Blue Coat Systems, Inc. Q2 2010 Earnings Call Transcript

Blue Coat Systems, Inc. (BCSI)

Q2 2010 Earnings Call

November 24, 2009 5:00 pm ET

Executives

Jane Underwood – Vice President Investor Relations

Brian NeSmith – President, Chief Executive Officer

Gordon Brooks – Chief Financial Officer

Analysts

Troy Jensen – Piper Jaffray

Ryan Hutchinson – Lazard Capital Markets

[Woojin Ho] for Tai Liani – Bank of America

Jonathan Ruykhaver – ThinkEquity Partners

Anthony Carbone – Auriga USA

Erik Suppiger – Signal Hill Group

Rohit Chopra – Wedbush Securities

Richard Sherman – MKM Partners

Alex Henderson – Miller Tabak

Presentation

Operator

Welcome to the Blue Coat second quarter results conference. (Operator Instructions) I’ll now turn the call over to Jane Underwood, Vice President Investor Relations.

Jane Underwood

Good afternoon and thank you for joining us to discuss Blue Coat’s financial results for the second quarter of fiscal year 2010. With me on today’s call are Brian NeSmith, our President and Chief Executive Officer, and Gordon Brooks, our Chief Financial Officer.

Before I turn the call over to Gordie, let me remind you during the course of this call we will be making forward-looking statements about Blue Coat Systems Inc. These include statements regarding expectations concerning market growth an business opportunities including levels of IT spending, expectations regarding future revenues, expenses, margins, profits, tax rates and other financial metrics, the success of our business strategy, acquisitions, restructuring and changes in our business model and operations and other matters impacting Blue Coat’s financial outlook and future business.

All statements other than statements of historical fact are statements that could be deemed forward-looking statements including any statements of expectation or belief and any statements of assumption underlying any of the foregoing. Risks and uncertainties and assumptions include the risks that are described from time to time in reports filed by Blue Coat with the Securities and Exchange Commission including but not limited to the risks described in Blue Coats annual report on Form 10-K for the year ended April 30, 2009 and quarterly reports on Form 10-Q for the quarter ended July 31, 2009.

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

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

Gordon Brooks

Good afternoon. Today we are pleased to announce a company net revenue of $120 million for the second quarter of fiscal 2010, an increase of 4% compared with net revenue of $116 million reported in the prior quarter, and an increase of 1% when compared with a net revenue of $119 million in the same quarter a year ago.

Product revenue which includes appliances and Blue Coat Web Filter was $77 million, an increase of 4% when compared with product revenue of $74 million in the prior quarter and a decrease of 10% when compared with product revenue of $85 million in the same quarter a year ago.

For the second quarter of fiscal 2010, product revenue was $13 million for PacketShaper. Service revenue, which is primarily composed of revenue related to support and maintenance was $44 million, an increase of 4% compared with service revenue of $42 million reported in the prior quarter, and an increase of 28% compared with service revenue of $34 million in the same quarter a year ago. For the second quarter of fiscal 2010 service revenue was $10 million for Packet Tier related products.

On a geographic basis, net revenue in the America’s was $55 million, an increase of 4% sequentially and representing 46% of total revenue. Net revenue in EMIA was $45 million, an increase of 8% sequentially and representing 37% of total revenue, and net revenue in Asia Pacific was $20 million, a decrease of 3% sequentially and comprising 17% of total revenue.

We had five deals in the quarter whose total value including products and services was greater than $1 million, but no deals whose deals whose value was greater than $5 million.

In general, we experienced greater visibility in certainty in our pipeline this period, specifically the elimination of stocking rights from our distributors, allowed us greater visibility in end user deals as the amount of inventory distributors with stocking rights decreased significantly and to a nominal level as of October 31. I will discuss this topic further in a moment.

On a non-GAAP basis, gross margin increased to 75.9% compared with 75.6% in the previous quarter due to a small shift in mix to higher margin products. Non-GAAP operating expenses decreased to $72.7 million in the second fiscal quarter from $73.2 million in the previous quarter and $73.1 million in the same period a year ago.

The sequential decrease in operating expenses was primarily due to a decrease in total employee head count from 1,498 as of July 31, to 1481 as of October 31.

