Blue Coat Systems Inc. F1Q10 (Qtr End 07/31/09) Earnings Call Transcript

Blue Coat Systems Inc. (BCSI)

F1Q10 Earnings Call

August 25, 2009 5:00 pm ET

Executives

Jane Underwood – Vice President of Investor Relations

Brian M. NeSmith – President and Chief Executive Officer

Tyler Purvis – Senior Director of Finance

Analysts

Jonathan Ruykhaver - Thinkequity LLC

Ryan Hutchinson - Lazard Capital Markets

Erik Suppiger - Signal Hill Group LLC

[Anthony Carbone – Orega]

Richard Sherman - MKM Partners LLC

Alex Kurtz - Merriman Curhan Ford & Co.

Alex Henderson - Miller Tabak

Rohit Chopra - Wedbush Morgan Securities Inc.

Rob Owens - Pacific Crest Securities

Gabriel Lowy - Noble Financial Capital Market

Samuel Wilson - JMP Securities

Scott Zeller - Needham & Company

Presentation

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Blue Coat Systems first quarter of fiscal year 2010 financial results. (Operator Instructions) And as a reminder, this conference is being recorded.

I’ll now turn the conference over to Jane Underwood, Vice President, Investor Relations. Please go ahead.

Jane Underwood

Thank you, and good afternoon. And thank you for joining us to discuss Blue Coat’s financial results for the first quarter of fiscal year 2010. With me on today’s call are Brian NeSmith, our President and Chief Executive Officer and Tyler Purvis, our Senior Director of Finance.

Before I turn the call over to Brian, let me remind you during the course of this call we will make forward-looking statements about Blue Coat Systems, Inc. These statements regarding expectations concerning market growth and business opportunities including levels of IT spending, expectations regarding future revenues, expenses, margins, profits, tax rates and other financial metrics, the success of our business strategy and changes in our business model and operations and other matters impacting Blue Coat’s financial outlook and future business. All statements other than statements of historical fact are statements that could be deemed forward-looking statements including any statements of expectations or beliefs and any statements of assumptions underlying any of the foregoing. Risks, uncertainties and assumptions include the risks that are described from time to time in the reports filed by Blue Coat with the Securities and Exchange Commission, including but not limited to the risks described in Blue Coat’s annual report on Form 10-K for the year ended April 30, 2009.

No assurances can be given that any of these events anticipated by the forward-looking statements will transpire or occur, or if any of them do, what impact they will have on the results of operations or financial condition of Blue Coat. Blue Coat assumes no obligation and does not intend to update these forward-looking statements except as required by applicable law.

Now I’d like to turn the call over to Brian.

Brian M. NeSmith

Thanks, Jane. Good afternoon and thank you for joining us today. I am pleased to report that Blue Coat achieved solid Q1 results. Revenue and non-GAAP EPS performance were within our previously announced guidance ranges and highlight improvement on both a year-over-year and sequential basis. We also generated good cash flow and made solid progress in improving non-GAAP operating profitability.

As we discussed in our last conference call, driving better leverage in our business model is an important initiative for Blue Coat in fiscal 2010. Net revenue for Q1 was $116 million, a 2% increase compared with the net revenue of $114 million in the prior quarter. Product revenue for fiscal Q1 was $74 million compared with $74 million in the prior quarter. Included in product revenue is revenue from PacketShaper products, which was about $15 million and was flat compared with Q4. It also includes revenue from the Blue Coat WebFilter product of $7 million which was flat compared to the prior quarter.

In the first quarter we recognized $42 million in service revenue, a $3 million increase over the prior quarter. On a geographic basis, net revenue in the Americas was $53 million, representing approximately 46% of total revenue. Net revenue in EMEA was $42 million, representing approximately 36% of total revenue. And net revenue in the Asia Pacific region was $21 million, representing approximately 18% of total revenue.

Gross margin on a non-GAAP basis increased to 75.6% in fiscal Q1 compared to 75.3% in the prior quarter. On a non-GAAP basis operating expenses in the first quarter were flat from the prior quarter at $73 million. Non-GAAP operating income was $15 million or 12.5% of revenue compared with $12 million or 10.9% of revenue in the prior quarter. On a non-GAAP basis net income for the quarter was $10 million or $0.23 per diluted share compared with $8 million and $0.19 in the prior quarter.

The fully diluted share count for fiscal Q4 was approximately 44.6 million shares. Turning to the balance sheet, we ended the quarter with cash and restricted cash of approximately $123 million, representing a net positive cash flow of $8 million in the quarter. Operating cash flow in the first quarter was $11 million.

Now I’d like to turn to comments on the highlights for Q1 followed by our perspective on the market and our business going forward. And finally I will conclude with our guidance for fiscal Q2 and discussion on an important addition to our senior management team.

Overall, given the tough economic climate and the high degree of uncertainty that has permeated the market, Blue Coat had a very respectable Q1. The biggest factor impacting our business is the challenging macroeconomic environment, as customers are cautiously investing in their network infrastructure. While our sales pipeline was quite strong, closure rates are difficult to predict. Clearly Blue Coat is not alone with this challenge as evidenced by our competitor’s recent financial results. In fact, according to IEC, the WAN application delivery market was down 16.1% sequentially in calendar Q1 2009 as a result of difficult economic conditions.

I do believe we are executing better than our competitors and are gaining market share with our unique Application Delivery Network or you’ll hear us use this acronym time and again, our ADN Value Proposition, which integrates visibility, acceleration and security into a single solution. Just don’t take my word for it. Last quarter Infonetics, IEC and Gartner all found Blue Coat to be a leader in the worldwide WAN optimization market.

