Riverbed Technology Inc. Q3 2009 Earnings Call Transcript

Riverbed Technology, Inc. (RVBD)

Q3 2009 Earnings Call

October 22, 2009; 05:30 pm ET

Executives

Jerry Kennelly - President & Chief Executive Officer

Randy Gottfried - Chief Financial Officer

Eric Wolford - Senior Vice President Marketing & Business Development

Renee Lyall - Director of Investor Relation

Analysts

Troy Jensen - Piper Jaffray

Douglas Ireland - JMP

Mark Sue - RBC Capital Markets

Jason Ader - William Blair

John Marchetti - Cowen and Co.

Jonathan Ruykhaver - Thinkequity

Alex Kurtz - Merriman Curhan Ford

Ken Muth - Baird

Daniel Ives - FBR Capital Markets

Rohit Chopra - Wedbush Morgan

Eric Suppiger - Signal Hill

Ryan Hutchinson - Lazard Capital Markets

Alex Henderson - Miller Tabak

Sanjiv Wadhwani - Stifel Nicolaus

Scott Zeller - Needham & Co.

[Eugene Hill]- Banc of America/Merrill Lynch

Jess Lubert - Wells Fargo

Min Park - Goldman Sachs

Presentation

Operator

Good afternoon. My name is Sarah and I will be your conference operator today. At this time I would like to welcome everyone to the Riverbed third quarter ‘09 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions) Thank you.

Ms. Renee Lyall, Director of Investor Relation, you may begin your conference.

Renee Lyall

Thanks Sarah. Good afternoon and thank you for joining us on today’s conference call to discuss Riverbed’s third quarter fiscal year 2009 results. I’m Renee Lyall Riverbed’s Director of Investor Relations. Joining me on the call today are Jerry Kennelly, Riverbed’s President and CEO; Randy Gottfried, Riverbed’s Chief Financial Officer; and Eric Wolford, Riverbed’s Senior Vice President of Marketing and Business Development.

Before we begin, let me cover some administrative items. A press release detailing our third quarter financial results, was distributed today at 1:05 pm Pacific Time by a business wire. The press release is available on our website at www.riverbed.com. This conference call is being webcast live via the internet at www.riverbed.com/investors and will be archived on our website for the next 12 months.

The information we present or discuss today will include forward-looking statements including without limitation statements about Riverbed’s financial results, business, financial outlook, sales pipeline, competitive and market position and customer cost savings. These forward-looking statements are only predictions and involve risks and uncertainties, but that actual results may vary significantly.

These risks are set forth in detail in our Form 10-Q for the fiscal quarter ended June 30, 2009. These forward-looking statements reflect beliefs, estimates and predictions as of the date of this call. Riverbed disclaims any obligation to update any forward-looking statements. Unless otherwise stated, financial information that we review on today’s conference call is presented on a non-GAAP basis.

Non-GAAP revenue excludes the effect of purchase accounting adjustments, representing the fair value of Mazu Network deferred services revenue. Non-GAAP net income excludes the impact of stock-based compensation, stock-based payroll expenses, amortization of acquired intangible assets; acquisition related expenses and related income tax effect.

Non-GAAP financial measures should be considered in addition to results prepared in accordance with GAAP, but should not be considered a substitute for or superior to GAAP results. The most directly comparable GAAP information, reasons why management uses non-GAAP information and a reconciliation between non-GAAP and GAAP figures is provided in our Q3, 2009 press release, which has been furnished to the SEC on Form 8-K today.

Any future product, feature or related specification that maybe referenced in today’s call are for informational purposes only and are not commitments to deliver any technology or enhancement. Riverbed reserves the right to modify or cancel future product plans at any time.

I’d now like to turn the call over to Riverbed’s President and CEO, Jerry Kennelly.

Jerry Kennelly

Thank you, Renee. Welcome everyone and thank you for joining us this afternoon. Q3 was an exceptional quarter for Riverbed with record revenue of $102.6 million, record operating profit of $22.5 million and an ending cash balance of almost $300 million and we continue to have no debt. Over the past 18 months, the world has experienced an economic reset.

During this time, certain technologies have thrived and WAN optimization was one of those technologies. WAN optimization allows organizations to take cost of their operations while still increasing productivity. It allows people to work together efficiently and securely regardless of location. Riverbed is the pioneer of this space and the clear market leader. Gartner recently published second quarter market share results.

Riverbed increased its revenue share again that 32.5% in the advanced platform category, more than 9 percentage points ahead of the closest competitor. WAN optimization is a mainstream and proven solution deployed to improve the IT infrastructure performance of small businesses, global 1,000 companies and government agencies worldwide.

The results of a survey published this month found nearly 40% of CIOs interviewed named WAN optimization as a top network in priorities for 2010. The survey also revealed that the top three trends driving spending decisions were server virtualization, cloud computing and storage virtualization. These critical business initiatives all leveraged WAN optimization to be successful.

