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VMware, Inc. (NYSE:VMW)

Q3 2009 Earnings Call

October 21, 2009 5:00 pm ET

Executives

Michael Haase - Vice President of Investor Relations

Mark S. Peek – Chief Financial Officer

Tod Neilsen - Chief Operating Officer

Paul Maritz - President and Chief Executive Officer

Analysts

Heather Bellini - ISI Group

Kash Rangan - Merrill Lynch

Brian Marshall - Broadpoint AmTech

John Difucci - J.P. Morgan

Katherine Egbert - Jefferies & Company

Derek Bingham - Goldman Sachs

Adam Holt - Morgan Stanley

Unidentified Analyst - Morgan, Keegan & Company, Inc.

Bill Fearnley - FTN Equity Capital Markets

Keith Bachman - Bank of Montreal

Michael Turits - Raymond James

Operator

Good afternoon. Welcome to VMware's third quarter 2009 conference call. (Operator Instructions)

At this time I'd like to turn the call over Mike Haase, Vice President of Investor Relations. Mr. Haase, you may begin your conference.

Michael Haase

Thank you, and welcome to VMware's third quarter 2009 earnings conference call.

With us today we have Paul Maritz, our CEO, Tod Neilsen, our COO, and Mark Peek, our CFO. Following their prepared remarks we will take your questions.

This call is being simultaneously webcast on our website. Our press release was issued after close of market and is posted on the website.

Statements made on this call that are not statements of historical fact are forward-looking statements subject to safe harbor provisions. This includes statements with the words will, believes, expects, continues, and similar phrases that denote future expectation or intent. This includes but is not limited to statements regarding our financial outlook, future product offerings and future demand. These statements are based on current expectations as of the date of this call and are subject to uncertainties and changes in condition, significance, value and effects, as well as other risks detailed in documents filed with the SEC, including our quarterly report on Form 10-Q for the period ending June 30, 2009 that may cause actual results to differ materially from those set forth in our statements.

In addition, during today's call we will discuss certain non-GAAP financial measures. These non-GAAP financial measures, which are used as measures of VMware's performance, should be considered in addition to, not as a substitute for or in isolation from, GAAP measures. Our non-GAAP measures exclude the effects on our GAAP results of share-based compensation, amortization of intangible assets, employer payroll tax on employee stock transactions, the net effect of amortization and capitalization of software, and acquisition-related items. You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP measures, in our earnings release for the period ended September 30, 2009 and on the Investor Relations page of our website.

The webcast replay of this call will be available for the next 30 days on our company website under the Investor Relations link.

Our fourth quarter quiet period begins at the close of business December 17, 2009.

Also, unless otherwise stated, all financial comparisons in this call will be in reference to our results for the comparable period of 2008.

With that, let's begin, and let me hand it over to Mark.

Mark S. Peek

Thanks, Mike. Good afternoon, and welcome to our third quarter earnings call. Let's start by summarizing where we are.

We had a solid third quarter. We were pleased with the U.S. federal sector, with transaction volumes and continued interest in ELAs, albeit smaller in size than we saw last year. We benefited from our operational change in local currency billing as the dollar weakened, and we had stronger than expected maintenance revenue recoveries. We delivered operating leverage from our top line results.

The macro environment has provided enough visibility so that we can increase our guidance for the fourth quarter. That said, it's important to underscore that we still remain cautious about the speed and pace of the economic recovery. When you listen carefully to economic views of the largest companies in the industry, there remains significant uncertainty as to how long the recovery will take and whether it'll be smooth and gradual or have bumps along the way. So while we welcome the improved short-term visibility in our business, we are still planning conservatively and assuming a slow recovery.

We're also pleased to see vSphere tracking well since our launch in May. We've seen customers both gravitating towards Enterprise Plus, our most feature-rich offering, and at the same time smaller customers purchasing Essentials and Essentials Plus. We also recently launched two new management products - vCenter Site Recovery Manager and vCenter CapacityIQ. Later this quarter we plan on launching our new View solution for desktop virtualization. Tod will cover these launches in more detail.

One of the real milestones of the quarter was closing our acquisition of SpringSource in September. We welcome the SpringSource employees to their first VMware earnings call.

Now the key financial headlines for the quarter: Revenues were $490 million. License revenues were $240 million. We achieved non-GAAP operating margins of 22.2%. Non-GAAP diluted EPS was $0.24 per share, driven by a $0.03 tax benefit not contemplated in our previous guidance. Non-GAAP operating cash flows were $199 million for the quarter and $898 million for the trailing 12 months. Free cash flows were $185 million for the quarter and $760 million for the trailing 12 months. Although we utilized $350 million to purchase SpringSource, we still have a very strong balance sheet, with $2.2 billion in cash and nearly $1 billion in deferred revenue.

Those are the headlines. Here are the details: Revenues for the third quarter were $490 million, which is an increase of 4% from a year ago and 7% sequentially. Our sales teams have executed well. Since adding general managers for each of our three regions, our decentralized decision making has enabled us to be more responsive to customer needs.