In calendar Q1, Infonetics ranked Blue Coat as a leader and reported that we were the only company to show quarter over quarter revenue growth. According to Infonetics in calendar Q1, Blue Coat increased its market share to 30% from 25.1% in the prior quarter. IEC also named Blue Coat the leader in the WAN application delivery market with 49.5% market share for calendar Q1, representing year-over-year revenue growth of 20%. And finally, Gartner advanced Blue Coat’s leadership position in the “Leaders” quadrant of its “Magic Quadrant for WAN Optimization Controllers” released in June. We believe our position in the “Leaders” quadrant is further validation that the WAN optimization market is increasingly becoming a part of a broader application aware infrastructure.

All of this market share data reflects customers are responding to our comprehensive approach to ADN, which integrates visibility, acceleration and security for web and enterprise applications. As such, the most demanding enterprises in the world including 83% of the Fortune Global 500 and 97 of the 100 largest companies in the world rely on Blue Coat for the intelligence and control to optimize or secure application delivery.

Our new sales force model that includes account and territory managers focused on strategic, large enterprise and mid-tier customers, is gaining good momentum. I’m particularly pleased the traction we are experiencing in our strategic accounts as evidenced by our growing pipeline of deals over 500k. An area where we can do better is in large enterprise accounts that represent deals in roughly the 100k to 300k range, which was the principal reason we realigned the sales force. Over the last few quarters we have focused our efforts in this area. I will believe we will now begin to see some improvement.

From a channel perspective, last quarter we realized a 12% sequential increase in the number of partners selling our products. Our channel account managers are executing very well as we are seeing a greater volume of no-touch revenue in deals below 50k.

Turning to some customer wins in the quarter, in North America three of the six largest U.S. banks deployed Blue Coat ProxySG appliances for their secured web Gateway infrastructure, to protect their Internet Gateways and accelerate acceptable content across their networks, while reducing balance consumption and containing their costs. In addition, we closed secured web Gateway deals with two of the largest banks in Canada.

Also in the U.S. we just saw deployments at companies such as Lincoln Educational Services, where the customer wanted to get the most of its existing network and optimize applications and content, including video, across its wide area network. Over the last few quarters, video has played an increasingly important consideration in WAN optimization deployment.

In the Philippines, the Asian Development Bank, a multi-lateral development financial institution, deployed a combination of our WAN optimization and secure web Gateway solutions to its headquarters and branch offices. Asian Development Bank resolved its slow application response time for most remote users, contained escalating network costs and provides a level of security it needed to protect its infrastructure users and data.

In EMEA, we closed two significant WAN optimization deals, the Ministry of Education in Kuwait and the Higher Colleges of Technology in United Arab Emirates. Both transactions were won in hotly contested bake-offs with a major competitor.

From a product standpoint, the reception from our partner community, the Version 5.4 of our ProxySG appliances has been very strong. They are realizing the immediate time to value of its simplified set up and configuration. This past March we launched a global channel rewards program. It incentifies retailers to engage customers in WAN optimization evaluations of our ProxySG appliances. To date, we have over 400 evals of pure acceleration opportunities.

Last quarter we continued to invest in PacketShaper by adding support for two popular applications, Twitter and Spotify. Understanding which social media tools are being utilized and how employees are using them is critical to our customers, as it enables them to understand the full value of their network investments.

Later this month we will be introducing a significant new release of the operating software for PackShaper appliances. This new release will set new benchmarks for granular applications visibility, enhance application intelligence and integrated policy base control which we call application accountability. Additionally, it will extend the way application delivery networks provide enterprises with the granular application and user control required to contain costs, enhance business productivity and respond quickly to changing business requirements.

Looking ahead the ADN market which industry analysts characterize as a comprehensive approach to visibility and acceleration of security, represents a very large and under penetrated opportunity. While the market is feeling the effects of this global recession, we are big believers in the space given its compelling ROI and the growing need for security. And in better economic times the ADN market should experience stronger growth than most other areas of IT as it facilitates critical business initiatives including branch office consolidation, server consolidation, application consolidation and a shift to cloud-based services.

Blue Coat is now a recognized leader in the WAN optimization, application performance monitoring and secure web Gateway markets, as our unique approach to ADN ties together best in class visibility, acceleration and security capabilities into an integrated solution. Our unique ADN value proposition has also allowed us to capture significant share in these difficult economic times, and positions us well to capture greater market share when the economy improves.

Going forward, we intend to manage our business with conservative macro assumptions and not to invest ahead of revenue growth. We are fully committed to improving our bottom line performance and increasing our non-GAAP operating profitability.

Now turning to our guidance for the second quarter of fiscal 2010, we currently anticipate net revenue in the range of $116 to $121 million. On a non-GAAP basis, EPS is expected to be between $0.23 and $0.28 per diluted share, which assumes a diluted share count of approximately 45 million. For planning purposes we are using a 30% tax rate for fiscal 2010.

Before I turn the call back over to Jane, I would like to briefly comment on our other press release issue today. This afternoon we announced that Gordon Brooks will be joining Blue Coat as its new Chief Financial Officer starting in early September. Gordy has a proven track record in helping lead high growth companies, as well as over 20 years of experience across areas of finance, accounting and M&A. Most recently Gordy was the Vice President of Corporate Finance at VMware. Prior to joining VMware, he was the CFO at SpikeSource and SVP Finance and Corporate Controller at BEA Systems. Gordy will be a valuable contributor in accessing the financial implications of all major business decisions, providing strategic input towards shaping Blue Coat’s global business objectives.

With that, I’d like to turn the call back over to Jane.

Jane Underwood

Thank you, Brian. That concludes today’s prepared remarks. Operator, we would now like to open up the call to questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Jonathan Ruykhaver - Thinkequity LLC.

Jonathan Ruykhaver - Thinkequity LLC

I don’t know if I missed this or not, but I did hear the sales generated from Packateer product of $15 million. Did you comment on the amount of services revenue from Packateer?