Riverbed is best position to exploit this opportunity. Our Steelhead appliance leads the market with its simplicity, scalability and superior technology. For the past few months, we have expanded our portfolio with new products and made significant enhancements to our Steelhead appliances.

We launched two new products and new Interceptor and Virtual Edition of the Central Management Console. The Interceptor is essentially a load balancer for Steelhead appliances, allowing enterprise customers to scale their WAN optimization solution to hundreds of thousands of end users. The new Interceptor supports 10 gig NIC cards, enabling customers to take advantage of newer data center designs.

CMC Virtual Edition was designed for managed service providers and offers a multi-tenant solution. The new appliance allows service providers to scale central management capabilities for their customers as they grow and bring on new customers seamlessly without purchasing and deploying new hardware. CMC-VE runs on VMWare ESX and managed service providers can run it on any existing server that has capacity.

On Monday of this week, we announced RiOS 6.0, the most feature rich software release in our history. With this release Riverbed enables organizations to support more users on more platforms by introducing new and improved optimizations for Citrix XenApp, Mac clients, Oracle E-Business Suite 12 and many web applications.

Other new features include augmented security with FSL inscription between appliances, increased scalability for disastrous recovery deployments and higher availability for the Riverbed services platform. RiOS 6.0 improves our ability to maximize Citrix XenApp by delivering better respond times, reducing bandwidth and enhancing Qwest capabilities.

In some cases, organizations are able to deploy more than twice the number XenApp clients without having to increase bandwidth at remote sites. A good example is Samsung manufacturing, a customer who is benefiting from deploying Steelhead appliances within a Citrix environment. Users who experienced delays as high as 30 to 40 seconds now see a near instantaneous response. Bandwidth utilization was cut by as much as 81%.

In addition to optimizing the Citrix environment, the company was able to avoid investing in a new data center by deploying one Steelhead appliance in its largest facility in China. This saved an immediate $300,000 plus the cost of ongoing maintenance and enabled the customer to pay for their Steelhead investment.

System manufacturing chose Riverbed after testing competitive offerings. These turns functionalities in the new software works with both HTTP and HTTPS, and RiOS optimizes SAP Net weaver, share point, agile and other web applications and in some instances up to 20 times faster.

6.0 also introduced the ability to optimize the Oracle 12 applications, making Riverbed the only vendor to provide this application level optimization. RiOS 6.0 further simplifies our solution for business continuity and faster recovery deployment. The new software recognizes DCVR traffic and automatically adjusts compression and duplication to optimize throughput and bandwidth use based on individual customer requirements. This allows organizations to protect more data in less time, while reducing cost and complexity. DCVR remains a targeted growth opportunity.

We have steadily built a stronger presence in the market this year, both with qualifications and expanded distribution. In the first quarter, we received E-Lap qualification with EMC’s SRDFA higher end product. In the third quarter, we added EMC select as a sales channel for certain appliances. We’re also qualified with Hitachi Data Systems business continuity solutions. In October, we were qualified with EMC near view for their mid range products.

As an update to end user Riverbed and storage settings, I also want to provide an update regarding Atlas. The Steelhead long term strategy continues to include addressing the storage market opportunity from a networking perspective. We have determined that Atlas has a discreet separate product that’s not a good fit for Riverbed and we do not plan to proceed as originally anticipated. While we no longer intend to bring Atlas to market as a standalone product, we will leverage Atlas technologies as key features of new products that target the computing market.

Before I turn the call over to Randy, I want to highlight a competitive differentiator for Riverbed that maybe under appreciated. We have dedicated resources to achieving security certifications, when recently announced accomplishment was the completion of testing by the Joint Interoperability Test Command or JITC, an organization under the Department of Defense.

Our success in completing this rigorous testing process ensures compliance with the highest standards of security and can speed the purchasing process by limiting the need for lengthy testing by customers. Riverbed’s investment in security initiatives, illustrates our commitment to providing the highest assurance to our federal customers. Our [powers] in this area has been especially useful in government other industries with tightening security concerns.

For example, third quarter sales included a U.S. government agency that needed to provide better service to their employees in the field where the cost and difficulty of bringing a new bandwidth was prohibitive. This customer also purchased the info box module for the RSP that will allow them to eliminate dedicated DNS, DHCP and authentication services from their remote locations. The Riverbed deployment is expected to pay for itself in approximately six months. This agency made their first Riverbed purchase in the third quarter of 2008 and continues to roll out additional sites.

To summarize, our overall market and competitive positions continues to strengthen. We continue to add distribution and differentiate ourselves competitively with new products. Enhancements to our core product line and branch consolidation enabled by this Riverbed Services Platform. As a new generation of business solution transforms IT eliminated the barriers between systems applications and end users, Riverbed is focused on being the performance driver of distributed IT and cloud infrastructures.

With that, I will turn the call over to Randy.