As a result of the increase in gross margin and the decrease in absolute operating expenses, operating margin percentage increased 300 basis points sequentially to 15.5% and 50 basis points compared with the same period a year ago.

In regards to the non-GAAP functional expenses, sales and marketing was flat sequentially in absolute dollars at $44 million or 36% of revenue compared with $44 million and 38% in the prior quarter.

R&D expenses increased to $19 million or 16% of net revenue compared with $18 million and 16% in the prior quarter. And lastly, G&A expenses decreased to $10 million or 8% of net revenue compared with $11 million and 10% in the prior quarter.

On a non-GAAP basis, the company reported net income of $13 million or $0.29 per diluted share in the second quarter of fiscal 2010 compared with $10 million or $0.23 per diluted share in the previous quarter, and $12 million or $0.27 per diluted share in the same quarter in the prior fiscal year.

Exchange rates negatively impacted operating margin in the quarter. If translated at the average rates in effect in the first fiscal quarter, operating income would have been approximately $1 million higher.

The company invoices in U.S. dollars and not in local currency, so the effect on exchange rate is limited to the cost of goods sold and operating expenses.

On a GAAP basis, net income was $8 million or $0.19 per diluted share in the second quarter compared with $4 million or $0.09 per diluted share in the prior quarter, an increase of 109% sequentially.

Turning to the balance sheet, cash, cash equivalents and restricted cash balance at October 31 were $143 million, an increase of $20 million over the prior quarter. Operating cash flow was $18 million, an increase of $8 million or 72% sequentially.

The quarterly cash flow can vary each quarter based on several factors including seasonality. Another way to measure cash flow that normalizes for any seasonality is using a trailing 12 month metric. Trailing 12 month cash operating cash flow was $58 million compared with $54 million in the prior year, an increase of 6%.

CapEx was $6 million in the quarter. $2.4 million was related to leasehold improvements for our R&D site in Waterloo, Canada which is not expected to recur. Accounts receivable decreased to $76 million, a sequential reduction of 6% primarily due to more effective collections process as well as a decrease in DSO to 57 days at the end of the second quarter from 59 days at the end of the first quarter.

Total deferred revenue including both short term and long term decreased sequentially to $133 million on October 31 from $135 million on July 31. Deferred revenue is composed primarily of unamortized support and maintenance contracts as well as inventory delivered to distributors but not sold through to an end user.

As we discussed in our Q1 earnings call, we’ve eliminated stocking rights for all of our distributors. Inventory delivered to distributors but not sold through has been accounted for in deferred revenue. Normalizing for the inventory change related to stocking rights, deferred revenue increased $1 million as of October 31 as compared to July 31.

The total value of stocking inventory remaining in deferred revenue as of October 31 was approximately $1 million compared with $4 million as of July 31. We expect the stocking inventory component of deferred revenue to gradually reduce to zero as the remaining stocking inventory is sold through by the distributors to end users.

Now, the restructuring program; first of all we remain on track to close the acquisition of F7 Software Solutions and we expect the transaction to close by the end of Q3. In addition, the restructuring program we announced earlier this month is also on track.

As noted in our previous call on November 5, we expect to reduce our cost base in the second half of fiscal 2010 commensurate with the 10% net head count reduction. The specific impact on our third fiscal quarter of the reductions and related transition is built into our guidance that I will articulate in a moment.

As a byproduct of the restructuring and related cost reduction we expect a higher likelihood we will deliver operating margin results in the achievement guidelines established for the company’s profit sharing plan for fiscal year 2010. The actual profit sharing plan was disclosed in an 8-K filed on May 1, 2009.

As a reminder, the profit sharing plan is calculated and accrued on a quarterly basis and it begins payout at a 15% non-GAAP operating margin percentage. Considering the impact of the profit sharing plan and pays out 100% at a 25% non-GAAP operating margin percentage.

The profit sharing is a worldwide plan and all employees with the exception of those on a commission plan are eligible within the guidelines of the plan. The dollar impact of the planned levels of head count articulated previously is $400,000 for every 100 basis points of margin. In addition, the plan is applied [ratively].

Turning to our guidance for the third quarter of fiscal 2010, we currently anticipate net revenue in the range of $121 million to $126 million. On a non-GAAP basis, we expect operating margin to be between 17% and 19% which translates to EPS in the range of $0.31 to $0.36 per fully diluted share at a tax rate of 30%.