Brian M. NeSmith

We did not but we can give it out to you if you’d like.

Tyler Purvis

Yes, John, Packateer service revenue is about $10.7 million in the quarter.

Jonathan Ruykhaver - Thinkequity LLC

And I know, Brian that you’re going to get away from mentioning specific metric amount around the number of sales teams that you end the quarter with. I think it was 147 last quarter. But I’m just curious, given the lower dollar amount spent on sales and marketing sequentially was there any kind of headcount reduction on the sales side in the quarter?

Brian M. NeSmith

No, I believe it slightly increased. I’m trying to see if we know the exact number, but I think we ended with what would have been the equivalent of about 152 sales teams even though we’re not reporting so. So we actually are slightly up even from the previous quarter.

Jonathan Ruykhaver - Thinkequity LLC

Can you give us some color what drove the better efficiencies? Is that lower amount of spend on sales and marketing was just some cuts to discretionary spending on certain marketing items?

Tyler Purvis

Some of it. The part that you have to be careful from Q4 to Q1, Q4 was the end of our fiscal year and a lot of our sales teams are in accelerators. And so Q1 there’s, not many are in their kind of annual accelerators because we have an annual compensation plan. The other part, too, is a lot more attention to what I would call the non-quota carrying capacity. So focusing on SEs, focusing on people that aren’t directly carrying quota, whether we need the same structure. We actually for a fairly significant portion of our sales force, we broke down the barrier which we historically operated to where every dedicated salesperson had a dedicated SE and now a good majority of the sales force, the SE pool is actually shared among the sales organization. So I think over time we’re going to just drive better efficiency with the use of both SEs and channel account managers and inside sales, because we’re optimizing each along the kind of the unique dimension that we need to.

Jonathan Ruykhaver - Thinkequity LLC

So I assume you see better productivity on those teams when you look at the headcount you have today, because of those changes made?

Tyler Purvis

Yes, ultimately you should because obviously where it’s really equate is in the amount of revenue you’re getting per sales head in a sales organization, but you know you’ve got to be a little bit careful because I think although historically we’ve not had a lot of seasonality in our model, I think that going forward we’re probably going to see more and more seasonality from Q4 to Q1 tradeoff. Not really due to seasonality but more to do just our fiscal year boundary.

Jonathan Ruykhaver - Thinkequity LLC

And given to your comment around not spending ahead of revenues, should we expect that the headcount on the sales side will be pretty stable the next quarter?

Brian M. NeSmith

I would expect so. You know obviously if we see an acceleration in revenue we’ll start hiring sales teams to continue to grow capacity. But yes I think we’re at the capacity where we think we need to be.

Jonathan Ruykhaver - Thinkequity LLC

I know historically sometimes ease of deployment has been an issue, and just kind of curious if you could give us some colored version, 5.4 of SGOS from a functionality standpoint. You know, how it’s different and if you sense any kind of change in competitive deals since its release last spring.

Brian M. NeSmith

I think as we highlight in the prepared comments, the 5.4, probably one of the fundamental tenets of 5.4 was to dramatically improve the ease of deployment. To the point that I don’t think to the extent it was a challenge, I don’t believe it’s a challenge any longer. We obviously look to differentiate, you know as we position with a broader application delivery story, our capability of dealing with video, our capability of dealing with encrypted content from the public Internet, better support for web applications in general. And that’s where we obviously differentiate. But to the extent that the challenge is around usability and deploy ability, the products are there, I think they’re effectively gone the 5.4.

Operator

Your next question comes from Ryan Hutchinson - Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets

You touched on it, Brian, in the prepared remarks but I just want to get some color on close rates and did they improve somewhat throughout the quarter? And then in terms of your assumptions as you look into the guidance you provided for the September quarter and related to that where you think the strength is going to come from in the upcoming quarter by vertical.

Brian M. NeSmith

The close rates from Q1 to Q4 [audio impairment] reported previous, actually went down. It actually returned to what it was in Q3. So in Q4 we saw a bit of a surge in the close rates and it dropped back to what it was effectively in Q3. So it went down a bit. I wouldn’t say it went down hugely, but it definitely went down compared to what it was before. So I guess like I said I was a little reluctant last quarter as we talked about the close rate improving to take a view.

As far as our guidance for next quarter, it’s based obviously on this lower close rate and kind of our feeling about where the actual rate of the business is overall in the organization. So I think it’s a fairly conservative view as far as the close rate is concerned.

Ryan Hutchinson - Lazard Capital Markets

And by vertical, I’m assuming the government portion should be fairly strong. Is there anything else that stands out, looking at the pipeline?

Brian M. NeSmith

You know I looked through it and I think that government, I think that specific countries are still doing very well. We have specific countries in south Asia, specific countries in Europe. I think financials notwithstanding, however public press financials tend to be a very strong area for us around the world. So I think that in general they’re doing pretty well in all of those segments.

Ryan Hutchinson - Lazard Capital Markets

When I look this on a pro forma basis it looks like G&A was really the only line item that was up quarter over quarter. So first off, do you expect that to be the case next quarter? And then in addition to that, when I’m doing my quick math here the EPS guidance basically implies that gross margins and operating expenses are essentially flat and depending on where the revenue falls out really determines where the EPS falls out in terms of the range you gave. Is that a fair way to look at that guidance that you’ve given?

Brian M. NeSmith

Yes, the latter half of the statement I think is true, that basically our margins and expenses we expect to roughly stay flat. And obviously the EPS swing will be more driven off of the revenue range than anything else.

And I don’t know about the G&A coming. I’m looking at that. I thought our G&A expenses were not materially different from [inaudible] although we had some expenses related to the year end audit, all the audit fees and everything.

Tyler Purvis

We had some increases related to year end audit.

Brian M. NeSmith

Yes. But the audit fees as we did end the year in audit come in Q1.