Despite a challenging environment for new server shipments, Q3 license revenues were $240 million, a sequential increase of 5% although down 16% from 2008.

The software maintenance portion of our services revenue was $213 million, up 44% compared to last year, and benefited from solid execution. With the launch of vSphere certain customers needed to be brought current on their maintenance. Revenue recognized on maintenance recovers in Q3 more than doubled over last year and provided about $5 million more in revenue than our expectations. In total, renewal bookings grew approximately 80% compared to the third quarter of 2008, a very strong indicator that customers are satisfied with the value they receive from our solutions.

Professional services revenue was $37 million, down 8% from last year. This decline was expected as our focus continues to be on enabling our partners to provide professional services around our solutions.

Our overall ELA activity was once again strong, with a large number of small and medium size ELA deals. As a percentage of total third quarter bookings, ELAs were approximately 15%, similar to last quarter and to the same period last year. In general, ELA dollar amounts are smaller than we experienced in 2008 and the first quarter of 2009.

Transactions with order values of less than $50,000 once again represented more than half of the dollar value of total orders. Our overall activity level continues to be strong, but closing the larger deals, particularly outside of the U.S., remains a challenge.

As I mentioned earlier, our results with the U.S. federal sector were strong, and the government is clearly moving in the direction of driving energy efficiency in its datacenters. This is a key differentiator for us given the maturity of our fourth generation datacenter products.

U.S. revenues declined 1% year-over-year to $246 million and grew 5% sequentially. International revenues grew 9% to $244 million, driven primarily by growth in Canada, South America and APAC, with easier comparables over last year. We've continued making investments through the recession in our international markets to grow our global sales footprint. In the third quarter we achieved sequential and year-over-year double-digit percentage revenue increases from APAC, and demand in China and Japan was strong.

As a reminder, late in Q2 we started to bill and collect in euro, pound sterling, yen and the Australian dollar. Until we have prior year comparables, we won't provide you with constant currency revenue impact; however, we did benefit from the weak dollar as compared to our budget rates when we provided guidance in July.

So in summarizing revenue, we were pleased with the U.S. federal sector, with transaction volumes, and continued interest in ELAs, albeit smaller in size than we saw last year. We benefited from our operational change to local currency billing as the dollar weakened, and we had stronger than expected back maintenance revenue.

Now turning to operating expenses, unless otherwise noted, all references to our expenses and operating results are on a non-GAAP basis, which are reconciled in the press release tables and posted on our IR website.

Total operating expenses, including cost of goods sold, increased 6% sequentially to $381 million, primarily by the weak dollar, sales compensation, the net cost associated with VMworld, additional royalty costs, and commissions paid to partners on booking back maintenance.

Operating margins for the third quarter were 22.2%. This was our first full quarter billing and collecting in local currencies, and our execution was smooth. As a result of billing in local currency, the impact of the weak dollar on our operating margin was less than our historical experience.

As a percentage of third quarter revenue, costs of revenues were 12.6%, consistent with the 2009 run rate.

Third quarter R&D expenses totaled $108 million or 22% of revenues compared with 24% in the second quarter of 2009. This was planned and part of our current product cycle. We have worked hard to operate efficiently and have had success in reducing our CapEx and resulting depreciation. We expect R&D expenses will increase in absolute dollars as we complete planning of our next product cycle and add SpringSource for a full quarter in Q4.

Sales and marketing expenses were $169 million or 34.5% of revenues compared with 33.7% in the second quarter. The increase was largely due to our ongoing global expansion efforts.

G&A expenses were $43 million or 8.7% of revenue, the same percentage as the second quarter.

Our operating profit, measured on a non-GAAP basis, was $109 million or 22.2% of revenue and slightly better than our forecast range due to operating leverage.

Diluted non-GAAP EPS was $0.24 per share on 403 million diluted shares. We had a $0.03 positive impact to EPS as a result of our lower than expected tax rate. Our tax rate is very sensitive to the mix between U.S. and international taxable income. The change was primarily due to a higher than anticipated concentration of expenses in the U.S., which was driven in part by the impact of the SpringSource acquisition. For the fourth quarter we expect the non-GAAP tax rate to be approximately 22%, about 10 points higher than our GAAP tax rate for the quarter. For the year we expect the 2009 non-GAAP tax rate to be approximately 19%, about 8 points higher than the GAAP tax rate.

Now on to our balance sheet and cash flow statement. The SpringSource acquisition closed mid-September for $420 million, of which $356 million was cash. We realized a $6 million gain from the acquisition as a result of an earlier investment we made in SpringSource. This gain has been excluded from our non-GAAP results.

We added around 150 employees with SpringSource. Given their subscription and services revenue model, we expect a dilutive effect on our non-GAAP operating margins of about 100 basis points in the fourth quarter. From a GAAP perspective, the impact will be larger.

Most of the purchase price was allocated to intangible assets and goodwill.

