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Executives

Kelly Blough – Vice President of Investor Relations

Matthew T. Medeiros T. Medeiros – President, CEO

Robert D. Selvi - CFO

Analysts

Robert Rezza - RBC Capital Market

Catharine Trebnick - Avian Securities

Sterling Auty - J.P. Morgan

Craig Nankervis - First Analysis

Rob Owens - Pacific Crest

Israel Hernandez - Barclays Capital

Ken Muth - Robert W. Baird Co.

Presentation

SonicWALL Inc. (SNWL) Q3 2009 Earnings Call October 21, 2009 4:15 PM ET

Operator

Good day and welcome to the SonicWALL third quarter 2009 earnings call. Today’s conference is being recorded. At this time I’d like to turn the conference over to Ms. Kelly Blough, please go ahead, ma’am.

Kelly Blough

Thank you, Cynthia. Welcome to our third quarter 2009 earnings conference call. With us today are Matt Medeiros, President and CEO of SonicWALL and Rob Selvi, our CFO. Before we begin I’d like to remind everyone that during this conference call we will be making forward-looking statements. Within the meeting of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended.

Forward-looking statements include without limitation revenue GAAP and non-GAAP earnings per share and growth margin guidance for the fourth quarter of 2009, expected operating expense increases for the fourth quarter of 2009, increase momentum and enterprise markets and proving competitiveness of our solutions. Customer response to our new product lines, our continuing commitment to operational efficiency and the impact of that commitment on our financial performance. The impact of certain economic factors, especially in S&B on our abilities to generate revenue and growth. Factors contributing to operating expense performance and our ability to take advantage of government sales opportunities in the future.

All forward-looking statements made on this call are subject to risks, uncertainties and assumptions that could cause actual results or events to differ materially from those contained in the forward-looking statement.

For a detailed description of risks and uncertainties that could cause actual results to differ materially from those expressed or implied in our forward-looking statement, as well as the risks related to our business in general we refer you to the periodic report that the company has filed with the SEC. Including discussions in the risk factor section in the company’s annual report on Form 10-K for the year ended December 31, 2008.

The company undertakes no obligation to update forward-looking statements at any time or for any reason. In additional to supplement our consolidated financial statements presented in accordance with generally accepted accounting principles or GAAP, SonicWALL presents certain non-GAAP financial measures. Management regularly uses these non-GAAP financial measures to evaluate aspects of the company’s operating performance with respect to business objectives and planning targets.

These non-GAAP financial measures also facilitates comparisons of our operating performance to other companies in our industry which may also disclose similar non-GAAP financial measures to supplement their GAAP results.

We also believe that investors benefit from this additional disclosure as it provides transparency into financial information used by management in our assessments of operating performance. A reconciliation of each non-GAAP financial measure referenced in this presentation to the most directly comparable GAAP financial measure is in the news release issued earlier today.

In tables immediately following the condensed consolidated statements of cash flows. These non-GAAP measure should not be viewed as a substitute for the company’s GAAP results.

I will now turn the call over to Matt Medeiros.

Matthew T. Medeiros

Thank you, Kelly. Good afternoon everyone. Thank you for joining our call. Our third quarter was characterized by improvements in a number of key areas. We demonstrated strong unit and product revenue growth. We had a successful introduction of our new TZ product line, with unit growth and numerous customer upgrades.

We are seeing growing evidence of our fundamental competitiveness against incumbents demonstrated in that the market recognizes our technology differentiation and leadership. We are especially pleased with the increase in sales to mid-tier and enterprise customers with cross selling deployments of SSL VPN e-mail security and high end UTM appliances.

And we reported solid fundamentals including continued improvements in efficiencies at the gross and operating margin lines.

The high end of our product offering performed well in the quarter. We were encouraged by some impressive deals in our non-UTM product categories. For example, Barcap in South Africa signed a high five figure deal with multiple E-class SSL VPN appliances. A global New York based insurance company signed a sizable E-class SSL VPN contract. And a large Asian national bank became a new SonicWALL customer with an E-class SSL VPN purchases.

E-mail security products saw traction in education and healthcare verticals in the quarter. Winning several five figure deals with hospitals, universities, K-12 schools both in the US and in Europe. In South Carolina the South Carolina employment and securities commissions installed our e-mail ES 8300 Solution for their 2,500 person workforce.

CDP also had important customer wins in the quarter. For example, a local government in the northwest created a disaster recovery plan around our CDP technology in a five figure contract.

A European logistics company deployed multiple CDP appliances across his ocean liners for backup of their workforce data. This was another mid five figure contract.

And a medical device manufacture chose CDP to backup its critical business applications and provide offsite storage.