Operator

Your next question comes from Erik Suppiger - Signal Hill Group LLC.

Erik Suppiger - Signal Hill Group LLC

In terms of the Packeteer customer base, either quantitatively or qualitatively can you comment, what kind of penetration have you had? Do you feel like its still a unpenetrated base to work or how has that gone?

Brian M. NeSmith

Typically you say it’s penetrated by. You know when we talk about it from a standpoint of the Packeteer install base and selling incremental PacketShaper products into that install base, I think we’re getting pretty good traction in that area. We have great penetration from the standpoint of selling ProxySG as either a stairway to Gateway or our WAN op beyond what was already there. You know I would say we could do much better and we’re actually putting some energy into understanding how we sell through those channels. One of the things I think for us schematically is a big deal is that we didn’t get as much leverage out of it and where we’ve obviously put some energy into trying to improve on it. Out of the PacketShaper channel, selling our WAN optimization solutions and I think we can do better in that area.

But in general I’d say I think from an overall business standpoint I think we’ve done reasonably good. Clearly a few areas for some improvement but I think I’d give us a pretty good report card in that area.

Erik Suppiger - Signal Hill Group LLC

More on the security side, are you taking share from Websense do you believe?

Brian M. NeSmith

That’s a good question. I couldn’t tell you exactly. It’s one of those things that it’s hard for me to measure share until I get the benefit of hindsight and context. I can say that I haven’t heard anything from the sales organization that highlights any kind of increasing competitiveness of Websense or activity where we’re losing business that we didn’t expect to lose. So from that standpoint my kind of emotional reaction would be immediately no, but market share you have to wait for all the numbers to flow in to get a better sense of where it ended up in absolute terms.

Erik Suppiger - Signal Hill Group LLC

Then lastly, EMEA, any general comments? We’ve heard from a number of your peers that EMEA is showing some slowing. Just geographically, how did that perform relative to your expectations?

Brian M. NeSmith

You have to be careful to treat a whole region the same way. I think that France and Germany look reasonably good but the rest of the continent not so good. So whether that nets out as to whether its down, and clearly France and Germany are the strong areas of the continent, seem to be doing okay. But I think the rest of the continent has some challenges in general.

Operator

Your next question comes from [Anthony Carbone – Orega].

[Anthony Carbone – Orega]

Brian, a question with respect to linearity during this quarter. Your DSOs went up again. It seemed from our checks that you got off to a strong start to the quarter but obviously not reflected in the DSO increase. Can you comment a little bit about you know how business flowed through the quarter?

Brian M. NeSmith

You know linearity I would say is fairly consistent with the previous quarter. The only hit for us is we had our real live sales meeting in the first week of the quarter so if anything I would have thought it would have probably been a little bit around in the first couple of weeks there, bookings would have been a little bit, you know. And I’m not sure looking at the DSOs that within the margin of error and calculating things that it shows much of a difference in the kind of linearity. So I believe it was consistent with what we saw in the previous quarter.

[Anthony Carbone – Orega]

Can you comment with what the book-to-bill was for the quarter?

Brian M. NeSmith

We don’t and I don’t think have ever commented about book-to-bill.

[Anthony Carbone – Orega]

And then just kind of dovetailing on Ryan’s question on expenses and the fact that it looks like you’re guiding essentially flat expenses quarter over quarter. How would you characterize this expense reduction? So is this more of a case of you holding your breath with respect to discretionary expenses or is this more of a case of you doing cost cutting, implying that when business gets better that we could see some leverage in the model?

Brian M. NeSmith

In some areas we’ve taken a harder look at discretionary expenses, where we can cut back. But I think we’ve also not hired in some areas. And we’ve pulled back across the board. I don’t think we’re doing anything that’s going to cause us any kind of issue as far as our ability to scale the business as we come out of the downturn. So I think we’re well positioned. We’re still obviously making investments in the infrastructure of the company, putting ourselves in position to exploit both when it returns in a significant way. But you know it’s a mix of discretionary items, you know controlling discretionary items as well as in some cases if we have turnover not replacing it, slowing down hiring. I mean there’s a number of things that we’ve done.

[Anthony Carbone – Orega]

Then a question on your commentary with the macro, I mean I would agree with your assertion that you know a lot of your competitors have shown weakness this quarter within the security market. Why do you think this is actually through the downturn but one of the more stable areas within IT spending? Do you have any takeaways from your salespeople as far as why do they think that this quarter was relatively weak relative to other areas in IT spending?

Brian M. NeSmith

I think it’s just catching up with us all. I think that the best way I would put it is that people had to do some things in the earlier period they couldn’t avoid doing and now they’ve done some of those things. I’d be a little careful. You know you draw trends on a couple of data points, you may get misled but I think in general we’re just seeing people reevaluating can they live with what they have now. And that for us continues to be a theme kind of can I live with what I have now, can I delay what I’m doing and do it a quarter or two later. And that perpetually comes up time and again.

[Anthony Carbone – Orega]

And then lastly on government spend you’ve consistently commented in the October quarter about government and generally the strength that you see there, though you’ve never in your case cues or comments given us a real size. Is there any way you can frame either as a percentage of sales or give us a delta of you know how much government increases, just to try to give us some perspective of you know how much of a tailwind that that government spend could be?

Brian M. NeSmith

We’re careful because government spending tends to come in two quarters for us, in Q2 and in Q4. So we see a surge in those quarters and we tend to lead it’s slower. So you know we want to obviously not go bouncing up and down in what we’re doing here, and so we manage the business so that we deal with those kind of bounces up and down and demand out of the government sector. You know it is a good sector for us and I can’t quantify it for you. We haven’t ever quantified it for us.