Our balance sheet remains very strong, with cash at quarter end of $2.2 billion. We continue to become more efficient in our capital spending as we focus on free cash flow. Our net fixed assets declined for the second consecutive quarter. Although capital spending may vary from quarter to quarter, we are monitoring this closely as we understand the bow wave effect on expenses of current period capital spending on future quarters.

Total deferred revenues increased 6% sequentially to $990 million. Year-to-date, total deferred revenue has increased 14%.

Our net accounts receivable declined nearly $2 million from last quarter, and our DSO, including the change in deferred revenue, is approximately 43 days.

The interest rate on our $450 million note with EMC adjusts each quarter at LIBOR plus 55 basis points. Our Q4 rate is 84 basis points or 31 basis points lower than Q3. Likewise, however, we expect our investment yields in Q4 to be lower than in Q3.

Non-GAAP operating cash flows were $199 million for Q3. Free cash flows for the quarter were $185 million. On a trailing 12-month basis, non-GAAP operating cash flows were $898 million, an increase of 27% from the same period in September 2008. For the same period, free cash flows increased 44% to $760 million.

Our full-time headcount at the end of the third quarter was approximately 7,100 people, up about 200 people from the prior quarter, reflecting the inclusion of SpringSource employees.

Our fully diluted share count increased to 403 million shares for the third quarter, driven by the impact of a higher share price on the calculation of dilutive securities. We expect that our diluted weighted average share count for Q4 will be approximately 410 million shares, which reflects both the higher share price and the full quarter impact of the shares issued for the SpringSource acquisition.

Before I turn it to Tod, I want to share with you how we are looking at the business to give you some assistance in developing your estimates.

We are beginning to get better visibility into our business, and it appears more customers are moving forward with their IT investment plans. But their approach remains cautious and deliberate. As I mentioned earlier, while we welcome the improved short-term visibility in our business, we are still planning conservatively and assuming a slow recovery.

We believe that Q4 will follow seasonal patterns, and we are planning on a range of between $540 and $560 million in total revenue. Given our growing deferred revenue balance and our expectation that the trend in maintenance recoveries will continue, we expect that services revenues as a percentage of total revenue will continue to grow, and we expect to see a double-digit decline in license revenue in Q4 compared to last year.

Barring any unusual items, we believe that our fourth quarter non-GAAP operating margins will be between 23% and 25% after taking into account our adjustments to GAAP operating income that Mike Haase disclosed at the start of this call. We expect our GAAP operating margin to be approximately 16 to 17 percentage points lower than the non-GAAP margin.

Although we aren't providing a lot of details today beyond the fourth quarter, we want to provide a couple of data points on Q1 2010. We're expecting Q1 2010 revenue to be seasonally down from Q4 - approximately 5% is a good working assumption - and will update you again in January.

To summarize, we are pleased with our execution and solid performance in the third quarter, and we're planning for the future assuming that the economic recovery will be gradual.

With that, I will turn it to Tod. Tod?

Tod Neilsen

Thanks, Mark. Good afternoon.

As you'll recall, I spent a significant portion of my prepared remarks last quarter discussing vSphere and the effort under way to drive important operational improvements here at VMware.

These efforts have progressed, illustrated by a solid third quarter and positive upward movement of several key indicators of our health. Some of these include customer satisfaction, which continues to trend at industry highs, renewal bookings, which performed very well and were up approximately 80% year-over-year, and lastly, we continue to experience strong interest in vSphere as measured by over 500,000 downloads in the first four months of availability. Further, according to a recent web poll, approximately 75% of customers are upgrading or plan to upgrade to vSphere withink six months.

As we've mentioned before, vSphere will take several quarters to make its way through the channel before it begins to significantly impact our revenue. The signs are encouraging, and overall demand for VMware products remains strong. This is reinforced by the 21,000 new customers who were added to our VMware family in the first half of 2009. Many of these customers participated in VMworld 2009, which we hosted in San Francisco in September. Over 12,500 customers and partners were in attendance, a solid attendance number, especially given most industry conferences have shown sharp declines in attendance this year due to travel restrictions.

We also hosted 140 industry analysts at our coinciding two-day analyst conference. It was our largest conference ever and signaled the growing influence of VMware as representatives from sectors well beyond virtualization attended, including storage, networking, and application development.

Significant announcements at VMworld included additions to our vCenter virtualization management solutions family, including Site Recovery Manager 4, which expands enterprise class disaster recovery capabilities while minimizing cost and complexity. We also announced CapacityIQ, a new solution that delivers unprecedented insight into infrastructure capacity and resources. These solutions compliment Appspeed, Chargeback and Lab Manager 4, which we introduced and shipped in Q3.

We also made good progress increasing ecosystem support for vSphere. New joint solutions include an integrated solution with HP called Insight Control for VMware vCenter server. This solution will help customers simplify management of mixed physical and virtual datacenters. We also announced vCloud Express, a new cloud service that's based on VMware technology from the world's leading service providers, including AT&T, Verizon and Terremark.