We performed well across our entire UTM product offering in the quarter. For the first time in a year TZ units were up both year-over-year and sequentially. Customers and partners are responding well to the new TZ 210, 200 and 100 products, all of which contributed to strong unit growth. Numerous existing SonicWALL customers upgraded to the new TZ product line in Q3. For example, Mimi’s Cafe upgraded their SonicWALL infrastructure with a six figure contract for TZ 200s. An oil company in the northeast upgraded their TZ installation with the purchase of 75 TZ 210s. And Swisscom upgraded their network securities deploying TZ 210s and our global management system.

Additionally, TZs are winning new customers. A northwest retail chain became a large customer with a six figure contract for over 200 TZ 210s securing its store fronts. The NSA E5500 for its headquarters and our global managements system to deploy and to manage the existing infrastructure.

In addition, Aaron Rents, St. Clair Oil, the Florida Blood Center, Standard Parking, and numerous others became SonicWALL TZ customers during the quarter.

NSA revenue was up both year-over-year and sequentially, boosted by unit and revenue growth in the highest performing products the E6500 and the E7500. To name just a few examples, a large Japanese manufacture deployed high availability pairs of our E6500.

In Europe, Wooloffs Systems House and KDW of the Netherlands, CBRE in France, the York College in the UK deployed E6500s and Pension First in the UK deployed E7500s.

In North America, Greenbrier Hotels deployed E6500s, several universities and local governments replaced their existing security deployments with SonicWALL E6500s and E7500.

As you know, we’ve identified the US Federal Government as an area of investment for SonicWALL. And I’m pleased to report that our third quarter results demonstrate continued momentum and growth in that segment across all product lines.

While I can’t provide specific details regarding these transactions, here are some illustrated examples. A federal agency is deploying 10 NSA 3500s in support of US overseas efforts. A major federal agency bought 30 TZ 210s to secure its remote offices. A federal customer of our E-class SSL VPN products chose SonicWALL over competitors when it purchased our NSA E5500 and 6500 appliances in the quarter.

And SonicWALL was awarded a six figure contract with the federal agency for high availability deployment of our NSA 5500 solutions.

SonicWALL was successful amid strong competitions in that deal based on superior technical performance as well as more competitive total cost of ownership for our high availability solution.

Overall, I’m pleased with what we were able to accomplish in the quarter. Now let me turn it over to Rob to review our financial results

Robert D. Selvi

Thanks, Matt. Good afternoon everyone. Of the $50.7 million in total third quarter revenue, UTM Solutions contributed 78%, Secure Content Management Solutions contributed 9%, SSL VPN Solutions contributed 9% and CDP contributed 4%.

Total revenue units shipped in the quarter were 4,500. Product revenue was $19.2 million, up 17% sequentially and down 10% year-over-year.

As a percent of total product revenue, 79% was generated from products with average net revenue per unit below $1,500, 17% was generated from products with average net revenue per unit of $1,500-$5,000, and 4% was generated from products with average net revenue per unit above $5,000.

License and services revenue of $31.4 million declined by about $600,000 sequentially and $400,000 compared to the same period last year. License and services revenue represented 62% of total revenue in the quarter compared to 66% in the prior quarter and 60% in the same period last year.

License revenue represented 9% of total license and services revenue during the quarter, compared to 9% in the prior quarter and 7% in the same period last year.

Total subscription service billings increased to $36 million an increase of 4% over the second quarter and 8% over the same period last year. Multi year subscriptions accounted for approximately 40% of total subscription service billings in the third quarter compared to 43% in the second quarter and 28% in same period last year.

The growth in subscription services billing was primarily the result of increased renewals and attached services for our bundled UTN Solutions.

On a percentage basis, North America represented 68% and international represented 32% of total revenue. Europe, the Middle East and Africa contributed 20%, Asia, Pacific and Japan contributed 10% and Latin America contributed 2%.

I’ll begin my discussion on the income statement with our GAAP results then go on to report our non-GAAP results. GAAP gross margin was 71.6% compared with 72% in the prior quarter and 69% in the same period last year.

GAAP operating expenses were $31.5 million or 62% of third quarter revenue. On a GAAP basis research and development costs were $9.4 million or 19% of revenue. Sales and marketing expenses were $17.4 million or 34% of revenue. And general and administrative expenses were $4.7 million or 9% of revenue.

Non-GAAP gross margin was 73.3% compared to 73.8% in the second quarter and 70.7% in the third quarter of last year. Non-GAAP operating expenses were $29.2 million compared to $28.2 million in the second quarter and $32.2 million in the same period last year. The year-over-year decrease in non-GAAP operating expense was the result of reductions in salary and benefits in nearly every functional area. Reductions in contract services and lower travel costs partially offset by increases in legal and commissions expense.