The part that I can tell you about government deals is it’s very lumpy. So when we do see a lot of government deals they tend to be much larger on average, so you imagine obviously when you pick an agency, pick a government organization, they tend to come in a size and scale that’s even bigger than a typical enterprise. And so we definitely see it lumpy, which means that even in the quarters where we do good you can see a fairly wide range of how that might turn out depending on when the deals actually arrive and when they conclude.

But no, I don’t have a breakout for you numerically.

Operator

Your next question comes from Richard Sherman - MKM Partners LLC.

Richard Sherman - MKM Partners LLC

My question’s about kind of the distribution of deals across the sizes. Maybe if you could comment about how you did with the large transactions and then you had some comments I think about the sub-50k deals and more no-touch. But I was wondering if you could maybe classify the deals as you know large, medium, small and the relative performances of each of those segments during the July quarter.

Brian M. NeSmith

Yes. This goes in hand with what we did over a year ago as we reorganized the sales force and put people in place. So we had the strategic account managers. In the end we thought we were going to be focusing mainly on the larger deals and I think as an organization generally around the world we do that very well. We would put large deals kind of north of 500k. It’s a little bit misleading because with the strategic accounts it’s normally the revenue over a period of time, so that may consist of a lot of medium-sized deals but when you look at those kind of larger accounts I think we feel like we’ve got lots of traction there. We see good pipeline. We’ve seen reasonable growth in the pipeline with those large deals. But we generally characterize them north of 500k.

With the large enterprise account managers, which is a step down from the strategic account, those tend to be the deals that kind of, I said one to 300k in the script. Obviously there’s a gap between 300 and 500k but it’s kind of the something that’s a little bigger than just a couple of bucks but not necessarily a real large customer. And there what we did by splitting the organization from a vanilla territory model into a strategic account and large enterprise is that that’s the area that what we call those large enterprise kind of mid-sized deals we thought deserved better focus and we could get more revenue. And I think there is some upside possibility there.

What we had with the territory model before with what we call the DSMs or channel sales managers is tend to focus on the kind of 50k and below, generally more no-touch deals where the good majority of your work is working the channel. And there I think we did reasonably well. I think you can imagine the bookends are both strong so that the large strategic accounts are running and working very well and the channel leverage model seems to be working very well. We obviously just need I think to show some improvement in that, what I’d call mid-sized environment is the area where I think we can show the most improvement.

Richard Sherman - MKM Partners LLC

And then there’s lots of questions about pricing in the environment. Can you maybe talk about pricing on the product side, if that’s changed at all in the margin in terms of discounting or incentives that are needed out into the channel, particularly as it relates to the WAN optimization side. And then secondly on the pricing side, have you been selling any longer term maintenance deals or has it been incremental pressure on the maintenance contracts as well?

Brian M. NeSmith

I think, and discounting in general has been pretty consistent with what we saw in Q4. I don’t think there was a material change in the activity there. I will state that this is not something that’s changed over time but we do see on any individual deal that pricing can get aggressive. That’s I think reflective of what it was even a year ago, so it’s not a material change in the environment. This is you know definitely true in the WAN optimization market and even occasionally true in the secure web Gateway market.

We are and you will notice from the growth of preferred revenue around service, we are seeing a higher percentage of customers starting to buy longer term contracts. And that has been taking place really over the last several quarters, there’s been a growing trend line in what we’re doing there. And so you’re seeing the deferred revenue. I would actually predicted going into this quarter that our deferred revenue would have gone down a little bit, mainly because of the inventory because we defer distributor inventory when we’re recognizing that revenue on point of sale. And since we’re getting rid of most of our point of sale reporting I would have thought that deferred revenue would have gone down but the net total, it did go down for that but it went up by more than that related I think to these kind of, more service bookings associated with things.

One of the things which I think schematically is a trend for us as well is you know we’ve been around long enough that we have customers in refresh cycles and that are you know buying new gear and we’re definitely seeing this challenging economic environment, some of those customers wanting to extend the lifetime of that. And we as a company are showing some flexibility with some of those customers. Products that in some cases were end of life we’re allowing customers to extend for a half a year and in some cases a little bit longer than that.

Just from the standpoint of our relationship with the customer and you know being I think a better partner and for a lot of our customers what are even more challenging environment than what we’re living in. But I think we’ve definitely seen it and you’ll see it in the service revenue line going up that we’re seeing longer deals, we’re seeing more customers renewing service, you’re seeing us being more flexible in allowing customers to extend service beyond even what was the stated end of life period.

Richard Sherman - MKM Partners LLC

And maybe just one last one. Do you have the headcount total at the end of the quarter?

Brian M. NeSmith

I think it was like 1,498.

Operator

Your next question comes from Alex Kurtz - Merriman Curhan Ford & Co.

Alex Kurtz - Merriman Curhan Ford & Co.

Brian it looked like the services margin were up pretty good on a sequential basis. Can you just give us a little clarity on what happened there? Just better utilization rates, I guess in the quarter and how should we think about that going into October?

Brian M. NeSmith

I think that the main issue is we didn’t draw the expenses and the revenue. You know the amount recognized in the quarter went up, so it’s nothing more complicated than that.

Alex Kurtz - Merriman Curhan Ford & Co.

So the 71.5% margin, you know I guess that should go down sequentially next quarter and maybe you add a couple more bodies in that organization or how should we think about that line item?

Brian M. NeSmith

No, I would not expect it to go down. You know we’re being very conservative in hiring right now.

Alex Kurtz - Merriman Curhan Ford & Co.

Then I guess conversely on the product margin side, do you think sort of the low 78 range is sort of where you guys are going to be for the next you know couple of quarters here, or do you expect maybe less discounting going forward or how should we think about that then?