The non-GAAP guidance includes the acquisition of F7 and those elements of our restructuring that will be accounted for within our non-GAAP operating results, primarily the cost of approximately 130 employees on transition during the quarter.

On a GAAP basis, we expect EPS to be in the range of $0.01 to $0.12 including the restructuring per fully diluted share count of approximately 46.5 million shares. The additional range in GAAP net income share is due to the variability of the timing of restructuring expenses.

This guidance is based on foreign currency rates effective as of this announcement and any material changes could impact the number provided herein.

Now let me turn the call over to Brian.

Brian NeSmith

I’d like to use my portion of today’s call to discuss some highlights of the second quarter followed by an update on the restructuring program that we announced earlier this month.

Our results show the value and continued strength of the market demand for our application delivering network, our ADN solutions. We offer unique differentiation in each of the major markets in which we compete, application visibility, LAN optimization and web security.

In North America, demand for our ADN solutions in both the U.S Federal and enterprise remain strong. As we’d expected, our Federal business was good, representing 13% of product revenue which was consistent with Q2 of last year and compared to 8% in Q1 of this year.

Recently we achieved the Federal Level 2 certification for our ProxySG product, meaning that it has passed stringent security tests. Looking ahead we believe Phips Level 2 will help Blue Coat expand its footprint in the public sector not only in the U.S. but all over the world.

Our results in EMIA was similar to the America’s with solid performance across all sectors and regions. Customer spending in Asia was mixed.

There were some great customer wins last quarter. In North America we saw significant 100 plus wins as Cisco Corporation a global leader in selling marketing and distributing food products to restaurants, health care and educational facilities. American Corinthian Colleges Inc. with over 100 post secondary locations across the U.S.

It’s worth noting that the Cisco Corporation deal was highly competitive and was a displacement of an existing competitor.

In EMIA the National Health Service N3 Network, the country wide system for health care providers across the U.K., uses our appliances to provide acceleration and optimization for more than one million users.

In addition, Electrolux, one of the world’s largest appliance companies uses Blue Coat appliances as part of a strategic initiative to consolidate, streamline and optimize IT across all company locations.

These customers are great examples of how we are growing market share and are able to differentiate Blue Coat from our major competitors. Recent reports from Foster confirm that we are either extending or maintaining our lead in the win optimization and secure web gateway markets.

Informatics second calendar quarter shows Blue Coat extending it’s lead in the WAN optimization market for the second consecutive quarter, increasing its market share to 31% in calendar Q2 from 24% a year ago. Informatics also found that Blue Coat remained the leader in the content security gateway appliance market for calendar Q2. Notably, we were the leader when Informatics first began tracking this market in 2007 and we remain the leader today.

Forester announced Blue Coat achieved the leading position in its Wave report and scored the strongest among the eight vendors it evaluated in the WAN optimization. Importantly, the report also states that Blue Coat appliances are one of the most user friendly offerings in this space.

The number of partner Proxy SG and PacketShaper appliances grew sequentially by 11% worldwide. In addition we recruited 50 new optimization partners in the quarter. Our focus is selling to strategic and large enterprise accounts along with our channel sales managers covering geographies for all other accounts has helped Blue Coat gain efficiencies in our sales organization.

Now turning to our restructuring program; the ADN market is continuing to grow. We realize that there is revenue opportunity beyond what Blue Coat primarily does today, traditional hardware appliances.

Customers want COG based services, software, appliance and hybrid combinations of all or any of the above. We believe we are positioned in this market to deliver the appropriate packaging that best addresses the customer needs whether it’s software, appliances our Cloud.

To take full advantage of these expanded market opportunities, we have realigned our engineering, product management and product marketing employees and resources and created progress focused on three different solutions; ADN appliances and software, carrier infrastructure and Cloud services.

First let’s talk about the ADN product group. This group will continue to expand our portfolio of appliance capabilities. Today we generate the bulk of our revenue from two appliances, our Proxy SG appliance and PacketShaper appliance. We intend introducing new innovative features in both of these appliances. They are our core platforms and they remain key growth levers for our business both from a revenue and a market share perspective.