The sequential increase in non-GAAP operating expense was due to headquarters move related expenses, travel expenses, accounting fees, and other employee related expenses offset by reductions in marketing expenses.

Total non-GAAP operating expenses represented approximately 58% of revenue for the quarter compared to 58% in the prior quarter and 60% in the third quarter of 2008. Non-GAAP operating expenses for research and development represented 17% of revenue. Non-GAAP sales and marketing expenses represented 33% of revenue and non-GAAP general administrative expenses represented 8% of revenue.

On a GAAP basis, our third quarter operating margin was 9.6% compared to 9.1% in the prior quarter and 3.2% in the same period last year. Non-GAAP operating margin was 15.8% versus 15.7% in the prior quarter and 10.3% in the same period last year.

Interest income net in the third quarter was $600,000 compared to $1 million in the prior quarter and $1.1 million in the same period in 2008. The decline in interest income is due to reduction in available yield and investment vehicles.

GAAP net earnings for the third quarter were $3 million or $0.05 per diluted share. Non-GAAP net earnings for the third quarter were $5.4 million or $0.10 per diluted share.

At the end of the third quarter total regular employee headcount was 829, compared to 788 and the end of the second quarter. The increase in headcount reflects the insourcing of our European support operations.

And now I’ll review the balance sheet and cash flow statement. We had another solid cash flow quarter generating operating cash flow of $13.4 million. Operating cash flow benefited from the growth and deferred revenue. The contribution from income and offsetting movements in asset and liability categories.

At the end of the quarter cash, cash equivalents and total investments were $203 million compared to $189 million at the end of the second quarter. Net accounts receivable were $21.2 million the third quarter compared to $17.5 million in the prior quarter and DSO was 38 days compared to 33 days in the prior quarter.

Net inventories were $6.6 million in the third quarter compared to $6.1 million in the previous quarter and $7.6 million in the same period last year. Net inventories consist of inventory at two of our largest distributors and finished goods at our third-party manufacturers and logistics provider.

Total annualized inventory turns were nine times. Deferred revenue increased $5.4 million quarter-over-quarter to $117 million, up 5% sequentially and 10% year-over-year. The increased in total deferred revenue is related primarily to an increase in subscription deferred revenue which was also up 5% sequentially and was up 13% in comparison to the same period last years.

I’ll not complete my comments with guidance for the fourth quarter of 2009. We remain somewhat cautious due to the uncertainty overall demand environment particularly as it relates to small business growth. We’re also cautious about the fourth quarter demand of our environment as it relates to mid-tier and enterprise markets.

While our pipeline for larger deals continues to improve, bigger transactions are subject to longer sales cycles and our success will depend on our ability to close those transactions. We expect fourth quarter revenue in the range of $50-$53 million. Our forecast for GAAP gross margin in the quarter is in the range of 70%-71% and non-GAAP gross margin in a range of 71.5%-72.5% reflecting in part our expectation that in fourth quarter product revenue will continue to be the great proportion of the revenue mix.

We expect GAAP earnings of $0.05-$0.06 per diluted share and non-GAAP earnings in the fourth quarter to be in the range of $0.09-$0.10 per diluted share.

This guidance reflects increases in operating expenses related to sales, customer support, legal and accounting fees.

And now I’ll turn the call back over to Matt.

Matthew T. Medeiros

Thank you, Rob. There were encouraging signs in our business in the third quarter yet we’re not seeing the economic conditions necessary to provide confidence regarding a substantial SMB recovery. SMB remains imputed by many factors, tighter credit conditions, lower than normal business starts, and declining payrolls.

We are encouraged with President Obama’s acknowledgments yesterday that the recovery of SMB will be the real foundation for both near term and economic recovery and growth. With more stabilization in the US financial systems we remain confident that our government will put more attention toward and SMB recovery.

SonicWALL’s third quarter performance represents improvements in spite of continued economic concerns indicating the competitive environment is shifting in SonicWALL’s favor.

More customers recognize SonicWALL can provide no compromise security with the highest performance at the lowest total cost of ownership.

I’d like to thank our employees, our partners for their hard work in Q3. And now let’s take your questions.

Kelly Blough

Cynthia, can you please pull for questions?

Questions and Answer Session

Operator

Thank you. The question and answer session will be conducted electronically. (Operator’s Instructions) Our first question will come from Robert Rezza with RBC Capital Market.