Randy Gottfried

Thanks, Jerry. As a reminder, unless stated otherwise, the numbers I’ll discuss today are non-GAAP. For your reference, in addition to the reconciliation included in the press release, we’ve posted a supplemental reconciliation of non-GAAP financial measures to their directly comparable GAAP measures on the Investor Relations portion of our website. We’re obviously very pleased with our third quarter results, especially against the backdrop of the still challenging global economy.

The numbers reported today, demonstrate the leverage in our operating model and support our strategy to invest in resources and development that drive revenue growth in the under-penetrated WAN optimization market. Total revenue increased 12% over the second quarter and 18% year-over-year to $102.6 million. Product revenue grew 15% sequentially, and 7% over the year ago period to $69.5 million.

Third quarter service revenue increased 5% quarter-on-quarter and 55% year-over-year to $33 million. The majority of our service revenue comes from support contracts. Cascade contributed $2.2 million to total revenue in the third quarter. This split was approximately half services half product.

Turning to distribution, 94% of our revenue came from indirect channels with the remaining 6% coming from direct sales. Geographically, the U.S. represented 57% of total revenue driven by strong sales to the federal government for the fiscal year end. The U.S. enterprise market was mixed, but we are seeing signs spending could pick up in the fourth quarter. EMEA contributed 25% to revenue and rest of world was 18% with especially good performance in the Australia/New Zealand region.

Our revenue stream continued to be diversified with no customers representing 10% of revenue. Looking at product revenue by vertical, we continue to see broad based demand. Historically, we’ve had five to six verticals contribute about 10% to product revenue and six or seven contribute approximately 5%. Government, manufacturing, finance, technology and energy are some of the larger verticals.

We expected the government vertical to be a strong contributor in the third quarter and it came in at about 29% of product revenue. This vertical is comprised of U.S. Federal, local, state and international government. In the third quarter, it was more heavily weighted towards US federal sales.

Now let me shift to costs and expenses. Product gross margin was 79.7% in Q3, benefiting from channel and product mix. In the fourth quarter and future periods, we expect product gross margin to return to the 76% to 78% range. Service gross margin came in at 74.9%. Combined our gross margin was 78.1% compared to 76.1% in the second quarter. We exited the September quarter with 996 employees, up from 963 at June 30.

Total operating expenses increased 6% sequentially, but decreased as a percentage of revenue. Headcount additions contributed to the overall increase. Our operating margin was 22% this quarter, a record high for Riverbed underscoring the leverage in our model. Other income was $141,000. The tax rate for the third quarter was 36%.

Net income was $14.5 million or $0.19 per diluted share. Net income increased 41% sequentially and 32% year-over-year. We reported a GAAP profit of $5.5 million or $0.08 per share. GAAP results include a number of entries related to our acquisition of Mazu earlier this year. As I said before, under of the acquisition accounting rules there maybe some meaningful expense fluctuations, up or down in our GAAP results over the next six months driven primarily by the earn out component of the Mazu acquisition.

Moving on to the balance sheet, Riverbed ended the September quarter with cash, cash equivalents and marketable securities of $296.8 million and we continue to have no debt. During the third quarter, we purchased about 620,000 shares or $12 million of Riverbed stock under our buyback program at an average price of $19.63 per share.

To date we’ve spent $79 million on share repurchases and have about $21 million remaining under the program. Cash flow from operations was $38.2 million compared to $8.2 million in the second quarter. Strong collections resulted in days sales outstanding of 42 days. Inventory totaled $12.1 million at September 30 compared to $9.2 million at June 30. The rise in inventory was driven by increased finished goods.

Total deferred revenue was $76 million, an increase of 9% over June 30. The majority of our deferred revenue is derived from maintenance and support contracts. Turning to our fourth quarter outlook, while there are certainly a sign of improvement the sales environment remains challenging. We are cautiously optimistic and encouraged by what we are seeing in the field.

We are experiencing strong new customer additions and existing customer rollouts continue every quarter. We are forecasting our U.S. enterprise sales to grow in Q4 while we expect a decrease, but still solid contribution from the government vertical. We expect modest growth internationally. Our fourth quarter guidance is non-GAAP. We expect to deliver sequential and year-over-year revenue growth with revenue in the range of $104 million to $107 million.

We expect our gross margin to be closer to our targeted model and Q2 level of about 76%. We are planning for operating expenses between $59 million and $61 million. We continue to carefully add resources where needed. Sales and marketing also tends to be higher in Q4 as the sales team progressing through the annual commission plan. We are targeting a tax rate of 35% and we are forecasting earnings per share of about $0.18 based on 76 million diluted shares outstanding.

I’ll now turn the call back over to Jerry.

Jerry Kennelly

Thank you, Randy. Riverbed has been a publicly traded company for just over three years. In that time we have helped thousands of organizations around the world change the way they do business and given our expectations for the fourth quarter that we have just shared with you, we expect that we’ll very shortly pass $1 billion in cumulative revenue.