Last week we introduced a new series of ProxySG and ProxyAV appliances. New threat analysis technologies in our Cloud based web service and extended protection for remote workers through our ProxyClient product, collectively expand Blue Coat’s hybrid secure gateway solutions.

The hardware and software innovations in our ProxySG 9000 series appliance results in a 5X performance improvement over existing appliances. With this boost in performance, customers can support up to 60,000 users with a single appliance, thereby reducing rack space and power requirements.

The ProxySG appliances are backed by the collaborative Cloud defense from our service and provide the latest protection against web based threats without requiring patches, upgrades or new equipment deployment.

Our ADN product group is also focused on our expansion of virtualized software offerings which we intend to introduce in the first half of 2010 calendar year. As part of our virtualization strategy, we are working together with key technology partners including VM Ware to identify synergies that will create all unit expansion opportunities. These OEM relationships may include software or [blade] versions of our appliances.

Turning to our carrier product group, we have identified many emerging trends in the carrier environment that represent significant growth opportunities for Blue Coat including the explosion of internet traffic, continued growth of broadband and mobile users, the richness of content and the deployment of web applications.

These market trends are leading to a flexing point for carriers. They must decide whether to scale bandwidth or to revisit caching technology as a cost effective way to scale service delivery.

Importantly, Blue Coat has a rich history in the carrier market from our days in cache flow and currently have an installed base of over 150 carrier customers worldwide. Going forward, we plan to leverage our market leading caching technology and introduce new products that will help carry, contain and manage payment costs, scale service delivery and drive new sources of revenue.

Finally, turning to our Cloud services group, we see the Cloud services market as a very large untapped opportunity that we at Blue Coat can target with our own Cloud service. Cloud services are becoming a favorite alternative for certain segments of the market, in particular, the mid market.

We’ve additionally invested in Cloud based services with our Web Pulse service offering. This is a collaborative Cloud service that supports over 62 million users, helping protect against different types of web content and threats.

In summary, we currently have projects under development for virtualized, OEM and Cloud based offerings. Over the coming year, we will announce new products and capabilities as OEM routes to market.

Turning to another area of the company affected by our restructuring program, we made changes in our services and support organization that mirror our sales model. We now have reps focused on strategic large enterprise and mid tier market accounts.

We also collapsed tiers of support within the organization so that the higher skills are brought to bear more rapidly in technically challenging customer cases. In addition, support for strategic accounts will now be handled by a team of product specialists and will receive priority based routing.

Overall, these changes will allow us to better handle complex multi product customer situations and should drive increased profitability.

In closing, we remain committed to a healthy balance of top line growth, operating leverage and investments for the future. With our recent restructuring, we believe we are putting into place a business model that can support growth as well as greater operating leverage while at the same time allowing us to strengthen Blue Coat’s market lead and invest in our strategic growth opportunities.

With that, I would now like to turn the call over to Jane.

Jane Underwood

That concludes today’s prepared remarks. Before opening the call to Q&A I’d like to remind everyone that Blue Coat will be holding an analyst day event on Monday, December 7 starting at 12 pm Pacific time at the Marriott. Registration for the event is on the investor relations event calendar portion of our website. The event will also be webcast.

We’d now like to open up the call to your questions.

Question-and-Answer Session

Operator

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

Troy Jensen – Piper Jaffray

Looking at the guidance out of you and Riverbed, it seems like the WAN optimization guidance seems to be below that of other companies in the IT space. I’m wondering if you could touch on that, if you think the space is maturing a little bit or what would cause the growth rates to be lower here than we’re seeing in other categories.

Brian NeSmith

You mean the growth in WAN optimization versus other indications categories?

Troy Jensen – Piper Jaffray

I’m just looking at the sequential growth rates that you provided and your competitor provided. It seems to be below that, kind of other segments that we’re seeing.

Brian NeSmith

I’m not sure I have any good insight. We look at the pipeline. We look at the opportunity flow. I don’t know whether in one particular quarter we could draw a trend on that fundamentally changing the nature of the market.

I know that from our perspective, we sell solutions that are generally are optimization and we more focus on broader application delivery so it’s hard for me to draw contrast depending on which competitor you’re comparing it to.