Robert Rezza - RBC Capital Market

Matt, I was wondering if you can talk a little bit about the success of the TZ line. Do you think it was some pent-up demand for the TZ, just a better product launch for you? I guess I’m kind of wondering just kind of as you look at the sustainability of the product introduction, going forward here, obviously it’s met with some pretty good success so far.

Matthew T. Medeiros T. Medeiros

Yeah, Rob, I think the most important factors are technology. We invested heavily in the new technology. We’re demonstrating substantial improvements not only against our previous product family, TZ product family, but against the competition. And when you can demonstrate a 10X improvement over the competition in UTM I think it’s really simple for customers to make the decision they way that they did. But, no, we’re very happy with the transition that we’ve made from our previous line of TZ products to our new product.

Robert Rezza - RBC Capital Market

Maybe Rob, I mean, operating margins are doing quite well. And hopefully as we come out of this recovery and the SMB and you guys get more confidence there, I mean, how should we think about margins going forward? Should be kind of a stabilizing then growth or you think you’re going to have to make investments? Obviously getting the TZ launched here makes the investments side maybe a little bit less and you guys just making consistently managing costs. But any thoughts about the margin profile, I guess, maybe as we come out of this recession?

Robert D. Selvi

Yeah. I think we’re not going to deviate, Rob from our overall long term guidance at the moment with sustained mid teen operating performance. I think the way you characterized the go forward is correct. As we benefit from an opportunity to grow the business both in terms of unit volume as well as revenue, there are investments that’ll need to be made along the way. Overall we do think we have a leverageable platform, I would say. But it’s not a platform that doesn’t require investments. So we’re going to stick with mid teen operating performance for you.

Robert Rezza - RBC Capital Market

Great. Thanks. Nice quarter.

Operator

And moving on to Catharine Trebnick with Avian Securities

Catharine Trebnick - Avian Securities

Good quarter, guys. I have a question on the mid-tier. Going into fourth quarter you said that perhaps the pipeline wasn’t – just so I have it clear so I’m paraphrasing, I might have misheard, wasn’t as robust or is that more macro economics conditions? Because what I’m really getting to in the question is, how is your VAR strategy at the mid-tier because you have such a good VAR strategy as the SMB level and is that getting more robust at the mid-tier level and is that in any way impacting maybe opportunity going forward?

Matthew T. Medeiros

Yeah. Catharine, let me see if I can be very clear about the pipeline. The pipeline is building. And I think our comment was in regards to sales cycle. We do know that both at the mid-tier and enterprise sales cycles tend to extend themselves. We’ve seen this before where we get some of these types of customers actually pushing out their order process. But, look, our pipeline is building. We’ve made continued progress not only in our ability to sell our UTM Solution but also cross selling all of our product offering into the enterprise and into mid-tier customers. And we’re seeing a conversion from competitors at a pretty interesting rate that we’re feeling far more confident that our technology is winning in those markets.

Catharine Trebnick - Avian Securities

Okay. That helps that. Now, as far as the VAR strategy, are you building more value added resellers to go after that market also at the same time?

Matthew T. Medeiros

Absolutely, Catharine. In fact our efforts right now are on VAR recruitment both for the enterprise as well as for mid-tier and government. It is a work in progress. I think that we take this as a multi-quarter type of platform. We evaluate our VARs whether they be for enterprise or SMB continually and there’s some turn there. But I’m pleased to say that when I look at the level of recruitment and new VARs I see a substantial number of systems integrators and VARs and systems integrators that would support the mid-tier and enterprise.

Catharine Trebnick - Avian Securities

All right. Thank you. A round about way I was really trying to get to that. Thanks.

Operator

Moving onto Sterling Auty with J.P. Morgan

Sterling Auty - J.P. Morgan

So, Matt, one of the comments that you made kind of intrigued me which was Swisscom upgrading to, I think, the TZ210s. I remember I think the first time around that they came in for a purchase. Along those lines can you give us a sense that at this point what do you think the size of the installed base looks like? And what are you getting in terms of the sense of the retirement/replacement opportunity as you look forward into 2010?

Matthew T. Medeiros

Sterling, you know Swisscom we had Cybercity actually also in Europe. We had some business with Telecom Italia, and many of our MSSPs or if you will, ISPs and broadband providers that we’ve had are certainly evaluating TZs and as Swisscom did several of them are starting to replace, or if you will, upgrade their networks. And they’re doing that primarily because our new platform affords them more security services, right. They can actually get more services revenue per solution. And that’s really the motivator when we’re talking about carriers like Swisscom and others.

As far as the rate of replacement, we need to spend some more time with the new products before we can come up with any kind of forecast in the area of replacement. And that’s what our sales teams are working at today.

Rob, do you have anything else that you wanted to add?

