Quest Software, Inc Q3 2009 Earnings Call Transcript

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 |  About: Quest Software, Inc. (QSFT)
by: SA Transcripts

Operator

Good day, everyone. And welcome to today's Quest Software Conference Third Quarter Earnings Release. Today's conference is being recorded. Joining us today are Vinny Smith; Executive Chairman; Doug Garn, Chief Executive Officer; Scott Davidson, Chief Financial Officer and Steven Wideman, Treasurer.

Now, I would like to turn the conference over to Steven Wideman. Please go ahead.

Steven Wideman

Great, thanks, and thanks everyone for joining Quest Software's earnings call for the quarter that ended September 30, 2009. Of course, we happy today and have with us on the Vinny Smith; Executive Chairman; Doug Garn, President and Chief Executive Officer; and Scott Davidson, Chief Financial Officer. Scott, Doug and Vinny will give some thoughts on the quarter and then we will open up the call for Q&A.

Our call is being webcast from our investor relations website, and you can get a copy of our press release that we just issued on this website as well. A replay of the call will be available on the site or using the instructions in our release.

At this point, let me turn briefly to our Safe Harbor statement. Some of the statements we make today maybe considered forward-looking, including statements including statements regarding our anticipated revenue and operating margins in future periods, statements relating to the settlement of the shareholder class action and other statements about our plans, prospects and strategies.

These statements involve a number of risks and uncertainties that could actually cause results to differ materially. Please also note that these forward-looking statements reflect our opinions and expectations only as of the date of this presentation and we undertake no obligation to update these forward-looking statements to reflect subsequent events or circumstances.

Please refer to our SEC filings including our annual report on Form 10-K for the year ended December 31, 2008. Our quarterly reports on Form 10-Q for the quarters that ended March 31, 2009 and June 30, 2009 as well as our Q3 earnings release for a more detailed description of the risk factors that may affect our results. Copies of these docs can be obtained from the SEC at sec.gov or by visiting the Investor Relations section of our website.

Also please note that certain of these financial measures we'll use on the call today such as EPS, net income, operating margin, and operating income are expressed on a non-GAAP basis, and have been adjusted to exclude various charges, including the after-tax effects of amortization of intangible assets acquired with business combinations, share-based compensation expenses, acquisition-related costs, and expenses and litigation loss provision associated with the securities class action arising from Quest stock option investigation.

We report our GAAP results as well as provide a GAAP to non-GAAP reconciliation in our earnings press release, a copy of which is available in the investor relations area of our website at quest.com. And with that, I'll turn it over to Doug.

Douglas F. Garn

Thanks, Steven. Good afternoon everyone and thank you for joining our earnings call. I'm Doug Garn, CEO. I'll first cover our Q3 results at a high-level and then cover what we saw in the quarter and give a sense of what we expect going forward.

Our financial results total revenues in Q3 2009 were $171 million, a 4% increase sequentially from Q2 of this year and a 9% decrease from Q3 2008, which was a particularly strong quarter. Total pro forma expenses in the quarter of a $129 million were down 1% sequentially and down 12% from Q3 2008. Pro forma operating margins were 24% as compared to 22% in the year ago quarter.

The Q3 ‘09 pro forma margins are a record high for Q3. Third quarter pro forma operating income was $41.6 million, an increase of 23% sequentially and flat year-over-year. Our focus on operating expenses and margins has year-to-date a 29% increase in year-to-date operating income of $107.4 million as compared to $83.5 million in the first three quarters of last year. Net income increased to 18% to $31.7 million from $26.8 million in Q3 of ’08. Scott as usual will review in a moment the financials in much greater detail.

Now let me give an overview. In 2009, we have delivered strong operating margins and income despite decline in license revenues. Our Q3 results reflect a specific focus to reduce expenses. While we stay focused on our cost structure, we are also taking steps to stimulate revenue growth in 2010. As I mentioned in our last call, we recently hired Alan Fudge as our Senior Vice President, Worldwide Sales. With the clear task of growing license revenued, Alan is energized and is expected to make a real difference within the business going forward.

We continually get feedback from analysts and customers Quest corporate profile and brand, do not match our actual product depth and excellent reputation for quality and for high value products. As such, we expect to take more active steps to increase our brand awareness and product positioning in 2010. We are investing a new market, such as managed service providers who provide remote IT services to small and medium businesses using newer generation IT management that deliver network systems or data base management services via the web.

For 2010, we seen an opportunity to cross sale and up sale into our Windows management customer base as many of these customers have only one or two of our existing products. We also have significant growth potentially in our desktop and server virtualization businesses as customers continue to virtualize their environment. All of these factors provide us with a level of increase confidence as we prepare for 2010. In the near term, we are seeing marginal improvement in customer demand in certain markets. We are hopeful we will see a slight improvement in the lower end deals and sense there will some slight budget flush in Q4, but as you can appreciate, this is not nearly as predictable in this quarter as it has been in other Q4s.