And on the desktop front we announced broad customer adoption of VMware View, with more than 1 million seats estimated across 7,000 customers. Our desktop opportunity continues to show momentum and promise. We now have dozens of customers who have adopted View for deployments of more than 5,000 seats, including five with over 20,000 seats deployed. This scale of deployment is an important signal that customers are getting more comfortable and are considering desktop virtualization as enterprise ready. In addition, we believe our upcoming View 4 launch further addresses the cost and quality issues that have inhibited broader adoption of desktop virtualization.

This said, we are very early in the desktop virtualization market, and the pace of growth is unknown. But we believe that VMware is well positioned, with great technology and a strong ecosystem, to lead this sector when it does take off.

Overall, I'm pleased with our performance in the quarter. Our field execution was impressive given the still challenging economy. As we look at some of the verticals in our geographic expansion efforts, we are seeing signs of real promise, including the U.S. federal sector and the Asia Pacific region.

I'll now hand the call over to Paul.

Paul Maritz

Thanks, Tod.

I'd first like to start by adding my thanks to those members of the team who helped bring home a good quarter in what are improving but still challenging times.

From a broader perspective, we continue to be focused on extending our core value proposition of achieving capital equipment savings via server consolidation to one of operational efficiency and access to the benefits of the cloud and doing all of that in an evolutionary way for our customers.

To this end we're both deepening and building on the vSphere foundation, as Tod and Mark noted. We continue to be pleased with the way vSphere is being accepted by our customers and the way that the technology is holding up under real world loads. We're investing heavily in this core technology, and we're well positioned for the opportunity to make vSphere the foundation for the cloud, both the private cloud and the public cloud.

On the public cloud front, we've extended our vCloud initiative with significant announcements from major service providers - AT&T, Verizon, Savvis, Terremark and others - and part of this announcement was the introduction of a service called vCloud Express that'll be offered by some of these service providers. This service allows customers to buy compute capacity very inexpensively by the drink while maintaining compatibility with VMware virtualization software, which is used by the majority of the world's IT shops. The net result is we now have a spectrum of service providers who can provide a complete range of cloud offerings.

Also, as Tod and Mark noted, in the third quarter we started delivering the members of our vCenter management solutions family. This family will give our customers further capabilities to realize operational efficiencies, and we will continue to extend this family with new capabilities over the coming quarters.

In the current quarter we're looking forward to releasing VMware View 4.0, our desktop virtualization solution. This release introduces the PC-over-IP protocol. This protocol brings us state-of-the-art capability to support thin clients and should open up the benefits of VMware-based virtualization on the desktop to an even larger set of customers who have more demanding requirements in terms of graphics and wide area performance. View 4.0 will also significantly upgrade the desktop management capabilities we offer to our customers, again in keeping with this theme of driving increased operational efficiencies. The net is that View 4.0 is going to allow customers that already have significant investments in VMware software in the datacenter to further leverage that existing infrastructure.

Lastly, in terms of our product journeys, as Mark noted, we formally closed the acquisition of SpringSource in September. SpringSource, as a way of reminder, has become the leader in terms of Java programming, with more than half of new Java code now being written to the Spring framework. The benefits of this framework are also being extended to new age web programmers via the Grails framework. In addition, the Spring family also includes the Hyperic application management capabilities and the TC and DM applications service.

We are enthusiastic about this set of capabilities not only because they lead in terms of increased developer productivity but again because of the operational efficiencies we can enable by integrating Spring capabilities with vSphere capabilities. We believe in time that this can be game changing and will further enable us to raise the bar for the industry.

With the team and the technical capabilities we now have in place, we believe that we are well positioned to make significant progress on this journey of enabling our customers to gain new levels of operational efficiency, to gain access to the cloud, and to do this in an evolutionary way.

Finally, as both Mark and Tod noted, the economic climate has improved, and there are definitely some swallows in the sky, but we should remain cautious. It's too early to declare that summer has returned in full.

With that I'll open up for questions.

Michael Haase

Thanks, Paul. Operator, let's begin the polling process please.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Heather Bellini - ISI Group.

Heather Bellini - ISI Group

I was wondering if you talk a little bit about the customer conversations you had this quarter and what's different about them in particular versus last quarter? And also, for example, why all of a sudden are they starting to spend again and feel better about ELAs? And I guess I'm also wondering what they're telling you about their virtualization plans for 2010.

Tod Neilsen

What we're hearing from customers is they're realizing where they are on this virtualization journey and what they need to do to effectively do more with less resource. They're actively looking how they can drive virtualization as a core part of their solutions process.

That said, it's not quite like the days of yesteryear where ELAs or customers were looking and buying three, four years out in advance in large ELAs. They are still looking conservatively and doing smaller, bite-sized transactions. So while the ELA activity was up and plenty of interest on all levels of the business, we're not seeing the big, large, significant buys that we may have seen a few years ago.