Robert D. Selvi

No, I think that covers it. That covers it well.

Sterling Auty - J.P. Morgan

Okay. And then, on the margin side. Rob, you made the question about increase operating expense in the fourth quarter for sales marketing and legal accounting. And what I’m working is as you guys look at the business do you feel like the business has – obviously everyone cut to the bone during the down turn. But is there a level that you could see getting through that you would say, wow, if we can get to this level expense we’d be comfortable and that would give us the capacity to grow this much on the topline. How are you thinking about that relationship?

Robert D. Selvi

Well, are you might expect, Sterling, I think we’re thinking about it as a dynamic balance. And in general we’re pretty comfortable with the level of expenditure that we’re making in the business right now, just in terms of representing a good balance between efficiency and investing in the future. I mean, there are some costs that are unavoidable that going forward that are factored into our Q4 forecast. We mentioned things like legal and accounting and we’re going to be a little less efficient in sales and marketing and cost because of increase costs in comparison to the prior quarter for European technical support. And the reason for that, without going into great detail, is just that we had a third party relationship there which terminated early which was a benefit in Q2 that won’t experience in Q3 as we wrap up our own support operations. Net over time that’s going to be cost neutral to our business and we believe it will give us an opportunity to offer our customers a much higher level of quality in terms of support. But, on balance I think we continue to monitor and mange the business carefully. But, we feel okay about those dynamic relationships at the moment.

Sterling Auty - J.P. Morgan

And last question, would be on cash flow. As you look at the cash flow in the quarter, obviously you had a nice overage in deferred revenue in the product side that would drive cash flow. But was there anything else that stood out in your mind to deliver the $13 million whether it be collections or something else?

Robert D. Selvi

No, I mean we continued to have a very efficient collection effort. I mean, the characteristics of the accounts receivable are very healthy. The increase in the accounts receivable quarter-over-quarter was just really related to an aggregate to the level of billings in the quarter and when they occurred in the quarter. And we have an increase, you know, as I mentioned the five days on DSOs from 33 of 38. But really it’s just a continuing strong contribution from profitability and the additions from deferred revenue. That’s what really spelled a successful quarter in terms of cash flow.

Sterling Auty - J.P. Morgan

All right. Thanks.

Operator

Moving on to Craig Nankervis with First Analysis.

Craig Nankervis - First Analysis

Yes. Thanks. Nice job. Could you perhaps talk qualitatively about Europe? Is that slow to improve or is that coming along? What are you seeing there? Maybe we start there.

Matthew T. Medeiros

You know, Craig, one of the things that in recognizing our European revenue, what we saw was a greater percentage of higher end products as a percent of revenue. So that’s encouraging, right. And that also might be more representative of Europe continuing to kind of, be right behind the US relative to the current macro economic situation. And perhaps we’re starting to see SMB in Europe struggle a little bit. But I think one of the most encouraging signs that we had about our European business was the fact that as a percentage of sales, the higher end products or E-class products clearly made a big jump this quarter.

Craig Nankervis - First Analysis

Okay. Okay. That is interesting. Rob, promotion impact on Q3 product revenue. Can you quantify that?

Robert D. Selvi

Yeah. I mean, I think the promotion impact to subscription revenue, you’re talking about the competitive upgrade program, right?

Craig Nankervis - First Analysis

Yes.

Robert D. Selvi

Yeah. So that program contributed about $1 million of subscription deferred revenue billings in the quarter. And had about roughly $1 million impact on the other way to product revenue.

Craig Nankervis - First Analysis

Okay. Okay. And then is that continuing in Q4? How do we think about that dynamic in the current quarter?

Robert D. Selvi

Yes. It will continue in the quarter. You should think of it as a long term program. We’ve made some adjustments to the pricing on the program that we’ve done at the beginning of the quarter. We continue to evaluate the effectiveness of that program. We’re quite happy with it now. And the other thing that we’re doing is we’re basically paralleling an effort with our own install base. So, there was a, I will call it, an unfair advantage to competitive install based customers that was offered just by virtue of a promotion. And what we’re going to see is pretty good consistency between our competitive upgrade program and our install base upgrade program.

Craig Nankervis - First Analysis

Right, right. Okay. And then on your topline guidance for the quarter, can you offer any color on how we think about the sequential improvement of the two revenue lines? Just, do they grow sequentially equally? I’m coming from the fact that the license and service line didn’t grow in Q3. How do we think about that here?