Now let me move on to license revenues and geographic trends. North American operations contributed 66% of total revenues and west rest of the world contributed 34% total revs in the quarter as compared to 64% and 36% last year. Areas of relative strength, where our large accounts in North America commercial and our North American public sector, which had a record quarter benefiting from the September federal budget year-end.

European operations again had weak results the bright spots within Europe where significant improvements versus the first half in Germany, Netherlands, and in Scandinavia. On the other hand U.K. and France remained week with very constrain spending. Now let me provide some detail on the transaction data.

We completed a 147 deals over $100,000 in Q3 '09 as compared to 176 last year a 16% decrease. The average deal size of over $100,000 deals increased to 319,000 from 297,000 last year. We have six deals that exceeded $1 million versus seven in Q3 of '08 with the average size of deals remaining inline year-over-year. The year-over-year decline in sub $100,000 transactions was consistent with our experiences in Q1 and Q2 of this year. While this trend remains a significant concern we saw science of stabilizing in Q3 and our average deal sizes are either up or flat across all brands compared to both Q3 of last year and Q2 of this year.

Now let me comment on our services revenue. Our services revenues contribution remains consistent with maintenance and support revenues contributing 91% of service revenues in professional services represented 9%. Our support renewal bookings exceeded plan in Q3 and a renewal rates were being strong, although we believe there is room for additional improvement within this area.

Now let me move on to our product trends. Our Windows business had another strong quarter, we closed four seven bigger deals and we closed 12 deals greater than 500,000, which was doubled what we did in Q3 of 2008. Those deals expand our active directory management business or identity in access management business and our experience migration business. We had great success in our public sector group in Q3 closing Windows driven business across various federal and state and local government agencies.

This is the reflection of the governments drive to consolidate and centralize much of the IT infrastructures across the government. Our windows products clearly help in these types of initiatives. Our QuestOne identity solutions for compliance, security and efficiency had a strong quarter, and its becoming a much stronger part of our Windows revenue base. With AD becoming more strategic, companies needed to better define and control their AD environments with better audit controls and security policies, which you can do through our suite of products.

Our SharePoint business continues to show good growth as companies are growing their SharePoint environments, we are growing with them. We still see most companies using our tools to manage their on premise SharePoint implementation as compared to hosted deployments. ScriptLogic saw strong interest in its new Version 8.0 of desktop authority product which was just released in mid September and we've already seen some strong upside in D.A. revenues as a result.It puts the script team in a good position to compete for year-end budget dollars.

Now, moving on to our database products, our database products were weak in Q3 with Toad and SharePlex declining both year-over-year and sequentially. We released our Toad Version 10 Q3 which is our major annual new version. There are many network features and positive initial market reaction should increase sales confidence in approved competitive selling success beginning in Q4.

We continue to see strong download numbers for our Toad Freeware Version which is a grading leading indicator for future Toad revenues next year. Even with our weakness within the database area we did close a couple of key significant wins. The largest integrated retail pharmacy company in the United States spent well over a $1 million on our Toad family of products.

The Toad family of tools was chosen as the solution eliminating numerous other tools already in use. Toad win for ease of use familiarity, and having the same looking for you all in larger across the various database platforms. In large cellular carrier is completing a new datacenter build out and selected Quest as the best of breed solution to managed their SQL Server databases.

As a 24/7 critical operation running shared systems and mandating a 5/9 high availability SOA for their databases, the customer required that LiteSpeed provide very granular information collected with extremely lower overhead while explain this data and then easy to interpret interface. Our LiteSpeed products further reduced their stand cost by 70% and provided high data availability through its granular recovery features.

Now, let me move more into our Application Management area. Even though our Application Management products were flat year-over-year and sequentially we have had several large transactions in Q3 for Foglight, including our largest Foglight transaction of the year which was a large communications company. This was a highly competitive win for Quest and the company found our proactive rather than reactive management and true end-to-end visibility of their critical business systems were compelling. Our advanced dashboarding capabilities in model based architecture also distinguish Foglight from its competition.

Now, let me move to our virtualization side of our business. Vizioncore, our server virtualization part of Quest continues to provide great dealership in the virtualization world. Our flagship product could be range of pro just won the best of VMware in data protection. This is a huge deal that all within Quest and Vizioncore as it validates the time and efforts spent to rebuild this new product. We also saw very strong growth from two relatively new products, our BEA, Foglight Pro product and our vOptimizer growth. vOptimizer pro allows users to easily reclaim unused storage in a virtualized environment. vFoglight Pro, which is been a bit longer with the catalyst risk closing the largest number of big deals in the division core business effort.