Heather Bellini - ISI Group

Can I just ask a follow up then to that because one of the bear stories has been that you have a bunch of ELAs that were signed two, three years ago that are going to come back to haunt you as people use up that capacity before they have to engage in new transactions. I was wondering if you could shed any light on that?

Tod Neilsen

Sure. On that front we really sort of got momentum with our ELA business in about the summer timeframe of 2007, so in 2010 is when those opportunities to renew those ELAs will be upon us.

As you know, our licenses are perpetual licenses in general, and so the opportunity to renew really is selling additional value, additional products, management products, desktop or expanding beyond what is in the core ELA. But we don't expect those to really start to come into play into mid next year.

Paul Maritz

I think the other point, Heather, is that the good news is by and large people have gone through their ELA licenses very quickly, so we've seen people actually deploying those and getting usage out of them. And of the early ELAs that are coming up for renewal, by and large we're seeing that customers are willing to renew and in some cases even extend beyond what they had in their earlier ELAs.

I think to your earlier question, sort of what's different this past quarter from the first half of the year, I think that people have collectively realized that the sun is going to come up tomorrow morning and they better start planning for that. So people are starting to think again in longer terms rather than just thinking about survival from quarter to quarter. But that being said, even though they're thinking longer term they're still trying to be very cautious and make sure that they don't go out on a limb and get surprised if this recovery does turn out to be, as Mark said, more bumpy than we might think.

But certainly the welcome news here is that people are starting to think in longer-term horizons and not just thinking about immediate survival.

Operator

Your next question comes from Kash Rangan - Merrill Lynch.

Kash Rangan - Merrill Lynch

I had two questions to ask you. One is I'm wondering if you can quantify, Mark, the [license revenue] impact from switching over to the new billing system? I would assume that you've built a bit of that in your guidance, but the dollar spend probably surprised you a little bit. I was wondering if you could quantify that.

And also, secondly, just doing some really rough math it's obviously good to see the business rebound back, and you sound a lot more confident than you did a couple of quarters back. But I'm just looking at your implied guidance for Q4 and Q1, and the license revenue looks like you're still projecting it to be roughly down to maybe flat, best case, in the upcoming March quarter against what looks to be an easy comparison to March quarter a year earlier. I would probably have expected a little bit more warmer guidance given that you still are a hot priority for IT spending for next year and whatnot. I'm just wondering if you could shed some color on what is behind those relatively - at this point at least, which looks to be flattish to slightly down - license revenues for the upcoming March quarter against easy comparisons.

Mark S. Peek

Kash, on local currency billing, we had factored part of that into our guidance back in July, but as the dollar did weaken we had about a 70, 75 basis point lift on license revenue during the third quarter across all currencies.

And with respect to first quarter guidance, as I mentioned in the opening remarks, we're proceeding cautiously, we're planning cautiously, but a reminder that Q1 of last year had the benefit of some very large enterprise agreements that we did with both the U.S. military and with certain companies in the private sector, so our ELA license revenue during the quarter was really very strong. Also we had some OEM carryover from Q4 of 2008, which had a positive impact on the quarter.

And as we look ahead into the quarter, we'll give you a better look at it in January, but at this point we're still looking at a decline in license revenue growth in the first quarter based on the implied guidance.

Kash Rangan - Merrill Lynch

Any revenue contribution from SpringSource that was material or perhaps not, I would imagine.

Mark S. Peek

For the third quarter we closed the transaction really mid-September, so not much of a contribution.

And based on their revenue model, which is largely services and maintenance amortization, there's not a large impact in the forward quarters. It's largely a strategic acquisition for us, and we're getting a lot of interest from customers as we talk to them on the enterprise about ELAs as well.

Operator

Your next question comes from Brian Marshall - Broadpoint AmTech.

Brian Marshall - Broadpoint AmTech

A quick clarification - with regard to this professional service revenue declining on a sequential basis, even with that decline it seems as though the license business will still grow slower on sequential than the services. Did I hear you correctly?

Mark S. Peek

Yes. The mix in the guidance that we provided of $540 million to $560 million will continue to tip more towards services.

Brian Marshall - Broadpoint AmTech

And then with regard to VDI, it seems as though View 4.0 is going to have much more of a PC-like experience on a thin client, and so I guess the question is clearly this is a fantastic secular growth opportunity going forward, so do you care to speculate when we could see this cross over the threshold of double digits in terms of percentage of total sales?

Tod Neilsen

We've got a lot of customer interest. And as we mentioned on last quarter's call, we're spending 20% to 30% of our SC time with customers doing evaluations and proof of concepts. So when you look at the overall market opportunity, we're bullish on it.

As far as when it's actually going to tip and start to take off, it's really unknown. There's a lot of factors as far as when will companies pursue desktop refresh, when will the update to Windows 7 come out, etc., etc., and so we're just continuing to stay focused and execute, and we just don't know when it will tip.