Brian M. NeSmith

I don’t see a big change in the environment. It’s a bit of a wild card in the sense that you know we’ve obviously got a lot of competitors out there, but we’re all somewhat bound by the same constraints. So I’m not sure I see a real change in either any product that we’re introducing or any of our competitors are introducing that would cause a material change in our product gross margins or our service gross margins. And like you know it’s not just purely pricing that drives the gross margin line. Obviously if we’re much more conservative in hiring and things that would affect the cost of goods sold that could actually improve gross margins as well.

So we’re looking for cost savings and benefits to the bottom line everywhere we can get that. And potentially some of that will even come through the gross margin line as well as the operating expenses.

Alex Kurtz - Merriman Curhan Ford & Co.

And just on the G&A line there’s a question from earlier. It sounds like you’ve had some end of year auditing fees that ended up in the quarter. Should we expect that number, the G&A number to go down to what it was at Q4? Q4 of ’09?

Brian M. NeSmith

I think the only thing you have to call that by is that I think we have an ongoing litigation activity which is I think carried in the G&A line that we don’t, it’s not like an operating expense that we can fully control. So that litigation expense also is I think a bigger factor in that equation related to G&A and we don’t break that out. You know part of our non-GAAP numbers are included in our non-GAAP numbers. So that litigation impact. But clearly related to auditing expenses and other things like that I think we would expect that to be less in Q2 than it was in Q1.

Alex Kurtz - Merriman Curhan Ford & Co.

I know last quarter you changed the stocking rights for some of your distributors and I think you’ve made some comments that that’s going to help enable you better visibility into your revenue number every quarter and thus you can sort of help fine tune your OpEx number going to the end of the quarter so you can really start to hit the operating line more consistently. You know, how did that happen this quarter? How did that play out? Do you feel like that helped or is that really going to see something you’ll see impact Q2?

Brian M. NeSmith

I think we got a little bit of a benefit in this past quarter but probably I think it’s probably more of a growing forward activity. We still had a fair amount of inventory that was still in the channel that even though we had removed stocking rights for inventory that had been delivered based on a stocking model, we still had to recognize that as point of sale revenue. So there was still some of that in the channel.

There will still be some of that even in fiscal Q2 but it will go down significantly as a percentage and I guess it will take probably the remainder of the fiscal year to fully get rid of it.

Operator

Your next question comes from Alex Henderson - Miller Tabak.

Alex Henderson - Miller Tabak

I was wondering if we could just go over the split on the international again. I missed that when you were doing it earlier.

Brian M. NeSmith

On the revenue side?

Alex Henderson - Miller Tabak

Yes.

Brian M. NeSmith

Yes, I can here. One second. Let me just.

Alex Henderson - Miller Tabak

I apologize for repeating something but I needed to get that data.

Brian M. NeSmith

Yes, let me just see if I can find it the way I actually read it here. Give me two seconds here. Let’s see. I’ll just repeat it. On a geographic basis, net revenue in the Americas was $53 million, approximately 46% of total revenue. Net revenue in EMEA was $42 million, approximately 36% of total and net revenue in Asia Pacific was $21, approximately 18% of total revenue.

Alex Henderson - Miller Tabak

Can we go back to conditions in the field for a second? So you’re comparing some odd quarters here when you’re talking about linearity. Clearly the quarter through the first calendar quarter was quite different in condition than the second calendar quarter. To the extent that that’s the case, you know when we’ve talked to some 30 vars selling your equipment over the last month, they’re telling us that they’re seeing considerable improvement in conditions month-to-month-to-month-to-month over the last four months. Can you talk a little bit about how you see conditions changing, you know adjusting a little bit for the normal seasonality of your fiscal year end and the fact that you had that sales force event at the beginning of this quarter? Do you feel like you’re seeing an acceleration in conditions here?

Brian M. NeSmith

Well I think that a couple of things, and to make sure you understand it, so the sales force changes that we made were made over a year ago. So we articulated them at the end of the fiscal year just because we were going to be removing a metric that we reported on which was the number of sales teams for a long time. So I think that it’s hard to say that that’s you know a driving factor in the changes and conditions. I don’t know which resellers you talked to. We have by my count over 1,000 of them so you’d have to talk to quite a few to get a sense and depending on which geographies you’re talking to people you’ll see different strengths in the business.

I do think it’s fair to state that you know compared to the first half of the year I think we’re seeing more just generally more stability in about everything. So that doesn’t necessarily equate to that we’re kind of back into that growth mode that we’ve been used to prior to entering the recession. But I think compared to what we saw in the first half of the year I think we’re definitely seeing an improvement in what I call stability, or you call it a bottoming out of things if you wanted to look at it that way.

But I can’t comment on that because I don’t know the resellers you talked to or what in particular they highlighted to you, whether that changes our model. Again as we’ve always been clear, the guidance that we give reflects the best knowledge that we have in all of the different ways that we look at the data and we don’t give guidance past the quarter so I’m not really in a position to give you a sense as to what the longer term view looks like.

Alex Henderson - Miller Tabak

What I was driving at is it seems pretty clear that the activity rates have accelerated from April to May, May to June, June to July and that that appears to be persisting here in August. It also sounds like your closure rates at a minimum have stabilized. I realize you had a little bit of a spike in your closure rates in the Q4 period but consistent with normal closure rates and possibly improving forward. And it also sounds like you’re seeing a little bit of improvement in your deal sizes. So I guess the question is, stabilization though is certainly the buy word in the middle of the summer but at this point I’m trying to determine whether you’re seeing any sense or have any optimism around not just stabilization but actually recovery.

Brian M. NeSmith

Well I think that obviously the guidance reflects us from flat to a pretty good increase, which I would say in this environment is generally pretty optimistic. We’ve definitely seen the pipeline improve. We see the close rates, we expect them to be consistent with what we saw other than the aberration in Q4. And we continue to make enhancements. So I think I could probably generate the fact that most of the things that you highlighted there are true and that we would probably be you know a bit more positive than we were even compared to the previous quarter. But I don’t know if I could talk about how much of that. I mean the degree that you would talk about that is a bit more of a challenge for us.