I still think we’re growing faster than the market and I still think the market is relatively untapped but in the end, what happens in any one quarter is a little bit hard to call to pinpoint a contrast to everybody else.

Troy Jensen – Piper Jaffray

When you look at your OpEx guidance here for Q3, I’m curious to know how much of these cost cuts are implied in Q3. Is there going to incrementally lower cost structure in Q4?

Gordon Brooks

Actually one of the reasons I point out the fact that we have 130 people who are in transition, we bear the cost of those until those folks are through the actual system. That will happen through Q3 and Q4. So obviously I wouldn’t provide any guidance going into Q4 but those reductions will continue to happen throughout the quarter.

Troy Jensen – Piper Jaffray

Can you give us any insight with what revenue level would you need to reach a 25% operating margin assuming 75% gross and the new cost structure?

Gordon Brooks

I don’t have that but I think the math is actually pretty simple. If you take a look at our cost structure and you assume that the additional revenue would fall to the bottom line, it can give you pretty easy calculation as to where that would be.

Operator

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

Ryan Hutchinson – Lazard Capital Markets

On the guidance, can you help us understand what percentage of the quarter was government specifically and then as it relates to the guidance, what’s that take into account in terms of a decline in the government business, and then obviously the seasonality in the month of January?

Brian NeSmith

The government business is roughly 13% and we would expect the government business to return to its normal kind of 7% to 8% in the quarter. But it’s fairly typical for us. I don’t view that as something different that occurred even in the previous five years. I think we’ve generally seen a surge in fiscal Q2 around government revenue. So I don’t know that there’s really much of a change there.

As far as seasonality and other aspects of that, historically Q3 and Q4 are generally stronger quarters for us partly because we get a calendar year end and we get a calendar year beginning matched up to most of our customers and in Q4 we get obviously our sales competition clients incentives for people driving to try to maximize their commission payoff and accelerators as they hit that last fiscal quarter.

But how that compares in the different segments, I’m not sure there’s anything I can really point out that’s anything special here. We do the forecast and guidance that we give basically consists of we look at the pipeline. We understand what we think the close rates are going to be and we factor that down and that’s how we basically provide the guidance.

But nothing has really changed in the model of how we’re doing and how we’re providing the guidance.

Ryan Hutchinson – Lazard Capital Markets

So no change in the assumption on close rates versus prior quarters.

Brian NeSmith

No. I think the range that we’ve given you basically includes pretty much the last three or four quarters of historical comparison, not obviously a long term historical view, but a short term historical view, those close rates are consistent with what we’re seeing there.

Ryan Hutchinson – Lazard Capital Markets

On the OpEx, just a better understanding by line item maybe if you could drill down a little bit deeper on guidance where we should see the biggest changes in terms of a decline here on an absolute dollar basis.

Gordon Brooks

I think as we pointed out on our call in November, the majority of the head count in transition is hitting our R&D lines and our support lines, the cost of support lines, so the changes that you’ll see going into Q4 and Q1 will primarily impact those lines, offset a little bit by the acquisition of F7 and the additional R&D folks that we’ll bring in there.

From a sales and marketing standpoint, and G&A, most of that will have worked itself out within that guidance, so down a little bit, again offset by the profit sharing. But really the change you’ll see over the next couple of quarters is the bleed out of the folks in transition through R&D and the support line.

Ryan Hutchinson – Lazard Capital Markets

On PacketShaper, just the expectations there was down $2 million sequentially. You’ve referenced in the past you felt fairly comfortable with $20 million, $25 million, $26 million run rate both in product and service combined. Is that still a fair assumption?

Brian NeSmith

The hard part that you have to break out when you look at the PacketShaper revenue in general is what amount is Packet tier revenue that would have been maybe ends up being ProxySG revenue. So I feel comfortable with we’re getting the result of the acquisition that we were looking for.

What exactly happening with PacketShaper revenue, it’s probably a little lower than we would have liked or expected in the quarter. I don’t think it’s hugely so, but I think we’ll continue to see a slight deterioration in that business, probably a little more than we expected, but that’s being offset by us having greater success in ProxySG situation through that form Packet tier channel.

If you look at just pure PacketShaper revenue, it’s probably a little bit more than we hoped for.