That is a significant milestone to achieve in just over three years as a public company. I feel confident in Riverbed’s position as we look ahead. We are selling the market leading WAN optimization solutions into a growing and under penetrated market. We are adding sales channels, most recently EMC and we continue to expand our technology partnerships.

A separate survey of Fortune 1000 IT executives published last month found that Riverbed was the networking company most likely to receive IT budget after Cisco, but ahead of Hewlett Packard and Juniper. This is remarkable given our relative size compared to these larger vendors and points to solid brand awareness. Since 2004 Riverbed has led the way in enabling WAN like performance for consolidated and visualized IT environments often refer to now as private clouds.

Cloud computing introduces the same complexity surrounding latency and application performance that Riverbed addresses today. Steelhead products remove the performance barrier to cloud solutions. Riverbed is in the leadership position that makes division of cloud computing a reality. Thank you for joining us today. Eric, Randy and I will now take your questions.

Operator, Sarah, we’ll go to the queue.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Troy Jensen - Piper Jaffray.

Troy Jensen - Piper Jaffray

Could you just go over the gross margin guidance? I guess kind of surprising to believe that you guys would be down 200 basis points sequentially here given that revenues are expected to grow here?

Randy Gottfried

I think in general, Troy we’ve been pleased about the overall progress we’ve made in the gross margin line. What we are saying is Q3 was a fantastic quarter. It was a unique combination of product mix and channel mix, basically a perfect storm.

The Q2 numbers we had were basically about 76% and we’re assuming we go back to that level, which has always been closer to our long term target. So we still think the gross margin is still pretty good number. We’re pleased by Q3 and just assume we’re going to go back to a more normalized number in Q4.

Troy Jensen - Piper Jaffray

Another one really quick, any sense like a revenue level or timeframe you need to hit kind of your operating margin targets now that you’re at gross margin levels here?

Randy Gottfried

We’re most focused as a company and there’s been no change to this philosophy. The primary focus is growing the revenue line. We think again this is a very under penetrated market in the very early stages. So we’re very focused on reigniting the growth in the business and I think we’re optimistic about that. The second priority would be growing profits. The last on the list would be increasing the percentage. We still think it’s important. We think we can generate a respectable profit line as a percentage, but we’re most focused on growing revenues and absolute dollars and profit.

Jerry Kennelly

In this recent economic environment, number one is market share and revenue growth, and when the economic winds blow stronger again, we’ll be back to chasing that operating margin target for sure.

Operator

Your next question comes from Douglas Ireland - JMP.

Douglas Ireland - JMP

I wanted to ask about virtual mobile controller and the RSP, if you could give us any color on how those are performing?

Eric Wolford

They’re very related, so I just to clarify for everyone, virtual mobile controller runs on the RSP. So let me first start by addressing RSP. RSP had another really strong quarter and increased its attach rate from the previous quarter. We are nearly at 20% now and so RSP continues to be an important part of our pitch to the market and to our customers. It’s being received very well. The notion of the branch office box, that Gartner as spoke about is something that we fully believe and then subscribe to and are trying to make happen.

We just released a module that fits into RSP on Steelhead, which is the Steelhead mobile controller, and this has had a good amount of take up for an entry level type purchase. So it is a good starting point. Steelhead mobile in total, I think generated about 100 mobile customers and some of those were Steelhead mobile controllers on the Virtual Edition, but that’s just getting started.

Operator

Your next question comes from Mark Sue - RBC Capital Markets.

Mark Sue - RBC Capital Markets

Jerry, excluding the fed, where the other verticals up or down sequentially and also did you recover the bulk of the slip deals from last quarter? Does that explain the upside of the quarter or is it just better federal trends? In your guidance are you assuming both a bigger pipeline and also a better closure rate?

Jerry Kennelly

Its sounds like three questions Mark. We had a robust quarter for Q3, of course government business and fed, certainly contributed to that and it was strong. We did actually bring in a fair amount of the Q2 deals into Q3, but actually those are already baked into the guidance we gave. So we’re response, they did come in, they did happen, but they’re not responsible for the upside above our guidance. The upside was just raw performance and some good selling.

So as we go into Q4, we think government will be strong again for Q4, but not the kind of jump up you’ll see in the September quarter, but combined with the up look in enterprise, we think we can actually cover the government sales and still grow on top of that. So that’s what’s in our guidance for Q4.

We have a pipeline. It’s as robust as it’s ever been. We still think it’s choppy out there, but the word cautiously optimistic comes to mind and the sales review with the reps there, they’re also a little bit slightly more cautiously optimistic than we’ve heard earlier in the year. We also get a little bit of the Q4 effect, where sales comps and everything else seems to come together and the history of having a nice Q4. So we’ve it all banked in our guidance and we’re going forward.

Mark Sue - RBC Capital Markets

Lastly, is there another big market that you’re going after now that not pursuing Atlas?