Paul Maritz

I'll just give some color on that. The market for desktop virtualization really falls into two categories. There's a category of people, primarily the early adopters and where we've seen a lot of success to date, who are driven primarily by security and control priorities, particularly in the financial sector, the military sector, to some extent in education and health care, where people really want to make sure that all information stays centralized and nothing leaks out of the desktop. That is very important, but it is a minority of the total possible market.

What we have to do now is speak to people for whom security and control are concerns, but they're not the only concerns. The complete economic impact and the operational costs have to be taken into account. And that's where we've got to just of necessity spend a longer sales cycle working through that and convincing those people that this not only is a safer and more secure way of doing things, but a cheaper way of doing things. And that's going to take some time.

Operator

Your next question comes from John Difucci - J.P. Morgan.

John Difucci - J.P. Morgan

Mark, I have a question about the fourth quarter. Do you expect to see more maintenance catch ups in the fourth quarter because [inaudible] license to be down double digits and, I don't know, unless you expect something to happen here with the services after being down 8% this quarter, I'm just trying to make the model work. It's just kind of hard to make it work without some more maintenance catch up there.

Mark S. Peek

Yes, John, yes, we do expect the trend in maintenance recoveries to continue through at least the fourth quarter, and so that's partly built into the guidance.

John Difucci - J.P. Morgan

Okay. And can you tell us about how much you'd expect in that?

Mark S. Peek

Well, we expect the trend to continue, up sequentially. And as I mentioned, for the third quarter it was stronger than we had anticipated, contributing about $5 million of services revenue in addition to what we had built into our guidance in the quarter. So we expect the trend to actually grow and to increase over Q3.

John Difucci - J.P. Morgan

And then just to quickly follow up, in the U.S. you said you had good contribution from federal at the end of fiscal year, and the U.S. itself was sort of flattish. I'm just curious what you see - assuming this is the strong U.S. federal government contribution - what you kind of see happening here in the U.S. It sounds like momentum's getting better for you; you're seeing less declines in license revenue. At the same time, that particular region, which obviously is important, doesn't look as healthy.

Mark S. Peek

From a geographic perspective as we looked at guidance, the U.S. appears to be a bit stronger. We are seeing some weakness in EMEA. We're coming off of their seasonally weak quarter, and so there's some expectation that it will grow sequentially and there'll be improvement, and there was a lot of strength in APAC.

The federal sector, strong contribution in Q3, but part of that is also maintenance and so when we talk about the overall strength, part of that's going to our deferred revenue line.

John Difucci - J.P. Morgan

We've had some other companies, too, where they've had some good, strong federal sector, which you would expect at the end of the fiscal year, but it was also some maintenance, bit maintenance, catch ups there. Was that a contributor to the maintenance catch up here?

Mark S. Peek

It was really across the board. It wasn't isolated to the federal sector at all.

Tod Neilsen

We put a program in place in the May timeframe to really focus on smaller transactions that, because of our growth and focus, we hadn't really put as much energy at getting the smaller deals to renew their maintenance contracts. And so as a result of that program we've seen some great strengths in Q3 and, as Mark said, we expect that to continue in Q4.

And one of the primary reasons is people are excited about vSphere, and their opportunity to upgrade to vSphere is a compelling reason for them to catch up on their back maintenance and get current.

Operator

Your next question comes from Katherine Egbert - Jefferies & Company.

Katherine Egbert - Jefferies & Company

I just wanted to follow up a little bit on the question about license growth. I, too, came up with a relatively flat number for Q1. When do you think licenses can grow again? And then, relatedly, why wouldn't you start renewing some of these ELAs early?

Mark S. Peek

As I said in the earlier comments, we're approaching the economy very cautiously. And we'll give you more color on 2010 in the January call, but we're looking at server shipments, we're looking at a general trend in IT where spending is not forecasted to be robust. We certainly believe that we'll get our share of that, but we're just not at this point ready to declare that license revenue will accelerate and grow year-over-year.

Katherine Egbert - Jefferies & Company

Okay, what about the ELA renewals? Why wouldn't you try to renew those somewhat ahead of schedule if most of them are coming up in the back half of 2010.

Tod Neilsen

In some cases we're absolutely engaged with all of our ELA customers that will have renewals in 2010, and if we can or we're in a situation where we can bring things forward and close the deal, we absolutely will do that.

But given just where the economic climate is, a lot of customers are saying I'm just going to continue to stay with where I'm at, and as we get to the quarter when the ELA will expire, at that point is when they'll renew.

But, trust me, if there's an opportunity to renew it early, our sales folks are incented to make that happen.

Operator

Your next question comes from Derek Bingham - Goldman Sachs.

Derek Bingham - Goldman Sachs

I wanted to see if you could drill down a little bit into the dynamic of ASPs that you're seeing. You've got two new sets of SKUs on the high end, also on the low end. Could you just address what you're seeing as the net result?

Tod Neilsen

Sure. We've been pleased in the sense that with our Enterprise Plus product we've seen a significant amount of interest, of customers upgrading to that, which is our highest end, feature rich product, but we've also seen a lot of transactions or volume with our Essentials and Essentials Plus product. And the net affect is we've been able to balance out and hold our ASPs to where they've been the last couple of quarters.