Operator

Your next question comes from [Woojin Ho] for Tai Liani – Bank of America.

[Woojin Ho] for Tai Liani – Bank of America

With the restructuring as well as the new go to market strategy for carriers as well as Cloud services, how do you minimize the disruption in your sales force in order to execute on your long term strategy?

Brian NeSmith

Some of the disruption is there on purpose. I think it’s how you manage change. The first thing is we made changes about a year and a half ago that affected how we go to market where we split our sales teams into one focused on strategic, a separate group focused on large enterprise and a third group broke out into geographic coverage.

The bulk of the change that was affecting our sales organization was driven along that front. In recent history we’ve had some carrier overlay sales people that were dedicated to just the carrier part of the organization. What we’re doing going forward is taking that overlay and making it more of a direct selling type role where they’re going to be handling the carrier customers.

The business unit that we talked about is building a new product focused on the core of the carrier infrastructure. Actually each of the business units will probably still sell the carrier, so it’s not we’re going to have one business unit exclusively selling products to carriers.

We haven’t introduced that product yet. I don’t think it will be disruptive in the majority of our organization. It’s mainly going to offer a new product for those carrier sales people that are focused on the carrier environment.

As far as Cloud services and how that might be disruptive, it’s partly disruptive in the sense that it’s expansive and it opens up new market opportunities. We don’t focus on the end market. We don’t have a lot of activity in the S&B market and we see Cloud as extending our ability to be able to compete in that environment.

We also think that by building hybrid combination of appliance, software and Cloud, we’re really just expanding the portfolio. It’s clearly incumbent on us to do the training, to explain the positioning, to help our sales force and help our channel partners to position that properly, but we have made a lot of investments and we continue to make investments in being able to do that.

We always look at the complexity of selling both acceleration and security at the same time with added visibility to that equation over the last year, so I don’t think what we’re talking about here is going to make our life that much more complex.

[Woojin Ho] for Tai Liani – Bank of America

In terms of the channel was there any disruption during the quarter to cause the down tick in product revenue in the quarter?

Brian NeSmith

On a sequential basis, I think product revenue was up, so I’m not quite sure what product revenue you’re talking about. I think to answer the question in broad terms is one, first of all based on what we stated, that product revenue was actually up. You compare it to a year ago it was slightly down, but I think we all realize that Q2 last fiscal year was a bit of an anomaly coming out of the acquisition.

You look at the six to seven quarter trend; I think you’re seeing generally with this quarter now, we’re kind of getting back into the product area which is where we want to be obviously.

Operator

Your next question comes from Jonathan Ruykhaver – ThinkEquity Partners.

Jonathan Ruykhaver – ThinkEquity Partners

Can you elaborate a little bit more this web pulse hosted security service? How is it differentiated relative to web security services that are sold by the likes of Cisco, Barracuda? And then how do you envision monetizing that offering as you start to deliver more Cloud based services. Is it just something that’s going to help drive more appliance sales or is there a stand alone subscription opportunity as well?

Brian NeSmith

The first part is we have an existing Cloud service we call Web Pulse and we sell that. It augments obviously the ProxySG that we have now and we both have an upfront component that we sell as well that’s a piece of that.

I think as we go forward, the hard part for me to contrast what you’re seeing from some of the start up programs out there versus what we’re doing. Since we haven’t given you the details of what we’re doing I can’t make a contrast.

Suffice it to say that I think anybody that knows me from a product standpoint, I’m not generally interested in introducing a me too product or something that doesn’t provide differentiation or value in the market, so I just encourage you to look as we do provide the details and make the specific product announcements.

I think we see things we can differentiate on. We believe there are areas and deficiencies around some of our competitor’s products where we can add value.

As far as how it will be sold, we think primarily view it in two ways. One is augmenting our install base and using Cloud based capabilities what we do with Web Pulse but even more than that to add value to what the ProxySG appliances provide to our customers.

The second part is expanding the available market. Today we don’t in many cases try to compete in the mid market. We don’t try to compete in the S&P market, and I think with both the software solutions as well as the Cloud based solutions, I think we’re going to be able to compete there.

I view that as really an extended market opportunity for applications of our networking, obviously delivered differently than the appliance but developed with the expertise, the understanding, the history, the context of what we know having been in this market for ten plus year and all the experience that we’ve developed as we sold appliances. We just see these as different ways of delivering that value proposition.