Robert D. Selvi

Well, you know there’s the two primary components are license and services. One is an in period revenue line, which is the license piece. And the other piece is related to roll out from the balance sheet primarily for subscription revenue. And we do expect an increase in roll off from the balance sheet quarter-over-quarter. But we’re less optimistic about the rest of license and services revenue. And we think the impact of those things taken together is likely to result in something that looks pretty level quarter-to-quarter. And so the variance that you’re pointing our in our guidance range from the low to the high is all going to be a function of product revenue in our view. I mean, it’s possible for there to be an additional deviation in license revenue in the quarter. But based on our outlook we think the difference between the high and the low of those revenue estimates is going to be in product revenue.

Craig Nankervis - First Analysis

Okay. That’s helpful. And lastly, it’s the newer offering is at CAS, do I have that right?

Robert D. Selvi

Yes, you do.

Craig Nankervis - First Analysis

Can you just offer any – is there any color to offer on that?

Robert D. Selvi

I think it’s early in the game for CAS, so I don’t have any meaningful statistics to provide on today’s call.

Craig Nankervis - First Analysis

Okay. That does it. Thank you.

Operator

Moving on to Rob Owens with Pacific Crest.

Rob Owens - Pacific Crest

Couple of questions, first with the discussion of a general upgrade cycle for networks and data centers. Do you think that plays much into your customer base? How much spill over do you think you get?

Matthew T. Medeiros

Well, it’s certainly is an opportunity for SonicWALL. I think as we start to demonstrate higher performance than our competition we see the opportunity to truly engage in meeting with those types of customers and hopefully upgrading their technologies. We have, again, continued demonstration and continued customer wins based on our ability to process, if you will, to take UTM technology and actually process it at the highest rate within the industry.

Rob Owens - Pacific Crest

And does it become more of a speeds and feats type of discussion or is the proposition more around security, I guess is what I’m getting at?

Matthew T. Medeiros

Well, I think it’s both. I think that there has to be no compromise to security. But speeds and feeds play a very important part of it. So one of the reasons why I think we’ve been able to take a specific competitor and really demonstrate our leadership against that competitor is because you cannot do complete intrusion prevention or gateway antivirus at the same time. So, a lot of our upgrade program, this competitive upgrade program that Rob has been talking about earlier has been targeted to those types of competitors where we can actually show substantial technology strength.

Rob Owens - Pacific Crest

Great. Then a little more specifically on the fed front. Can you talk about the types of projects you’re currently doing and what the go to market strategy is there?

Matthew T. Medeiros

I think one of the common elements of the fed projects is that to a large order these are distributed networks or there are no one single site networks. And that’s really to our advantage to find more customers in the feds like that. Because our global management system becomes again a key differentiator to those customers.

The other thing, believe it or not, our federal government is absolutely measuring total cost of ownership. And that’s an area where we can demonstrate based on our UTM performance and through-put substantial leadership. And then finally I think what’s really important to understand is that when we can cross sell a federal government account from a UTM to a SSL VPN our global management system along with the global management system to manage, if you will, the separate networks. It really aids them in multiple platform network management as well. So managing a UTM, an SSL VPN and an e-mail security solution from one consul aids them in substantial network productivity.

Rob Owens - Pacific Crest

Great. And so are you just on approved government purchasing lists? Are there some strategic SIs that you’re currently leveraging that?

Robert D. Selvi

There’s both. So we are on – if you would imagine, all of our distributors here in North America we’re on everyone of the GSA listing for them. We’re also on the GSA listing for CDW and Dell. And we have two major systems integrators that were working with in the federal government. So, we’re pleased with progress that our fed team has been making. And I think that quite frankly the timings on both technology and also our price point of technology is really working in our favor in the federal government.

Rob Owens - Pacific Crest

Great. And last question, how did linearity shake out in the quarter?

Matthew T. Medeiros

Well, as Rob mentioned it wasn’t so bad and our cash flow kind of represented that, right. So, we were pleased with the linearity. I think that we still saw a bit of a slower August in Europe which perhaps was to be expected. Not as slow as it usually gets, but a bit slower than what we perhaps would have liked. But overall we felt good about the linearity.

Rob Owens - Pacific Crest

Great. Thanks everyone.

Operator

Moving onto to Israel Hernandez with Barclays Capital.

Israel Hernandez - Barclays Capital

Yeah. Rob, just asked my questions around fed. But I guess the question I have for Matt, given you have the solid cash position. Seems like business is starting to find a bottom here. As you look out over the next several quarters do you see any opportunities, perhaps on the M&A front to expand the product or services footprint? How is M&A going to play out here for you guys over the next few quarters?

