it will either execute or it won't execute. That's correct.

Derek Bingham – Goldman Sachs

And then if it doesn't, you know, what's the process to kind of resetting it, do you need to wait for another board meeting or can you...

Doug Garn

We can – presuming that we are in an open market window, i.e., not a blackout period, we can reset it at any time we want. We're just not able to reset during a non-open market window.

Derek Bingham – Goldman Sachs

Okay, thanks a lot. I appreciate it.

Operator

We will go next to Gregg Moskowitz with Auriga.

Gregg Moskowitz – Auriga

Thanks very much. Just a question on the maintenance, getting back to the commentary that the average dollar size of the renewal decreased year-over-year. I know currency played a role here, but if we exclude that just curious what you saw anecdotally with regard to pricing on maintenance renewal?

Scott Davidson

It wasn’t. Gregg, it's Scott. It was – so there was some currency, currency was actually a bigger proportion compared to anything else, but there are instances for example where you got a customer than they have had a thousand licenses, seat-based licenses for something and they reduced their headcount by 10%. So they only want to renew you know, 90% of what they had previously. So things like that. That was also an impact. So that actually reduces the deal size amount.

Gregg Moskowitz – Auriga

Okay great, and then maybe for Vinny or Doug, just wondering if you can update us on the progress of the next release of the Vizioncore product. I think previously it was being targeted for around the September timeframe.

Vinny Smith

Yes, this is Vinny – we actually released it ahead of schedule, and went out last month in July, and so we're starting to move customers, now we have actually with really positive early acceptance of the product, which has been exciting.

Gregg Moskowitz – Auriga

Okay, got it. So we should look for I guess, currently no other product refreshes that are near term on Vizioncore, but you know, kind of look forward to this release and then obviously to 2010 in terms of future improvements?

Doug Garn

This was a significant – this was the rewrite of the product to allow it to offer greater scale and offer fine-grained object level (inaudible) services and things like that. So it is just much more of an industrial strength products, and so there'll be incremental releases that is pretty significant one in the late fall. So we will see steady, probably two times a year, but the big one went out in July, and we'll start to move that customer base up. We'll give it a couple months to shake it out and then we will start moving the customer base out up to it in the early part of the fall.

Gregg Moskowitz – Auriga

Great. And then just a quick one for Scott. Just wondering if you can update us on how much cash is left in the US.

Scott Davidson

In the US?

Gregg Moskowitz – Auriga

Or in other words, I guess conversely, how much cash is overseas at this stage?

Scott Davidson

Yes, so I guess the question is that pre or post the mortgage. So let me give it to you this way. So if you look at as of the 6/30 number where we had $331 million, about $120 million of it was in the US. We paid for a portion of the buybacks, a portion of the $95 million was paid by overseas cash that we are able to bring back, and so then you add the mortgage to that. So, as of right now, there is about $120 million or so in the US.

Gregg Moskowitz – Auriga

Okay, perfect. Thanks guys.

Scott Davidson

And that of course, doesn't include availability; the line of credit is still open in $100 million with zero balance.

Gregg Moskowitz – Auriga

Right, great. Thank you.

Operator

We will go to next to Mark Murphy with Piper Jaffray.

Brian Schwartz – Piper Jaffray

Hi, this is Brian Schwartz for Mark Murphy. Scott, just want to follow up on the maintenance side. I apologize if you gave this some already, but did you give us what the maintenance revenue number was in the quarter. Just want to see if that grew sequentially?

Scott Davidson

Yes, I didn’t, but it's in the Q, there [ph] on $93 million.

Brian Schwartz – Piper Jaffray

Just following up some on the balance sheet, it looks like the DSO has ticked up a bit and I was just wondering if you could comment on the linearity in the quarter. Wondering if the conviction that budgets are possibly loosing up here is due to more deal activity that you saw on the end of June and possibly through the first half of Q3.

Scott Davidson

Now, I mean I don't think that you know, materially went up a couple of days. I don't think I will tie it to any necessarily change in deal activity or anything specific like that. I don't have any real specific reason for that.

Brian Schwartz – Piper Jaffray

And then just a final question. You've talked a lot on the call here about the growth opportunity in the virtualization segment of the business. Is it possible to quantify how fast that business is growing or possibly how much of a contribution that business is to the overall company?

Doug Garn

Yes, I'm sorry, but we don't disclose that.

Brian Schwartz – Piper Jaffray

Okay, that's all I have. Thank you for taking my questions.

Doug Garn

Sure.

Operator

We have time for one final question. That question is from Todd Raker with Deutsche Bank.

Todd Raker – Deutsche Bank

Yes. I was wondering if you just update us on the competitive landscape by the kind of big three focus areas, and what the downturn has been. And has there been any kind of significant change in terms of win rates or pricing environment?

Doug Garn

It's a broad question. There is probably a lots of different – the problem we have is we have really three different segments between database, windows, and virtualization. I don't know if we call them – much change in increased competitiveness.

Scott Davidson

No, not at all.

Doug Garn

There is definitely pricing pressure, but it is coming from the customer saying this is what I have or I just can't pay this much and that's where you see some negotiation on term licenses and things like that. We are trying to work with customers to get deals off the table, but it's interesting like there has been brighter questions about what's going to happen to that business under 25-K and under 10-K, and we believe that it is essential products that are just being postponed. It's not going away. We don't really believe, and this has been quite different than what we would have expected. As Doug mentioned in his notes earlier, in the earlier downturn around 2001 and 2002, 2003, we saw this business stay intact and strong, while the big deals were down.

Vinny Smith

So, we're going to include a bunch of customers, and they said that their purchasing limit has been pushed way down from that they used to be at $25,000 or $50,000. They have seen their ability to get things done, pushed down in some cases below 1000, which is just completely different from what we expected and had seen before.

Doug Garn

But, I don't know if this addresses your question, but competitiveness, I don't think too much has changed. We're hoping to improve our competitive position by tightening down some sales practices, how we go-to-market, take advantage of the downturn and actually improve. We are doing things that we think will allow us to be stronger as the economy, as the IT economy shows some strength. But this is definitely challenging. We are struggling on growing our license revenue, and we are meeting that struggle by trying to toughen or strengthen our ways we go to market, so we will be stronger and also generate more cash.

Todd Raker – Deutsche Bank

Okay, thanks, guys.

Doug Garn

Thank you.

Operator

(Operator instructions) And that does conclude our question-and-answer session.

Steven Wideman

All right. We do appreciate Mr. Doug. We do appreciate everybody who has taken the time to be with us today. Some of you may not realize that in the next couple of days is our ten-year anniversary of being a publicly traded company. So we have had the chance to interface with many a few for now ten years. I haven't, but certainly Vinny has, and we just want to first of all, thank all of you for continuing to be faithful to us and we truly also appreciate our employees that have allowed this experience to continue, and we genuinely are thankful for the culture and the people that we have within Quest.

It is very unique, and we certainly also appreciate our customers that have helped allow this engine to keep running as well, and you know as we have talked about a great deal today, we are very committed to establishing license growth, but also maintaining our cost structure, and really driving towards trying to contribute, and continue to see growth in our margin business.

So a lot of good things and we are very pleased that the ten-year anniversary, we have been able to make it. And hopefully we'll see all you guys for ten more years. So thanks to all, and have a great day and we will talk to you later.

Operator

That does conclude today's conference. We thank you for your participation.

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