Alex Henderson - Miller Tabak

The PacketShaper integration, it sounds to me like that still has a ways to go to be fully integrated into the operating systems associated with your traditional product line. Can you give us a little bit more of an update on when you expect that product to be fully integrated so that the management controls aren’t just simply patched across it?

Brian M. NeSmith

I don’t think we’re going to ever take everything that’s in PacketShaper and put it in ProxySG. So you know probably the simplest answer to your question is probably never. From the standpoint of I think the functionality that matters to be integrated into ProxySG I think will happen over the course of the next year. We’ve already done some releases to move some functionality. We’ll continue over the course of the next three to four releases to drive you know more integration of functionality but we’re not going to take everything that PacketSaver does and put it inside ProxySG. We don’t feel we need to first and more importantly I don’t think it’s probably the best way for us to deliver you know capability around the Application Delivery Network.

Clearly PacketShaper provided a big improvement in visibility as to what application’s running on your infrastructure and gave you a very good fine grain control over those applications in what you want it to do. And we’re going to move most of that over into ProxySG but there’s a lot of other things that PacketShaper that I don’t expect us to ever move over into. PacketShaper for us I think you know 10 years from now it wouldn’t surprise me for us to still be selling PacketShapers. Now that might be a bit bullish in the broad scheme of things, but I think that we clearly made a big commitment to ongoing PacketShaper enhancements and even as I announced on the call here we’re going to continue to deliver on functionality there. But I think the answer to your question I think what you’re asking is roughly in the next year you should see a substantive portion of what PacketShaper does get integrated into our ProxySG.

Alex Henderson - Miller Tabak

Actually I was really addressing more the management control systems between the two linkages of managing multiple boxes with your Director products.

Brian M. NeSmith

Oh I think that that we already to the good majority of that. So with what Packeteer has with intelligence center and with what we have with Director, the things that we think we need to integrate we did that fairly early on.

Operator

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

Rohit Chopra - Wedbush Morgan Securities Inc.

I had a question about the WAN only e-valves that you talked about. I think you mentioned 400 WAN only e-valves that you have out there with the new program. That’s a good chunk of deals it looks like. Can you give me a sense of the price differential between you and your competitors on the WAN only side?

Brian M. NeSmith

What we call MACH5 Edition which is the acceleration only version of our product, I think it’s priced comparable to our main competitors there. I don’t think we’re actually appreciably cheaper or are more expensive. I think we’re roughly the same.

Rohit Chopra - Wedbush Morgan Securities Inc.

So would you say that these 400 e-valves, they’re probably evaluating other products at the same time? That wouldn’t just be you? Would that be a fair statement?

Brian M. NeSmith

That’s a good question. I don’t 100% know. I would guess the answer to that would be yes but I’ve not really tested that.

Rohit Chopra - Wedbush Morgan Securities Inc.

You talked about end of [lifeing] some products and I just wanted to get a sense, I know you’re trying to be flexible with your existing customer base but are there some products that you’re going to be end of lifeing over the next six months and could that be you know a catalyst that you guys are looking towards?

Brian M. NeSmith

We have and we’ve gone through multiple end of life cycles in the history of the company. We are and already partly in the beginning of a cycle from one about four years ago. So that’s ongoing and will continue through the remainder of this calendar year and into the first half of next year. Both around ProxySG and PacketShaper products. But is that going to be a driver in a fundamental way to changing revenue growth? I think you have to be a little careful with that, especially in this economic environment a lot of customers where they normally would have gone through that hardware change out we’re showing a lot more flexibility with our customers, trying to work on the long term relationship there. And so I think it’s probably going to soften what would have probably been a stronger impact. But they’ll either renew service or they’re going to buy product so in either case they’re still customers and still happy and we just want to help them you know manage their business as they work through these economic times as well.

Rohit Chopra - Wedbush Morgan Securities Inc.

I want to come back to Packeteer just for a second and the PacketShaper product. It still looks like that revenue from that revenue base kind of flattish, but I talked to a few vars and it seems like you guys have a new program out there to attack the old Packeteer base and try to upgrade them or upsell them some new products. Could you talk a little bit about that?

Brian M. NeSmith

We launched a couple of programs into the PacketShaper, into sellers that historically were Packeteer only reseller. Part of it is an incentive program for cross selling ProxySG and PacketShaper and part of it is an incentive for going after new deals related to PacketShaper. I don’t know if I could say that it’s different in what we did even out of the gate as a result of the acquisition. We’ve had a series of different programs to try to stimulate you know and manage that business.

That being said, I wouldn’t expect and hopefully none of you are expecting the PacketShaper revenue to get significantly better. You know we’re managing that business. We believe it’s an area, it’s a mature business, one that we can reap a lot of value but not one that I necessarily would look to see a lot of incremental revenue growth. Maybe there’s slight growth in that but I don’t think that’s huge growth.

The extent that you’re hearing about programs like that, I would say probably what I would consider more on a sustaining mode of managing the business from a revenue standpoint rather than a growth mode.

Rohit Chopra - Wedbush Morgan Securities Inc.

And then lastly I just want to get the CapEx number, if you have that.

Brian M. NeSmith

I think in the quarter I didn’t have that number in front of me.

Tyler Purvis

Yes, Rohit, the CapEx for the quarter was $3.9 million.

Operator

Your next question comes from Rob Owens - Pacific Crest Securities.

Rob Owens - Pacific Crest Securities

Yes, my questions have been answered. Thank you.

Operator

Your next question comes from Gabriel Lowy - Noble Financial Capital Market

Gabriel Lowy - Noble Financial Capital Market

Brian, can you talk about the managed services part of the business, how that’s doing, is it growing as a percentage of the total? And then sort of linked to that, what have you got in the plans for what you can reveal about virtualizing the boxes and the software?