Matthew T. Medeiros

You know, Israel, we study cash and cash usage virtually every month with our board through out strategic planning committee meeting. We’ve been investing organically and as you know, historically we’ve done some inorganic investments and opportunities. I agree with you, I think that with things bottoming out there’s a good chance for us to look at other opportunities. We have nothing to report to you today. And quite frankly with our new product footprint with the investments that we’ve made in technology I think I’ve got a few organic things that are really going to wake up the marketplace here coming forward. And I’d like to just keep a bit (inaudible) for that opportunity.

Israel Hernandez - Barclays Capital

All right. Thank you.

Operator

Next is Ken Muth with Robert Baird.

Ken Muth - Robert W. Baird Co.

Could you go over some of the kind of new features that maybe getting to the adoption where people are kind of getting a little bit more excited, I mean, because just kind of the faster horsepower. Is there anything kind of application wise that’s on there that you didn’t have before?

Matthew T. Medeiros

Well, you know Ken, I think on the UTM fronts some of the things that we’re really investing in are firm ware changes for high availability, better throughput. We’re doing things around active active and state sink that are quite interesting. IPV 6 will be coming out very shortly for SonicWALL which is a very important part about future proofing all networks. So we’re feeling very good about our feature set in the UTM product. And then again, of course, speeds and feeds are going to be very important. Again, our view is that the internet is infinitely scaleable. How can I create a massively scalable UTM solution that regardless of type of traffic I can avoid the choke point of any network. If I can do that we really think that whether it be a data center, government, enterprises of all sizes are really going to be coming and looking at our technology. So we’re very pleased within the UTM space. Our improvements in the firm are what we would typically class as enterprise type features for our firm work.

In the area of SSL VPN we continue to look at concurrent session improvement. We’ve got some great stuff going on in client management. So our product, we have a virtual assist product where you can virtually take control of any client or any device that’s connected to the network and perform, whether it be management systems or complete control of the device. Those types of productivity tools really are in fact what IT professionals are looking for.

Our SSL VPN product is doing quite well on a competitive front based on features.

In the area of e-mail security it really is coming down to scam effectiveness and I think that that’s one of the benchmarks that we’ve always been very good at. And I’m pleased to report that our internal reports show us again exceeding top performing iron port solutions with the best spam effectiveness and compliance in that area. In out stripping quite frankly competitors like barracuda at a point of over 15% better effectiveness. So we’re very pleased with that area of our technology.

So, overall it’s really been quite interesting to see the investments of R&D. John Demunderan our entire engineering team have done an outstanding job of perfecting the products for SMB. But just as importantly meeting expectations in the enterprise.

Ken Muth - Robert W. Baird Co.

As you pointed out before, I mean, the SMB market seems to be kind of lagging some of the faster, kind of larger, verticals of turn around here. We’ve kind of seen it at the high end of the market, it’s actually come back first. So I mean, you’re results are improving and it seems like even your deals kind of internally in yourselves are maybe more at the high end. When would you expect maybe some of these smaller firms and customers of yours to start picking up?

Matthew T. Medeiros

Well Q3 was encouraging. The TZ product is clearly an SMB and a distributor network type of product. But as I mentioned I think that there still is a real problem with unfortunately credit availability with business starts. We really want to – Rob and I study everyday payroll. We study new business starts, meaning new business licenses in North America and we clearly look at the opportunities of where the SMB is going to find credit.

As I mentioned I was very pleased yesterday to listen to President Obama talk about the need and the importance that this federal government has to put onto an SMB plan to sustain and to get sustainable growth and recovery into this economy.

So, as I mentioned in my script I certainly hope that we see our federal government as a financial systems here in North America have been that we see them apply just as much attention and equal stimulus into the SMB market.

Ken Muth - Robert W. Baird Co.

And just kind of last follow up on just on the kind of greater than $5,000 revenue and price stand there. I mean, a little bit of pick up. What do you see kind of changing for kind of the next one or two quarters that that can get over the next level of revenue stream here for yourselves?

Matthew T. Medeiros

Well, again over the next two to three quarters I think you’re going to see some new product introductions that are going to truly be market shaking. We’re really taking this whole theory that again if the internet is infinitely scalable how do I create a massively scalable solution. And as we understand today and as we get better behind multicore processing and how critical this patent that we have is on reassembly free DPack inspection, which is truly giving us this opportunity to unchoke, if you will, to relieve a network regardless of the amount of traffic going through it of the burdened of security, we feel pretty good.

Robert D. Selvi

I would just add that we did have some pretty good characteristics on the high end of the product line. During the quarter we had the E-class portion of the NSA product line was up from (inaudible) unit and dollar contribution standpoint. Units were up over 20% quarter to quarter. We actually had some year-over-year improvements in units as well. As well as revenue versus the same period last year. So that’s an important inflexion point if you will in our business and does give a glimpse of what we think is possible going forward our concentrated focus on improving that part of our business. And that would also hold true for us LVPN. We achieved unit performance that looked very similar to what we did in the same period last year and we were up sequentially by quite a lot. So now we think we’re making progress I guess is the best way to put it.