So we're excited that we're attracting a new set of customers that are just entering into their virtualization journey with Essentials and Essentials Plus, and then our existing Enterprise customers that really want to take advantage of the robust features and value of our solutions can do that with Enterprise Plus.

Derek Bingham - Goldman Sachs

For large deal activity at this point, early in the quarter, would it not surprise you to see the same kind of proportionate contribution from ELAs that you've seen in the fourth quarters of the last couple of years, over that 20% threshold again?

Mark S. Peek

I think that's fair. We've always hovered in between the 15% to 25% max, and so we would expect that to hit more to the high teens and possibly 20%. But a lot of that activity, it's in the pipeline but won't be known to us until the very end of the quarter.

Derek Bingham - Goldman Sachs

On hiring, do you have any sense where you expect to end the fourth quarter in how aggressive you get with ramping up hiring again as the environment feels better?

Mark S. Peek

Well, we're continuing to really invest strategically in the critical positions that we have across the company. We're just in the process now of onboarding 150 people from SpringSource. But we're continuing to hire, and we continue to hire key positions inside.

Derek Bingham - Goldman Sachs

Any change in the pace of the last couple of quarters, I guess it's been?

Paul Maritz

As Mark was saying earlier, we continue to manage in a cautious but deliberate way, so we will continue to invest where we think it's necessary to invest for the long term. Specifically, as we've said before, we're investing in the growth geographies of Asia and the developing world, so a lot of our headcount growth, net headcount growth, is coming in those areas as well as in certain key R&D functions. But outside of that we remain still at this point trying to be very disciplined and very cautious.

Operator

Your next question comes from Adam Holt - Morgan Stanley.

Adam Holt - Morgan Stanley

I'll ask a follow up, actually, to that last question, to Paul or Mark. As we look into next year - and understanding you're not going to give specific guidance but just at a high level - if we start to see IT spending improve and you start to see demand reaccelerate, will you wait a quarter or two to start to reinvest more aggressively? Should, in other words, we expect to see maybe margins be better than the trajectory that we've seen over the last several quarters for a period of time, or will you start to reinvest more aggressively, given all the growth opportunity you have in front of you?

Paul Maritz

I don't think we're in a position to speculate about that other than to reiterate what we've said, that we don't see any reason at this point in time to abandon our cautious stance.

Adam Holt - Morgan Stanley

So we should be thinking about margin expansion then next year?

Paul Maritz

It depends on what the top line does.

Adam Holt - Morgan Stanley

And then just one last question on the product side, if I could. You recently decided to continue selling the Enterprise edition when previously you were going to get rid of the Enterprise edition on the 15th of December. Can you walk us through A) the logic around that decision, and B) what impact do you expect that decision to have on the numbers, if any?

Tod Neilsen

Sure. The original plan was that December 15th we were going to end the Enterprise product, and then provide Enterprise Plus as the upgrade option for customers. What we've heard from our customers is some of them were not ready to make their upgrade decision to vSphere. They were waiting until they got through the end of the year or a particular cycle or event that they had in their IT shop, and they wanted to preserve the opportunity to upgrade to the Enterprise product. And if the SKU went away they felt like their hands were going to be tied.

So we decided to extend the opportunity for customers to do that. We don't expect it to have a significant impact on ASPs; if anything it's done good things with our customer goodwill and showing that we will listen to them and want to be a partner that will work with them to address their IT solutions.

Mark S. Peek

There's been some speculation that we were going to sunset Enterprise shortly, and that's just not the case.

Operator

Your next question comes from Unidentified Analyst - Morgan, Keegan & Company, Inc.

Unidentified Analyst - Morgan, Keegan & Company, Inc.

We were wondering, have you seen any big mix amongst your partners with HP and IBM? A shift in revenue from your major partners?

Tod Neilsen

No, we have not. It's been what it's been the last few quarters.

One thing I don't think we mentioned here on the call is that the OEM server shipments still continue to be down year-over-year. In Q3 Gardner just updated a number that OEM server shipments were down 16.3%. But we haven't seen a shift from one of our partners to another one. It's held pretty constant.

Operator

Your next question comes from Bill Fearnley - FTN Equity Capital Markets.

Bill Fearnley - FTN Equity Capital Markets

I had a question for you on the competition side, if I could. You've seen new products here and you've seen some pricing changes as well, so is there any change in the decision cycle that you've seen that is noticeable?

And then I also wanted to see if you've seen any change in your channel momentum, VARs or systems integrators - is one recovering better than the other?

Tod Neilsen

So from a decision cycle and engagement with customers, we haven't seen any impact from competitors. In the procurement cycle folks will talk about it, but when it comes to actual proof of concepts and kicking the tires and watching the value and the robustness of our solution in action, we stand above the rest.

As far as the channel partners and channel mix, we've got a strong channel ecosystem, and they're all firing well. We're seeing our transaction business run through, be it the VARs or the [DISTIs] or wherever, they're all executing well.