Our desktop virtualization business solutions are continued to be very competitive technically. We saw some very key wins and some significant fortune 500 accounts in Q3. We were particularly strong in the U.S. commercial and in the U.K. We saw an increase in the number of pilot projects implemented in Q3, which should translate into additional opportunities as these pilots expand. We continue to develop and strengthen some critical partnerships within the desktop virtualization business unit as well.

This is the business where there is tremendous opportunity. We are clearly in the early dates of growth, but I feel very good about where it is positioned. Those are my opening thoughts, now I’d like to pass it on to Scott to give you some greater details on the financials.

Scott J. Davidson

Thanks, Doug and good afternoon everyone. So while we stop positive signs on the top line on the sequential basis, particularly in the public sector. We continue to manage through a challenging demand environment notably in parts of Europe. The total revenues were $171 million or 9% lower than Q3 ’08. If we exclude the impact from currency total revenues would have been down 7%.

The Q3 license revenues decreased 22% year-over-year to $67 million or down approximately 19% excluding the impact from currency. Term deals were about $5.2 million during the quarter, a reduction from the recent quarters. Had these term deals been structured as perpetual licenses, license revenue would have been almost $3 million higher. So adjusting for currency and term licenses, license revenue would have been down approximately 16% during the quarter versus the 22% that was actually reported. Services revenue grew 3% and it's led by our Windows and virtualization products. 3% is lower than historical growth rate and is a result of four successive quarters of year-over-year declines in new license bookings which eventually impacts the services revenue growth rate.

Our revenue mix continue to trend towards the services line, with license revenues comprising approximately 39% of the total revenues, while services generated the 61% balance, this compares to a 46% license, 54% services mix in the third quarter of 2008. The total non-GAAP expenses in the quarter were down 12% year-over-year to approximately $120 million or down 7% excluding the impact from currency. We continue to contain headcount in discretionary expenses as well as benefiting from the strength in the U.S. dollar on a year-over-year basis.

During the quarter, our expenses were approximately $6 million lower due to the impact from foreign exchange. This represented about 38% of the reduction in total expenses. Expense management is a theme that will continue and we're searching across all categories for opportunities to become more efficient, these opportunities present themselves elsewhere we are look to make selective investments.

Turning now to the line items on the expense side, sales and marketing expenses were $64 million or 37% of total revenue compared to $75 million and 40% of total revenue in the same quarter a year ago. The year-over-year change is related to the lower commissions on reduced bookings, travel savings and the benefit of foreign exchange. Research and development expenses were $33 million or approximately 20% of total revenue, as compared to $36 million and 19% of revenue in the year ago quarter.

Minor increases in core labor costs were offset by benefit from foreign exchange entire expense management and discretionary areas. General and administrative expenses were $16 million or approximately 9% of revenue as compared to expenses of $18 million which was approximately 10% of total revenue last year. The reduction in G&A was related to lower fees for outside services, the benefits from FX and reduced headcount related costs.

Looking at income, GAAP operating margins were negative 1.2% in the quarter, primarily driven by the litigation settlement and the GAAP operating income was a negative $2 million. The non-GAAP operating income was $42 million generating operating margin of 24.3%, a record for Q3.

Beyond expense management, favorable currency changes reduced our total non-GAAP expenses by approximately $6 million compared to the negative impact from currency on the revenue line of about $3 million. The shift in mix on the revenue line towards services has also helped to increase margins.

Other income was $2.7 million versus a $6.5 million expense in Q3 '08 when we were unhedged. The year-over-year difference was driven primarily by currency impact against the value of non dollar denominated assets. During September we further expanded our balance sheet hedging program to mange volatility of our non-USD denominated assets. So on a sequential basis, the impact from FX was reduced by 26%. Additionally in the third quarter we closed on the mortgage of our primary headquarters and the interest expense of that plus the seasonal line of credit created interest expense for the period.

Now let me talk briefly about the class action related to our stock option investigation which obviously has had an impact on our reported GAAP results. We've reached an agreement and principles to settle the class action for $29.4 million while we continue to believe that we would have ultimately prevail the trial, we also recognized the significant expense necessarily take the case or trial and any appeals, and also the inherent uncertainty in any litigation. We made what we believe is a prudent business decision to resolve this matter now and put it behind us. We are currently negotiating a stipulation of settlement with the class representative which when finalized will be subject to court approval.

Our GAAP income tax rate for Q3 was a negative 315% compared to 18.6% in Q3 of '08, the difference is primarily related to the discreet tax impact from the settlement I've mentioned before and the class action suit, the geographic mix of the pretax income. Q3 non-GAAP tax rate was 29.6 compared to 23.3 in the quarter a year ago primarily due to the result in changes in the projected geographic mix of net income before taxes.