Brian M. NeSmith

Both of these areas are things that we’ve not made a lot of public announcements about what we’re doing or not doing. On the managed services front, we don’t actually sell anything that’s a managed services. We have a capability we call WebPulse that augments the ProxySG or really provides a dynamic calibrating capability but you need a ProxySG to be able to exploit that capability.

I wouldn’t strictly speaking, although you could think of it as a cloud server, it is more around getting a better understanding around malware and malicious content and URL ratings than it is an actual flow of traffic. But we continue to see pretty good traction with WebPulse so I think it’s a strong differentiator and for our ProxySG sales from that standpoint I think it’s a very strong benefit for us. But we don’t really have managed services in the sense that I think most people think of it.

The second part as to what we’re doing in the way of capabilities around virtualization, I mean we’ve alluded to some things but nothing specific I could highlight or state around any kind of capability in that area.

Gabriel Lowy - Noble Financial Capital Market

I actually meant selling into the managed services providers.

Brian M. NeSmith

Oh, sorry. I misunderstood the question completely.

Gabriel Lowy - Noble Financial Capital Market

And is that growing? I know you’re not offering it yourself but is the managed services channel for you a growing channel as a contribution? And the reason why I asked about virtualization is I imagine there’s some interest in that down the line.

Brian M. NeSmith

Yes. That is a very good question. You know what I would say is that we all along, actually about four years ago put a lot of emphasis on the carriers and selling managed services. And clearly as you’ve highlighted they would like that delivered as people’s software on a blade that can fit in a chassis. And we definitely see that requirement. Like I said we’ve alluded that we’re going to be doing something there. We haven’t made any specific announcement. I don’t know what the total percentage of our revenue is sold through managed services as last quarter was, but it was a pretty good percentage and we see it as an area that we can get a lot of traction.

We’ve got you know great relationships with AT&T, with Orange, with Sprint, with a lot of other carriers around the world selling our product and their service for other companies.

Gabriel Lowy - Noble Financial Capital Market

Do you think that maybe that explains some of that mid-market $100 to $300,000 range that you’re not quite seeing the lift that you’d like? That maybe that’s the market for the managed services providers?

Brian M. NeSmith

No, I don’t think so. I’d like to be able to tell you yes that would be true, but I don’t think that’s true just because we normally, the managed tier providers are transparent as to the actual end user customers they’re selling the product to. So we get visibility. We don’t bundle a managed service provider as a large deal. We understand who they’re selling it to.

Gabriel Lowy - Noble Financial Capital Market

Last one regarding that. Do you find that most of these customers who’ve got Sprints, Orange, AT&T, etc., those typically in the past with other types of network equipment like to dual source. Do you find that that’s also the case here with the Proxys that they also like to have a second source? Or is it usually one provider dominates and you get all of the business or the vast majority of it?

Brian M. NeSmith

It tends to be more of the latter. I haven’t found the dual sourcing issue. It’s not a commodity element. There’s a very big difference and you can’t just take one Proxy and replace it with another Proxy.

Operator

Your next question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

Actually I was wondering if you have seen any impact on the growth or from the growth of unified threat management. It seems like we’re seeing some vendors coming at this from sort of the side of unified threat management and I was wondering if you see that affecting sales especially as you add security features to your box? And if you see any missing pieces that you need to be effectively competitive in that arena.

Brian M. NeSmith

Well, we don’t actually try to compete in that arena so it’s not really a factor. UTM tends to be more on the small, medium business type thing. Our focus has historically been around large enterprise so we’re not a UTM box. I mean our history is as a security vendor, so we already I think have you know almost all the security features we really think are relevant for large enterprise environment, where we sell our Proxys so the answer is I don’t really see us needing to go down there and try to compete with those vendors.

Operator

Your next question comes from Scott Zeller - Needham & Company.

Scott Zeller - Needham & Company

Back to the earlier questions about the WAN only deals, could you give us a sense of the average sizing of them or the ASPs perhaps of what we might be looking at?

Brian M. NeSmith

I would expect most of those deals to be probably on the smaller side, you know on the order like three to eight, nine boxes sort of thing.

Scott Zeller - Needham & Company

And would that be primarily through channel partners or would any of that be direct?

Brian M. NeSmith

We don’t do anything direct, so it would be all through partners.

Scott Zeller - Needham & Company

And for Gordon coming in to join you, in addition to his previous you know financial reporting duties he have any sort of handed on corp dev and for his time at Blue Coat do you expect him to get involved in corp dev?

Brian M. NeSmith

I don’t know if I specifically remember anything on his resume to do that. That being said, I’m sure he’s capable of doing things in that environment. You know to the extent that you know we’re looking at deals and other kind of activities I don’t see how, I mean clearly the CFO is going to be an integral part of any kind of transaction like that.

Operator

Thank you. Your next question comes from Alex Kurtz - Merriman Curhan Ford & Co.

Alex Kurtz - Merriman Curhan Ford & Co.

Last quarter you gave us a metric on sort of uptick and partners I believe selling both products. Do you have a sense of what happened this quarter? Maybe I missed that earlier in the script.

Brian M. NeSmith

Yes. I don’t remember the question but it was up by about 4%.

Alex Kurtz - Merriman Curhan Ford & Co.

Sequentially?

Brian M. NeSmith

Yes.

Operator

Thank you. And we have no further questions. Please go ahead with any closing remarks.

Jane Underwood

Okay. Well, thank you. We would like to thank you for joining us on today’s call. A replay will be made available at 800-475-6701 beginning on August 25^th, 2009 at 5:00 PM Pacific Time. An audio archive will also be available on our website. Have a great day and we look forward to speaking with you again soon.

Operator

Thank you and ladies and gentlemen that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference. You may now disconnect.

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