Bill Fearnley - FTN Equity Capital Markets

And do you see anybody that you're talking to that might be kicking the tires or doing their evaluation, do you have many customers that are looking at fourth quarter and kind of skipping over the fourth quarter and focusing more on 2010 here or are they looking near term and short term?

Tod Neilsen

I would say compared to Q1 they're looking a little further out, but they're certainly not looking at all 2010. They're looking at fourth quarter and maybe the first quarter the next year or first half.

A lot of this is just project based, where folks are looking at next year I may want to do a datacenter move or a datacenter consolidation or a refresh or whatever the situation is, and that project may extend beyond the next 90 days, so we're seeing some of that.

But we're certainly not seeing folks in general say the next three years I'm going to do X, Y and Z, and I want to buy it all now.

Michael Haase

Operator, we're going to take two more questions, please.

Operator

Your next question comes from Keith Bachman - Bank of Montreal.

Keith Bachman - Bank of Montreal

You mentioned server ships, and I was just wondering if you could give any color on what the OEMs represent of your current business, particularly given the catch up accounting, if you will. You mentioned servers were down year-over-year, but both HP and Dell were up double digits sequentially, and so I'm surprised your license revenue wasn't up a bit more. But the first question is just on how much is the OEM of your current license rev just generally.

Mark S. Peek

Well, S86 system companies represent a significant part of our overall revenue, but part of that is through their own channel businesses. And so historically our OEM revenue and actually royalty reporting that attaches with server shipments has been in the 20% range or less.

Keith Bachman - Bank of Montreal

Sorry to interrupt, but just the royalty part is what I'm interested in. That's 20% or less?

Mark S. Peek

Yes.

Keith Bachman - Bank of Montreal

Okay, great.

Mark S. Peek

And that's just over a long period of time.

Now, that said, when these servers ship there still are licenses sold with them, but more so through the channel.

Keith Bachman - Bank of Montreal

Just a follow up question, if I could. Mark, you mentioned that you thought when the customers start adopting vSphere that your license rev, you would anticipate a pick up in your license rev. And I just wanted to see if you could help us understand how that process works or how that unfolds.

Mark S. Peek

For customers that are under maintenance they have rights to vSphere as part of their maintenance rights.

What we've said is that vSphere is strategic, it's part of the platform for developing the private cloud, and that customers are initially going to start by taking it out to test and dev, and gradually building their deployments over time.

We have opportunities both on new license revenue as well as upgrade revenue, and we've been pleased with the progress made on vSphere.

Paul Maritz

I think we've been at pains to point out that vSphere is not going to be a big bang. This has to go through the stages of adoption. The affect will be felt over several quarters.

Operator

Your next question comes from Michael Turits - Raymond James.

Michael Turits - Raymond James

Two questions, one, the maintenance catch ups, it sounds like that's $5 million to $10 million in next quarter since it's trending up a little bit, so does that just kind of start to trail off in first and second quarter or does that $5 million to $10 million just pretty much drop out?

Mark S. Peek

Well, certainly at some point - we started the program beginning in the second quarter, and it was really focused on the smaller transactions. We've always been a high volume transaction company, so over time we expect that to drop off. But we were pleased that the trend that we saw in the third quarter had an additional $5 million of revenue that we hadn't anticipated, and we expect that trend to continue at least through the fourth quarter.

Tod Neilsen

And even if, if you will, the back maintenance part drops off, we expect then once someone gets current with maintenance that they'll remain current and they'll renew again the continuing year, so they'll stay within the fold.

Michael Turits - Raymond James

A bigger picture question: As we move more to multi-core processors and an increasing amount of multi-threading within the cores, are we going to higher consolidation ratios, and how much of a dampening affect is that having on license sale? I know at VMworld you addressed this in saying the consolidation ratios become less of a factor with greater penetration, but I was just wondering how much of a dampening affect that is or isn't having right now.

Paul Maritz

There are several factors at work here. One is while certainly theoretically with the [inaudible] processors you can achieve greater consolidation ratios. What we find, however, is there are trends offsetting that as well, which is that as virtualization in our customers goes beyond Tier 2 and 3 loads, test and development, things like that, and they get closer to real production deployments, typically customers elect to not put as many workloads on a single machine so they can get greater performance and greater reliability.

The other thing that offsets the increased consolidation ratio is that we're providing customers the ability to do more things with those cores, an example being [inaudible] that we shipped with vSphere, which essentially chews up cores, if you like.

So the increased software functionality that we're giving them, plus the customers are electing to be more cautious in deployment, offsets to some extent the larger consolidation ratios that are theoretically possible.

So while this is certainly a factor, it's not the overwhelming factor that you might think it is.

Michael Haase

Great. Thanks a lot. That concludes the call.

Operator

This does conclude today's conference. Thank you for your participation.

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Source: VMware, Inc. Q3 2009 (Qtr End 9/30/09) Earnings Call Transcript

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