The GAAP net income in the quarter was $2.9 million and GAAP earnings per share was diluted $0.03. For the non-GAAP net income was $32 million and non-GAAP diluted earnings per share was $0.34. The fully diluted weighted average shares outstanding were approximately $92 million shares versus $107 million shares at the end of Q3 2008.

The reduction in shares is the result of two tender offers completed within the last 12 months, partially offset by new share issuance from option exercises during Q3 2009. Now turning to the cash flow statement and the balance sheet, as of September 30, cash and investment balances were $362 million, the $100 million line of credit established in February remains undrawn and capital of expenditures for the quarter were $4 million.

Cash flow from operations was strong at $44 million. Days sales outstanding was 67 days, a nine day increase over the 58 days in Q3 of 2008. In this quarter our revenues were more back-end loaded. Deferred revenues increased 7% to approximately $335 million, up $23 million year-over-year.

So in summary, Q3 had a similar tone to Q2 but exceeding the quarter, things seem to be improving slightly in certain geographic regions. We did a good job managing expenses and have the benefit from favorable currency impacts there by enabling us to further increase our operating margin. Below the operating line, our geographic mix generated a higher cash rate, but based upon the successful tender offers we had a very positive impact on earnings per share on a year-over-year basis, which showed the earnings power of the company.

So now let me turn it over to Vinny.

Vincent C. Smith

Thanks, Scott. I am going to take a few minutes in summary I will talk about our markets and technical trends that are occurring in the market and how we are adapting to this trends. Let me start with the database business. This is our first business that created Quest and it's actually the business that’s taking been affected by the recession the most. It’s suffered our place where we have revenue license decline and that’s happening in both the Oracle and SQL portion of the business.

As Doug mentioned, this business has a lot of high transaction under $10,000 orders and for some reasons in this slowdown in economically, that stand of business has been more dramatically hit than the other band of business. So since we have a high percentage of our business in database in that band, it's taking a more meaningful negative impact. So that’s one downside to the business. The other downside is the vendors that provide the database, Microsoft and Oracle, are partnering their platform and these are relatively matured businesses and they're closing down our opportunities in several areas and as the technology evolves opens up several new ones. So theres the negative parts of the database business.

The positive parts are, we have enormous user base, a fantastic connection with our user base, they use our products everyday to perform their job and we are literally over a million seats with some of our products and tens of thousands of companies use them. Another positive trend is the database, it's used and what’s going on is beginning to change. We're seeing enormous data volumes occur especially from consumer facing internet application as well as the use of clouds and SaaS models we think we'll become more prevailent in the future.

And with that change, it opens up the opportunity for us to take our users and be able to provide more value and more options for them. So I am confident that we are going to be able to invent new products streams and revenue flows that will be able to offset the negative license impact we've taken this year. And so that would go a long way for contributing to Quest. And this business generates a great cash flow and we need it to stay stable, we working to do that.

Next prevail I'd to talk to you about is Windows. In Windows business, we've had an incredible run over the last six or seven years. We have come into the market and asserted ourselves into a leadership position around AD management, exchange management and SharePoint management. We provide a unique service to Microsoft and its customers. Microsoft management is not what it needs to be if you have more than 5,000 or 50,000 or 500,000 users. They have sophisticated solutions for smaller number of users, but we provide the necessary and impactful management for those larger shops.

And so we have a wonderful relationship with Microsoft and that we make there infrastructure shine, and so where we go from here with the Microsoft infrastructure businesses is just a huge opportunity for us. We are going to continue to invest and acquire in around the identity management exchange marketplaces. We’ve been an aggressive acquirer in SharePoint and client management, and we think that we can continue to grow this business for many years in the future. The next business is virtualization, in a virtualization business we came to the market a couple of years ago in ESX when VMware started taking off and just in the short span we have connected with over 20,000 customers are now running our image level back up.We provided a new way a superior way for many businesses to do back up recovery and recovery of their virtualized environment.

Just last year we entered the market with a new way to do monitoring in the datacenter that's using ESX and we provided a datacenter monitor that is in use with over 5000 customer in just a first year it is approximately in the market. The virtualization trend is pervasive and many new solutions need to brought forward in order to manage the virtualized datacenter and we have two remarkable product offerings in the market today and as they evolve our opportunities will only get richer.

So this is been a great growth for last couple of years its slowed down this year because a lot of businesses transacted in the lower deal band just like the database but we think this will be vibrant grower for the next couple of years. One trend is permeating throughout the entire industry is the use of virtualization one server. Two years ago it was on 5% of the servers last year we are going to 10 maybe this year its going 20% of service but that trend is not going to stop, we are going to see virtualization get up over 50% of the servers in the next couple of years.