Eric Wolford

Yes, for sure. The opportunity that has presented itself to us and we’ll talk more about this next month, but we see a really attractive market opportunity to leverage our strength and innovate in enabling clouds, public and private for enterprises in government. We’ll have quite a bit more to say about that at Interop in New York next month. Stay tuned and we’ll disclose more.

Operator

Your next question comes from Jason Ader - William Blair.

Jason Ader - William Blair

It really is one question; you told us what the percentage of total government was. Can you tell us what the percentage from U.S. Fed was? Then secondly, related to that is did the U.S. enterprise actually grow in the quarter sequentially if you take out all the government stuff?

Randy Gottfried

I’d say, we’d not broken out within any vertical. Clearly, U.S. Federal was a key driver. It’s been a solid portion of our business, a solid portion of the government vertical for us, but again that’s not going away. We still expect a strong future in that category. That was a big driver for the Q3 growth.

Absent, if you take the Americas number and you back out the federal portion or the government portion from there, it was flattish, slightly down from Q2, but based on what we’re seeing in the field, we’re actually optimistic and we’re going to see some growth Q3 to Q4 in U.S. commercial.

Operator

Your next question comes from John Marchetti - Cowen and Co.

John Marchetti - Cowen and Co.

Just following up on Jason there for a second, can you talk a little bit, Jerry, about what you’re seeing maybe in some of the international markets? You mentioned very briefly, that you expect international to be up as you go into 4Q. Is that sort of a rebound that we’re starting to see in Europe? Is it coming more from Asia? If you could just help us sort of get some color for some of the other geographies as well?

Jerry Kennelly

Yes, Q3 was quite good internationally, both Europe and Asia. As we go into Q4, for us specifically industry are probably more in Europe. The big companies are rebounding. The central part of Europe is getting better. Northern Europe remains good. We’re seeing a little movement in the south. Our optimism is primarily European based for Q4.

Operator

Your next question comes from Jonathan Ruykhaver - Thinkequity.

Jonathan Ruykhaver - Thinkequity

A question regarding the partnership with EMC, Riverbed has been listed as the EMC select partner so apparently it’s working as a new resell. Can you just comment on where you are in that partnership in terms of training certification? When you would expect to see revenue?

Eric Wolford

We’ve just sort of launched this past quarter, in Q3, the EMC select relationship which is where EMC resells our product to speed up our SRDFA and mirror view applications. Prior to that, however, we did go through various qualifications on those different applications.

First, we have qualified on EMC SRDFA. We have qualified on EMC mirror view. And now we have EMC select where they will be reselling the products. That has just gotten kicked off. There was a handful of SRDS deals that were down in the quarter. We look forward to those sales in the upcoming year.

Jerry Kennelly

The EMC select program kicked up mid-September, but it should be good for us over the next year.

Operator

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

Alex Kurtz - Merriman Curhan Ford

Can you give us a sense of the refresh rate from your installed base obviously, you came out with your next version of your operating system. Now you have enough historical data to look at, can you quantify it for us when people are upgrading to new platforms?

Jerry Kennelly

People get the new software automatically when they’re under maintenance. Our maintenance contract is really, mostly software upgrade subscription rights, as well as grade fix for the hardware. As you can see, the percentage of our revenue comes from the maintenance contract has got to about the third, that has been very strong. I think it grew 55% year-on-year this quarter.

More to issues, when would people go out and buy new hardware units kind of refresh the install base in that regard. Typically in the industry that is, three to five years from purchase, people go out and do the hardware for the ability to run the latest version of the software. That gets released and we are probably a year out from that kicking in. Our material sales really started in 2006, 2007.

Alex Kurtz - Merriman Curhan Ford

For the next four quarters it’s all about net new customer acquisition and maybe a year out we can start thinking about the install-based coming back in size as they start to refresh. Is that right?

Jerry Kennelly

Not exactly so, what’s really all about is repeat buys by the install-based, filling out their deployment. It’s typically in a first purchase, people just buy a taste. Someone who wants 300 sites in the first purchase use buys ten or something and then overtime, anywhere from 12 months to 36 months, they’ll rollout the rest of the sites. That’s really the story. It’s really the sort of absorption capacity of our install-based that’s key and that remains quite large. The opportunity to fill out the unshipped units of our install-based is big as well as the addition of new customers.

Operator

Your next question comes from Ken Muth - Baird.

Ken Muth - Baird

It sounds like Cascade was a little bit below expectations if I heard the number right. Can you comment on that Delta?

Randy Gottfried

Cascade, we continue to like the product. We have good expectations we would liked to seen little better revenue in Q3, but we are six months into it we’ve basically tripled the amount of pilots we have out there.

Our sales force is getting used to it, the Cascade sales force is small, because it’s small and new tends to be choppy in terms of revenue and deals and their revenue recognition is slightly different than ours and it some cases and in some instances it’s on installation rather than shipments. So, they have a very robust pipeline for Q4. The customers, who have it like its being used by gigantic corporations and I still a big fan of Cascade.