Ken Muth - Robert W. Baird Co.

Okay, great. Thank you very much.

Operator

(Operator instructions). And moving to a follow up from Sterling Auty.

Sterling Auty - J.P. Morgan

I want to follow up on two points here. Rob, I think you were talking to an earlier question about the guidance range for the fourth quarter really the variability that the product revenue. If product revenue of fourth quarter is flat with the third quarter obviously you’re at the low end and then the rest of the variability from there?

Robert D. Selvi

That’s actually what I meant.

Sterling Auty - J.P. Morgan

Okay. I just wanted to make sure. Then could you go into a little bit of the breakdown of other income. Was there an FX impact or something else there. Because if I remember correctly I don’t think you bought back stock last quarter or this quarter. And I think cash balance was up. What was some of the moving parts there?

Robert D. Selvi

Really the moving parts all relate to what I mentioned, cryptically, at least in my prepared remarks which was that just be available yields on sanctioned investment vehicles for us under our investment policy are just a lot lower than some of the investments that are rolling out of the portfolio. So as we turn, if you will, our existing portfolio that has the benefit of investments that we made in some cases as much as a year ago or more, that tradeoff is detrimental to interest income. And so, I think the levels that we experienced from an overall yield standpoint in the third quarter are probably more indicative of the go forward than what we experienced historically unless we see a change in the yield curve in the environment.

Sterling Auty - J.P. Morgan

So, where would you kind of put what you’re earning on cash at this point? Is it under 1%?

Robert D. Selvi

It’s in the 1%-2% range.

Sterling Auty - J.P. Morgan

And if we saw flat revenue next quarter, you have a little bit of increase in expenses so net income takes a little bit of a hit. In that scenario – with just again going back thinking about the cash flow, the $13 million in cash flow, how much variation could you still do a double digit cash flow number under that scenario or is there something else that we should be thinking about in terms of impact on cash flow next quarter?

Robert D. Selvi

No, it’s the same traditional variables. I mean, the answer is yes, we could definitely do double digit cash flow as an overall, sort of guidance metric. We’ve been saying that operating cash flow should be in a range of 10-20% of revenue. However, we’ve been doing somewhat better than the high end of that range for the last couple quarters. So we’ll see how we do. I would say the most significant variable is for revenue and certainly additions from profitability.

Sterling Auty - J.P. Morgan

All right. Great. Thanks guys.

Operator

Moving on to a follow up from Robert Rezza.

Robert Rezza - RBC Capital Market

Yeah, Rob, just a quick follow up. We’re kind of going through and asking all our companies, as you looking forward, obviously a lot of companies have seen a dramatic improvement in their stock prices. And as we look forward as it relates to the (inaudible) from options can you kind of at least qualitatively talk us through how we should be modeling maybe going into next year from a share count perspective?

Robert D. Selvi

I mean, in general I think your observation is correct. And the improvement in price of stocks overall is going to come into the calculation and also in a couple of different forms just from the treasury stock management along with the conversion of options to shares outstanding. And in our case, I mean, we were up a million shares approximately quarter over quarter that really due to option exercises ESPP shares in the quarter and then just the treasury stock map.

From a go-forward standpoint I think it would be reasonable to assume share creep based on option exercises from employees. And absent any diluted efforts on our side, for example, share repurchase, I think that that would be a reasonable assumption. At what level, it’s hard to predict with any accuracy. I think I would probably go back to sort of historical share creep on that front and kind of look at what happened and the quarters of 2006 and 2007 to get a better view of how to look at that for 2009.

Robert Rezza - RBC Capital Market

Fair enough. Thank you.

Operator

There are no further questions at this time. I’d like to turn the conference back to Mr. Medeiros for any closing remarks.

Matthew T. Medeiros

Thanks, Cynthia. Listen, we’re very encouraged by our Q3 outcomes. In SMB our ability to upgrade cross sown and renew subscriptions was aided by our new products, the TZs 200 and 100. We’re equally as encouraged at the progress we’ve made in Q3 (inaudible) and also the federal government. Large nit size enterprises and governments worldwide are acknowledging our technical leadership.

So with that, thank you very much for the interest in SonicWALL. And we look forward to talking with you post to the holidays. So happy holidays also. By now.

Operator

That concludes our conference today. We’d like to thank you for your participation.

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Source: SonicWALL Inc. Q3 2009 Earnings Call Transcript
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