And frankly that type also has enabled this new notion of how Clouds are going to used. And so we have virtualization in one premise datacenters and then Cloud offerings or SaaS offerings they are available for customer to use. So these two kind of core fundamental IT themes are affecting all of our product lines, the database, the Windows and virtualization, and datacenter management are being turned on their head somewhat. And that creates problems for some of products but also huge opportunities for us to embrace these new trends and help carry our customers forward in using these trends to gain efficiencies and productivity and greater reliability. And so for me it's a really it's a very existing time and that we are able to reinvent so many of our products to adapt to the new trends and take advantage of them and to deliver more value for our customers.One consequence of these trends we didn’t appreciate here at Quest.

Over the last couple of years, we acquired and birthed and brought to market a full mid market offering for IT solutions and we didn't do this by design. We went and moved into some properties and before we know we had a very comprehensive line of products with tens of thousands of the customers in the mid market.

In 2010 you'll see this move aggressively in to branding our mid market solution and providing a much more comprehensive suite. And we are coming from a position of strength in that we already have large install bases around our image level back up as well as our client side management in the mid market. So this is a very exiting a kind of fourth new dimension request that we are going to be able to address new customers with new solutions which I think would be have to help to provide us more growth.

Stepping back from the three a kind of product categories in overall trends in IT is I just want comment on what's going on in 2009 from a financial run the business point of view and I appreciate the difficulties of Scott and (inaudible). And then we are cutting expenses, increasing margins, buying back stock, all at the same time, which seems like the right thing to do in this climate but the same time we are redirecting our R&D and our acquisition dollars to move our investment to these forward trends. And so for me it's a blend of doing the right thing at the right time in 2009 but make sure that you're investing in the future. And so, we're doing our best to do that and I feel very confident that these investments we were taking to embrace these new trends will pay off for us in 2010 or 'l1 and '12.

So that's the end of my comments. I think it's we can open up for question-and-answer now.

Question-and-Answer Session

Operator

Thanks very much. (Operator Instructions) We'll take our first question from Abhey Lamba from ISI Group. Caller, your line is open. We go next to John Difucci with JPMorgan.

John Difucci – JPMorgan

Thank you. I think Scott and Doug, or Vinny said that the run rate business has been tough lately and it's continued to be tough. I'm just curious is this something do you think that has to do more with sort of run rate business that low ASP business for people who are just having hard time or not buying lower priced items. Just focusing more on mission critical things, or do you think it has something more to do with the products say that are in that category, as I think Vinny pointed out, there are lot of database tools because there's other companies covered or at least we recover and they actually that business did come back and we saw some softness at the end of last year and into the first quarter, but it seems they have come back for some other companies. So I just wonder if you can comment on that?

Vincent C. Smith

This is Vinny speaking. I have tracked a couple of companies that have seen most of them been affected in this lower band either through slower growth like we've suffered through into negative growth, and lower growth. Certainly, the productivity tools they are not must have product tools will be put on the backbone or when you going through a IT budgeting process and I think so we're suffering from probably three competitive situations, one is the IT budget compression or economic climate. Two is that some of these tools are not must have tools. And then the third thing is in some places the platform vendor is providing free solutions that are getting a lot more utilization even though they maybe interior and could be justified typically and they can be easily justify the buy our product they are getting a second chance. So I think we are suffering from a variety of these trends that are affecting us in this band. I can just tell you that we were caught off guard a little bit by this because in prior slowdown this band tended to be relatively resilient, in this time what we think happened is more centralization was put into budgeting and the IT director or senior executive picked their core projects and didn’t let much buying going on beyond those projects that had direct oversight on.

Douglas F. Garn

Yeah I'm also seeing that if you take a look at some of the mid market customers, when your transactions come up to be approved, they are watching so closely what their profitability like as a company. They are turning on and off their purchasing trends pretty regularly and so as a result sometime we’ve get caught up with that, where in our larger customers even though yeah they maybe impacted by some of the economy they've still have a fair amount of cash and they are able to let the transactions go through and in fact in many cases they are fairly significant transactions. So what I've really seen is much more in the lower end to mid market customers. They're just literally watching every dollar that they have and they are extremely cautious and as a result they've been sitting on the orders.

John Difucci – J.PMorgan

Thanks guys. That was really helpful. And just a quick follow up on the flip side, you guys are doing what I would say is an impressive job on the cost side in running the business and especially given the IT spending environment and I’m just curious going forward as things perhaps gradually improve just if you can comment on how sustainable that is.