Operator

Your next question comes from Daniel Ives - FBR Capital Markets.

Daniel Ives - FBR Capital Markets

Can you just talk about what you saw differently this quarter than last in regards to customer engagements willing to sign in dotted line and maybe bigger deal format? You had a strong quarter, but just anecdotally you can talk about any changes quarter-to-quarter given the change in results? Thanks.

Jerry Kennelly

I’ve spent quite a bit of time visiting customers all over the world, Europe, Asia, US, really big customers and the IT world goes on. What I see is, yes there are budget constraints, yes there’s a tough world out there, but productivity and business advancement comes from the purchase deployment of the best-of-breed IT products.

People definitely intend to buy and spend and deploy technology such as Riverbed. I think the paralysis that have been seen in late 2008, 2009, there’s still budget constraints but the paralyzed feeling I believe that is going away and people are making plans. They know the world is coming back and they’re going to have to address it with the proper IT infrastructure.

Daniel Ives - FBR Capital Markets

Is your sense that there is going to be a budget plus and maybe could be more exacerbated from your conversations?

Jerry Kennelly

I’m always cautious of the term budget plus I prefer to say the Q4 effect. We’ll see we’re seeing a robust pipeline is what I can say for Q4.

Operator

Your next question comes from Rohit Chopra - Wedbush Morgan.

Rohit Chopra - Wedbush Morgan

You mentioned security in your opening remarks. Is that a renewed focus related to any loss share or customer request? I know you already have the people at form you have web sense you have a bunch of other stuff in there. Just wondering what is happening on that security front and why you had to mention that?

Jerry Kennelly

We’ve always been interested in it’s you have to distinguish between security for the government versus generalized security for enterprise. We address generalized security for the enterprise basically through best-of-breed partners selling to install in the RSP for government sales in particular. The certification is important and so we did focus on that and we received approval from the government on our approach and so that’s what I was trying to call out especially.

Operator

Your next question comes from Eric Suppiger - Signal Hill.

Eric Suppiger - Signal Hill

A couple here, do you expect the government business to go down to the more traditional 10% to 15% range in Q4 or do you feel like you are carrying some backlog there?

Jerry Kennelly

We would discuss backlog, but if you take a look at 2008, I think we were roughly 20% in Q3 and then in Q4 we were roughly 20% in government. So we had a kind of bulge up this year up to 29%. I don’t think it would be flat quarter-on-quarter, but I do believe we will have a robust government vertical for Q4.

Eric Suppiger - Signal Hill

Is that vertical typically 10% to 20% or what is the normal range there?

Jerry Kennelly

Typically upper teens.

Eric Suppiger - Signal Hill

Your finished goods were up $3 million. Why is the finished goods up?

Randy Gottfried

I’ll tell you a couple of reasons. First, we did do more business. We also had a number of deals in the quarter that could have had a variety of very different configurations. So we stocked for all those scenarios. We did finish probably with an extra two weeks or so of inventory than I originally wanted, given the numbers and the velocity of product that I’m not too worried.

Eric Suppiger - Signal Hill

Why no Atlas?

Eric Wolford

Just a couple of things; first, we made the business decision that Atlas is a standalone product, which is not a good fit for Riverbed and then second as I said earlier, we saw and I’m sure you all see it, too, that there is a very attractive market opportunity where we’re very strong and we can innovate and we can come up with some very exciting new products to enable clouds for enterprises and government.

So it’s a big shift going on inside of IT. There’s a long run shift and there’s problems that are identified by various smart organizations and we can solve those problems. So we’re going to disclose more about what we’re doing with regard to cloud at interrupt, but basically it was those two things, business decision on Atlas and attractive alternative market opportunities to go after.

Operator

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

Ryan Hutchinson - Lazard Capital Markets

I want to maybe dig into this stead deal a little bit more. Can you quantify if there was one to two deals? If there was one specifically and how it looks in terms of a rollout over the next couple of quarters?

Jerry Kennelly

We did not call out any specific deal. We said in general the government vertical was very strong in the third quarter, but we have no 10% or more customers.

Ryan Hutchinson - Lazard Captial Markets

Did it comprise of one or two large deals?

Jerry Kennelly

We had many deals in the government space this quarter.

Ryan Hutchinson - Lazard Captial Markets

Moving onto just the pricing side, earlier in the call you touched on it a little bit in terms of the gross margins coming down in terms of mix, but is there anything that we should be concerned about as it relates to potential pricing pressure within the overall WAN optimization market, specifically with the recently introduced Blue Coat product and anything on Cisco.

Jerry Kennelly

I think the pricing environment really has not changed very much. The overall trend didn’t see any change in the September quarter. As I mentioned, in that third quarter we had a bit of a perfect storm both on the product and channel mix. We are assuming that gross margins would settle back to I guess some more normalized number that we saw in the first part of the year, which we think are still good numbers.