Douglas F. Garn

We are going to spend like crazy. We have every intention of, we actually there has been some goodness in the sense that we have managed the business down in a very effective way but I also think that we have been able to, I think we spend on a good balance of where our expenses right now are in a good place and then if we do begin to see an uptick in our revenues which we do expect that if not of that almost all of it, very much of it we go to the bottom line. So we would certainly if that was to happen we would continue to see an increase hopefully in the margins.

John Difucci – J.PMorgan

Great, thank you very much.

Operator

We will take our next question from Richard Sherman with MKM Partners. Mr. Sherman, your line is open.

Richard Sherman – MKM Partners

Yeah, hey guys can you hear me.

Vincent C. Smith

Yep.

Richard Sherman – MKM Partners

The questions on this lower band of deals that you have been talking about, can you maybe stratify whether we are just talking about restrictions on the SMB segment or do you think that or how much of it is actually department level budgets are being centralized as you refer to how much it is SMB effect versus department level budgets been brought back to the central the CFO level of back up higher into the organization?

Vincent C. Smith

That’s a difficult one for us to answer, we do have our SMB business broken out we can tell you that was effected but product lines like Toad or a mixture of SMB in larger and so it will be difficult we will be guessing we don’t have the bands broken out by size of companies.

Richard Sherman – MKM Partners

Okay, that’s fine. And then in terms of our product are you rationalizing some of the products, is there the R&D expenses look like that being contained pretty well here. Are you reducing some of the products, some of the skews or combining some of them and how does that impact your business going forward?

Douglas F. Garn

We actually talked about this on one of the previous calls where we did go through a bit of a rationalization process and we are certainly not rationalizing to where we are moving revenue so much as more just making sure that the areas that we are taking out or things that either we are soon to go into the market and we are not sure that they were going to have the kind of success in the market that we are hoping they would have so we just didn’t even take it into the market or they were early entrants into the market, they had been in the market for a short period of time when we decided that we were better served to trim down and not continue with those investments. So we have made some trimming in the number of products but I mean is it been a huge number now. It's been a handful if you will.

Richard Sherman – MKM Partners

Gotcha thanks. And one more may be. On the Microsoft migration cycle as we head into 2010, obviously a bunch of new products coming out but you've stated in the past that you kind a more relying upon end of life for some products on the Microsoft cycle so maybe just give us a view about migration and how it's doing specifically this quarter and then what's its look like as we look ahead in the 2010. And those are my questions. Thank you.

Douglas F. Garn

From the migration point of view when you look at our AD business. Its still doing fine but the truth is it our AD business is really holding up well based on the tools that are within that segment within the exchange side of our business there is no question that our exchange migration business has declined slightly. There is just not as many exchange users left to migrate so it has been impacted to some degree.

Scott J. Davidson

Just going to add to that Rich that one other large deal we did this quarter, which is a multi time million-dollar deal was migration related in the Federal states. So they tend to be bigger but again as you said they are driven these days by more end of life and continue to support from Microsoft and we'll see how that plays out with exchange as you know 2010 coming out and Windows server 2008 and a portion of the desktop side with Windows 7 as well as it relates to Desktop Authority in terms of ScriptLogic.

Vincent C. Smith

But we are I mean the fact that we are seeing our AD tools business play a bigger role within our AD business is something that we get to build on in a big way. It is the migration business once it happens, it happens and then it's not a recurring revenue stream for us so much.

Richard Sherman – MKM Partners

Okay, thank you.

Operator

We'll go next to Gregg Moskowitz with Auriga.

Gregg Moskowitz – Auriga USA

Thank you and good afternoon guys. Just a follow-up on the product rationalization and how far through the process are you at this stage and also are there any severance charges incurred in Q3 and any that that may be incurred in Q4?

Scott J. Davidson

So, we're part of the way through, I mean, I think this a process that's going to take place over the next six months or so, we started it. So I don't know that there's necessarily an end-date to it. We're constantly culling through that list and evaluating that. And as we rollout budgets for 2010, that's part of the analysis that we're looking. At as it relates to severance, somewhere a little north of $1.5 million that's embedded in Q3, less than 2, I believe, that's embedded in that Q3 number and there maybe some for Q4 depending upon what the magnitude. I don’t think it’s going to be that much more. We didn't pro-forma that out, that's embedded in the numbers.

Gregg Moskowitz – Auriga USA

Right, okay Great. And, Doug, you've mentioned at the start of the call that obviously you have a relatively new VP of sales onboard. So I was wondering as you start to position for 2010, if you could sort of update us on your sales hiring strategy, as it kind of stands right now?