Ryan Hutchinson - Lazard Captial Markets

So we shouldn’t expect that level starts to trend lower as we move into next year?

Jerry Kennelly

We have not given any guidance passed the fourth quarter, but again on the question of competitor pressure on pricing, again no great change.

Operator

Your next question comes from Alex Henderson - Miller Tabak.

Alex Henderson - Miller Tabak

Just so I have a better handle on how you’re thinking about your business model. So if I take the two point swing in the margins at the gross level and remove that would take you from 22% down to 20.0% operating margin. Is it reasonable to think that the company would try to manage to maintain that 20% going out overtime and push it up from there? Or is it just a little bit too much of a spike to assume that you can sustain that level?

Randy Gottfried

Your general premise may be correct. There’s just quarter-to-quarter variation. So on the fourth quarter, you get a jump up in sales commissions when all the reps are in there, the final parts of their year plan. In the first quarter, it tends to be slightly challenging revenue. The second and third quarter tend to be more normalized or up. Your general theme is correct, but you can’t count on that as a flat across all the quarters at the year approach.

Alex Henderson - Miller Tabak

Of course not, but can I think of it that you’re trying to on a full year basis at least sustain over that 20% margin going forward?

Jerry Kennelly

We’re not giving guidance past December at this point. We’ll talk more about 2010 with our next call, but in general, we still think that long term target for this business has operating margins in the mid-20s. We haven’t been rising towards it just given the opportunity we see in the market.

We do think that there is again still a lot of penetration left and available for us. We’ve been very focused on getting the revenue growth and profit growth, but have not been chasing the percentage. We can get to the percent very easily, but we think we would be forsaking a fair bit of market potential.

Eric Wolford

As you have several years, the long term trend should be favorable for us in terms of depth of installed base and efficiency. We want to get to this economic turbulence get back to more normal economy and we will start chasing the operating margin target again.

Alex Henderson - Miller Tabak

There is clearly a lot of angst given the questions that have already been asked about the enterprise metrics being fairly stable or sequentially flattish and all the growth coming from the enterprise as from the government side of the equation here. Yet you feel comfortable for your outlook for the December quarter with enterprise obviously you having to makeup for a fall in the government piece. Can you talk to the metrics that you’re tracking? You see robust pipeline, more activity rates, bigger deal sizes, faster close rates the standard metrics that people use to track this stuff that’s giving you that confidence?

Randy Gottfried

These are the several things that we look at, how we come up with our numbers and overall outlook. We look at for new customers they go through some sort of evaluation process typically. We see the number of RSPs, to people who are looking to buy WAN optimization products out there. We see that as very strong, we’re optimistic about that piece. That gives us some visibility for new customer additions.

As Jerry mentioned, a lot of our revenue comes from existing customers, who are rolling out the product overtime. We now have an installed base that’s approaching 7,000 customers, many of whom, especially the largest, are in the earlier stages of deployment. We get visibility from those customers who are deploying over some period of time. When we come up with our numbers and think about the future, we think about all those factors and just overall activity level and optimism in the field. That flavors how we come up with our guidance.

Alex Henderson - Miller Tabak

Deal size is getting larger, activity rates accelerating, linearity improving over the course of the quarter?

Operator

Your next question comes from Sanjiv Wadhwani - Stifel Nicolaus.

Sanjiv Wadhwani - Stifel Nicolaus

I’ll promise to keep it to two questions. First one, Randy, can you talk about the SI plus service provider total revenues and how did the closure rate with them change in Q3 versus Q2? Then second question, any thoughts on the recent Cisco ISR G2 release? Do you think that increases your competitive pressure in the market or any thoughts there?

Jerry Kennelly

In general, about 30% of the business came from IS’s SPs, which is consistent with last quarter. We’re pleased by the execution in that space, and we’re pretty optimistic about that going forward. The second half of the question was on Cisco’s products?

Eric Wolford

We have been competing with Cisco regularly for quite sometime and have competed against the blade offering and have done obviously fairly well. If you look at the latest market share numbers, I think our market share advantage is about nine points right now. The biggest margin it’s been in many years so we are pleased about that.

Candidly, I don’t know that this change that Cisco is doing, which is really not just this space that they are in, but more about their core routing space, is the change that’s going to help the tide in their favor. We used to competing with them. We compete against the WAAS product, not really the ISR. Obviously, the blade has not had this big impact that it was once thought it was going to have. We feel very confident about our position.

Sanjiv Wadhwani - Stifel Nicolaus

Just to follow up quickly on that, Eric, I guess one of the issues has been putting the blade on the original ISR. The performance of the router went down dramatically. This new ISR obviously has a lot more out power. Do you think that changes the dynamics with the same blade or do you think that really doesn’t make any changes in the market dynamic?

Eric Wolford

The real problem is, one, the difference between the core products versus our core product, but then when you put that core product into the ISR, there’s additional administration and configuration that was particularly frustrating to customers. As a result, Cisco came out with a bunch of low end appliances that look a heck of a lot more like Riverbed boxes because it was easier to deploy when you put it in line at the path on the edge.

It seems as though the marketplace is choosing the easier way to deploy it, and then there’s the fundamental core product versus core product difference. So our performance wasn’t the main reason why that wasn’t being sold.

Operator

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

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Scott Zeller - Needham & Co.

Question, when you look at the buying behavior this quarter, did you see any up tick in purchases as part of a large data center kind of refresh project or were you still seeing a lot of discreet buying of Riverbed on its own?

Eric Wolford

Yes. Data center consolidation continues to be a main prime motivator for many of our sales. Every six months we survey our customer base to ask them what their purchase motivation was and one of the largest drivers of the purchase of our products is enabling data center consolidation and remote site consolidation. A lot of times that’s now being called private cloud creation, but we’ve been in that market, and that’s a big cost saver and we see a good future there.

Scott Zeller - Needham & Co.

Just to follow-up, was there any change where you’re seeing people doing larger projects and you get pulled more often or is it breaking system?

Eric Wolford

As Randy has said before, every quarter there’s a handful of $1million deals and then there’s another group of pretty big deals and then a lot of the transactions are under sub $100,000. Many those sub $100,000 are follow-on purchases out to remote sites that you don’t buy for 300 sites all at once. I can’t say we’ve seen a great change. It’s still a huge cost saving item for companies.

Operator

Your next question comes from [Eugene Hill] - Banc of America/Merrill Lynch.

Eugene Hill- Banc of America/Merrill Lynch

A quick question on the guidance, I understand that you are putting in some conservatism given the still tepid environment, but the mid point of the range implies approximately 4% sequentially up tick in revenue. You’re coming off 12% sequential up tick in the third quarter. Why the level of conservatism? Why you can’t get to the upper end or if not exceed the upper end of that range?

Randy Gottfried

I’ll mention again. We’re very pleased by Q3, part of that growth was driven by just year end buying, the US Federal Government. Again while we think federal will still be a good contributor in Q4, we are not assuming the same level of contribution as we had in Q3. So, while we are assuming enterprise and commercial growth Q3 to Q4 that would be partially offset by lower US fed spending.

Operator

Your next question comes from Jess Lubert - Wells Fargo.

Jess Lubert - Wells Fargo

I’m not sure if you said, but was book-to-bill greater than one?

Randy Gottfried

We don’t disclose backlog.

Jess Lubert - Wells Fargo

Are you getting a sense that larger customers and deals are becoming a bigger piece of our outlook or are deal customer sizes remaining relatively consistent?

Randy Gottfried

Deal sizes haven’t changed much, that the key thing is getting customers on and they deploy. You may have a very big customer example who deploys in a modest size purchase very regularly. So, the key thing is to get more customers and get existing customers to continue to deploy. How big those purchases are less important.

Jess Lubert - Wells Fargo

Then can you give us a sense of the contribution from HP?

Randy Gottfried

We do not call out the contribution from any of our partners. We don’t have any partners that are more than 10% of revenue.

Operator

Your final question comes from Min Park - Goldman Sachs.

Min Park - Goldman Sachs

Just on your service revenue, do you think your sequential services revenue growth rate its closer to normal levels or are you still benefiting from catch-up renewals from service contracts?

Randy Gottfried

In general, I think they are more normalized. Again when you think about our service revenue, it’s really a function of our life-to-date install-based and so it’s going to be a function of how much product we add every quarter to that whole install-based, so necessarily correlated to individual 90 days worth of product sales.

We have made some really nice improvements over the course of the last year in some of our service renewal rates. I don’t want to say we maxed out, but a lot of that benefit as far as the increase in that rate, I think we saw earlier this year.

Min Park - Goldman Sachs

You mentioned Cisco as a competitor that you see most and get we look at the market share Blue Coats rates in the top three. I just wondering why is that you see those as fully independent bids? Does that suggest that a large share of the market that you simply not addressing?

Eric Wolford

We do see Blue Coats I hope we are not misleading you definitely see Blue Coated just not nearly as much as we see Cisco. So we see Cisco the most and then there’s a drop off and then we see Juniper and Blue Coat a similar amount and then there is variety of other and that’s been very, very consistent.

Blue Coat is a little bit interesting in that oftentimes they are selling into a datacenter in the DMC to do a web proxy type sale or a secure web gateway sale and we don’t participate in that and then secondly, their install-based, when they sell in their install-based some legitimate WAN optimization, we also may not participate in and see that.

Renee Lyall

Thank you, everyone for joining us today. Our next quarterly conference call to discuss our fourth quarter fiscal year 2009 results will be on Tuesday, February 2. If you have any questions, please contact Riverbed Investor Relations.

Jerry Kennelly

Thanks.

Operator

This concludes today’s conference call. You may now disconnect.

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