Douglas F. Garn

The truth, I think we're very well positioned when you think about it. We did a fair amount of hiring back in the beginning of 2009 with anticipation of higher revs. and our headcount were maybe down slightly is still pretty much inline with that headcount was then, it's down a little bit. But so, we still have plenty of quota carrying reps on the streets to cover what we're thinking we might do in 2010. So, there might be a location here or there where we may hire, we are not really focusing on hiring whole lot a new folks at this point. And it's really because we did a lot of it last year and we just got hold on to them.

Gregg Moskowitz – Auriga USA

Okay, got it. And maybe just lastly for Vinny naturally be series been for about five months or now, so I was curious if you would attribute any on vision corps recent success to be serious and also if you could talk about your expectations around Hyper-V and what that could its been its over the next few or too that will be helpful. Thanks.

Vincent C. Smith

We would hope very much that Hyper V successful in the market because we think that will be a valuable new platform for us to address and we have products that are reaching that market now with a couple of products in the market and couple of products hitting, but it’s a the upticks been pretty slow. With regard to the ESX it's just motoring into the market at a pretty steady clip so that is where the opportunity sits today. And frankly, there is a lot to invent for all of us collectively vendors because, we have just moved from physical severance for that to more of a virtual service for all. And so problems were creating with some of these new trends are more significant then the problem we were solving. So the opportunities that are rich but we would love to see a Hyper-V be more pervasive and we are going to help Microsoft as best we can.

Gregg Moskowitz – Auriga USA

Okay, great. Thank you.

Operator

(Operator Instructions) We will go next to Derek Bingham with Goldman Sachs.

Derek Bingham – Goldman Sachs

Hi gentlemen, you mentioned an expectation of some amount of budget flush in December though its still, there is still some uncertainty around that. Could you give us a sense for kind of how the pipeline looks as you go into Q4 versus what would be typical going in to end of the year?

Douglas F. Garn

The pipeline is healthy, it looks good. So that’s converting it is the key and that’s really where we're focusing on now, but if you look at just the core pipeline, it's bigger than, frankly it's ever been. So in regards to the flush, it's that just my comments in my opening statement, I think are pretty much how I look at it. We're hopeful that it happens and we are hopeful we're going to participate in it.

Derek Bingham – Goldman Sachs

The bit of backend loadedness that you referenced, you chalked that up to federal business or enterprise or was it a mix?

Scott J. Davidson

It is primarily federal in Q3. We did larger, just the average deal size for everything over 100K was bigger than last year and the prior sequential quarter and it was little bit more based in the last month, but primarily federal driven where we get some bigger deals.

Derek Bingham – Goldman Sachs

How much of that step down? Do you expect in federal just from seasonal factors in Q4? Is there a still plenty of spending going on or should there be a step down?

Scott J. Davidson

Well, you would expect to see a step down, Derek, because it's fiscal at least on the federals side, most of the fiscal periods, while they do end year-end 9.30. So it’s logical that this quarter you would see the step down because we always have. A lot of states are still operating under continuing resolution. So I think in that instance it's a little bit more hit our mix, but typically Q3 as most companies you are going to see the biggest federal impact. So I would think we do nothing but to step down.

Derek Bingham – Goldman Sachs

Okay. And just a quick one there. Could you tell us what headcount was to close Q3 and then what you might expect total hedge to do in Q4?

Scott J. Davidson

33.64 was the close in Q3. Q4 is probably going to be that number, maybe a little less knocking really the much of the change. 75% of our cost historically have been related to headcount, the only thing that should substantively with respect to headcount cost, the labor cost in Q4 should be the commission cost associated with any license increase that we get which is typically higher in Q4 than Q3, but we're not queued up to bring on a bunch heads between Q3 and Q4 at this point. So I don’t think you can see anything dramatic on the headcount change into Q4.

Derek Bingham – Goldman Sachs

Okay, great. Thank you.

Operator

We'll go next to Tim Klasell with Thomas Weisel Partners.

Tim Klasell – Thomas Weisel Partners

Yeah, good afternoon everybody. Your margins continue to impress to the upside and where do you think they can peak out because companies of your business model and size would normally been a low to maybe mid-20s. Where do you think these could go?

Scott J. Davidson

I think, I tend to agree with you, we deliver very collectively the sort of mid-20s is probably where they peak out. And I mentioned this in my thoughts earlier that we outperformed on the margin side in Q3, a couple of reasons behind that, right? One is that we're seeing a shift more towards the services business, so less licenses means less commission, less sales cost that’s one aspect of it. The second thing is we got some currency benefit in there, and the third is we just in locking down on discretionary account. So we're little ahead of where we thought we would be in terms of margin for the quarter. What we've talked about is being able to have the full-year 2009 being higher than what the full-year 2008 was and we're clearly on track for that.

I think one of the things that it's a little bit different about Quest in terms of thinking about where margins peak out is because we have the different products in all of these different market, each market has a different growth dynamic. And so we have to make a decision where to make investments or where to reap the benefits and cutback as the case maybe. And in certain areas like virtualization, we are getting more investments that’s going that way as opposed to the database business. So we can throttle that investment one way or the other, but you would expect that if we get some license growth that we can continue on the same track at least and improving margins slightly on an annual basis, right? And that's really what we're focused on. They're going to oscillate quarter-to-quarter, but ideally we've always talked about mid-20s is the right number for us.

Tim Klasell – Thomas Weisel Partners

Okay, great. And your sales and marketing line, that was well lower than I thought. Are you guys changing anyway if you're going to market or some of the new products are you using resellers more particularly like the Vision Core in the Windows Business than you had in the past or any change in you go to market strategy?

Douglas F. Garn

No, really, no.

Scott J. Davidson

In mid-market and virtualization, we are 100% partner-oriented and so there is just this growth absolutely but there is no change that have been all of.

Tim Klasell – Thomas Weisel Partners

Okay, very good. Thank you.

Douglas F. Garn

Certainly we're enriching our partner relationships and trying to do more business through the partners and beginning to end morning the leverage the partner relationships longer term because it gives us more feed on the street but I wouldn't say that at this point that’s are the reasons that the cost are different.

Tim Klasell – Thomas Weisel Partners

Okay. [Inaudible]

Operator

We'll go next to Abhey Lamba with ISI Group.

Abhey Lamba – ISI Group

Yeah, thanks. Thanks for talking about some of the new drivers going into next year. So as you're planning for the next year, should we expect your expense close to lag your revenue growth deposit based on your base planning and margins just ramp from this year further?

Scott J. Davidson

Great, question, Abhey but we're not going talk about 2010 yet.

Abhey Lamba – ISI Group

Yes, okay. And when you talk about your virtualization business, one of the other external factors we should be paying attention to, should we look at the VMware's license revenues as a correlation with the virtualization business or are there any indication that we should be paying attention to it? Thanks.

Vincent C. Smith

I think, for me it, the VMware license revenue is probably one correlated number, a couple of other numbers would then the percentage of server that are getting virtualized in the datacenter and then the percent of PCs that become virtualized, we’ll have some derivative of those trends.

Abhey Lamba – ISI Group

All right, thanks.

Operator

We’ll go next to Rob Owens with Pacific Crest.

Rob Owens – Pacific Crest

Great, thanks. And I apologize if I missed this, when you commented on Q4 and sales and marketing as what the Q4 you said, sales and marketing is up because it should pace with license growth accelerating into year-end. Why was sales and marketing flat when you saw license growth quarter-over-quarter, Q3 over Q2?

Scott J. Davidson

Can you say what was the second part of your question, I am sorry.

Rob Owens – Pacific Crest

So licenses where it were 67.3 at this quarter versus 61.6 in June. So you are up also $6 million bucks, your sales and marketing is flat sequentially. Just curious what drove that dynamics?

Scott J. Davidson

Some of that is a reduction in term license deals that were recognized as opposed to landing on the deferral. So we add about $10 million or $11 million in term licenses in Q2 versus Q3. So that’s the one reason why license went up on a sequential basis. The other reason is we've sort of managed down some in certain areas, I've talked about this before, we have some costs associated with some headcount reductions that we made between Q2 and Q3 and that includes some sales as well.

Rob Owens - Pacific Crest

Great. And any thoughts on tax rate for Q4?

Scott J. Davidson

I think what you can do is that the current Q3 tax rate is represented above the current forecasted annual tax rate at this point of time. It's subjected to the mix between the geographic range of revenue. So I'd say take the exit run rate which is the high-20, 29 or 27 that has got for the rest of the year for now.

Rob Owens - Pacific Crest

Thanks.

Operator

And this end the question-and-answer session for today. I'd like to turn the call over to Doug Garn with any additional or closing remarks.

Douglas F. Garn

Thank you and thank you all for attending the call. And I certainly and most importantly want to thank our employees who certainly were achieving some very positive overall results to the company with the margin growth but I must tell you that our employees are the reason that this is happening and this is an incredible reflection on all of them. Certainly I also want to thank our customers who continue to support Quest in acquiring so many of our products, it's just great to have the relationships with them that we do. Certainly want to thank our partners. We also have a whole bunch of partners here at Quest today. So they even have a much bigger influence on us as they are walking the halls but truly I'm appreciative of their support for our product lines and our relationships. And then certainly our investors and shareholders and that we continue to get to serve them as a company and it’s quite a privilege to be and again, to our employees that most of all, thank you so much. I know Vinny, Scott and I are deeply intended to all that you guys do. So thank you very much and you all have a good day.

Operator

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

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