Jonathan Ruykhaver – ThinkEquity Partners

Is it a pretty safe assumption to make that you’re going to probably utilize that Cloud based platform to drive into a new segment of the market? I guess you’ve already alluded to that in terms of the mid market and the potential of the S&B so if that’s the focus, we should see some other appliances around products be introduced over time that support the S&B market requirements with Web Pulse?

Brian NeSmith

We’ll see. If you think in the large enterprise, even if we introduced a new high end appliance, the 9000, so that reinforces what we’re doing in the large enterprise. We introduced two new ProxyAV platforms that really improved the price performance level that we see in the larger enterprise environment.

I think for the small part of the S&B market, it’s probably going to be mostly Cloud based capability. As you go into the mid market, I think it’s probably going to be hybrid combinations of appliance and Cloud tied together.

That’s one of the things we think is going to uniquely differentiate us is our ability to deliver those hybrid based solutions and allow customers to pick and choose and really leverage the strengths of appliance, the strength of software and the strength of Cloud in a way that are now necessary in their environment.

I think broad thing is, I primarily view what we’re talking about here as ways for us to expand our market opportunity beyond appliances through software products.

Jonathan Ruykhaver – ThinkEquity Partners

I think you mentioned that Packet tier services revenues, was it $10 million or $11 million?

Gordon Brooks

$10 million.

Operator

Your next question comes from Anthony Carbone – Auriga USA.

Anthony Carbone – Auriga USA

Just duck tailing in line with the question with respect to seasonality, I’m trying to reconcile. You had a very strong Federal quarter which you normally do and you generally see a tick down there. You’re guidance is somewhat in line with what I would normally expect from a seasonal perspective. However, your commentary with respect to the product introductions, also while I don’t know if you commented directly, virtually every competitor and most of the self site surveys have come back pretty much stronger than expected. So I’m just wondering is there a take here. You mentioned Asia pack being a little weaker. Is there something else compensating to provide the normal seasonality in light of the upgrade cycles and the stronger U.S. enterprise?

Brian NeSmith

It’s almost similar to the earlier question about how we’re comparing to other industry segments. I think it’s hard to compare them. I think the macro economic cycles aren’t having the same effect on everybody in exactly the same way in what we’re looking at.

Normally what we see from Q2 to Q3 is strong Federal push in Q2 and we get a stronger enterprise push as we go into Q3 and into Q5. But there’s not that much seasonality in our business. This is a part that I think it’s worth reiterating here, and we somehow got on a seasonality discussion.

Seasonality for us is I think primarily a fiscal Q4 phenomenon, and the Federal sector is a Q2 phenomenon. But in general, we haven’t found ourselves in a kind of similar seasonalities that a lot of other companies have done. For us historically, Q3 and Q4 are generally a bit stronger than Q1 and Q2, so from that perspective there’s a bit of that but not even to draw a trend I’d be reluctant because I don’t think there is one if you look through our history with the strong kind of seasonality quarter to quarter.

Generally as a result, we look at the pipeline. We look at the close rates and we do a lot of work through the forecasting process and our sales organization to develop our forecast, and less do we depend on seasonality, macro economic view of activity to try to understand what we think we’re going to do from a revenue standpoint.

So the thing I’d point you to like we’ve done time and again, we look at the pipeline. We look at the close rates. We forecast by how we think the business is going to go and that’s how we drive guidance. And the seasonality, it’s hard for me to connect to dots between what everybody else is talking about the way the seasonality and the macro economic factors as to what our particular condition is.

I also think you have to add to that, is where a lot of other companies have been sequentially down over the previous year, we have generally not been, and so our recovery as we come out of this period may not be quite as strong as other people because I think they’ve been a lot more essentially down than we have been over the past year.

But again, that’s more of a educated guess or comment than it is ability on my part to draw a macro economic linkage as to how we do our forecast and our guidance.

Anthony Carbone – Auriga USA

Based on the destocking of distributors, a couple of quarters ago many of the other networking vendors had kind of mentioned this, though the context they’d mentioned it was more with respect to the credit crisis and they had said they had seen this destocking, they expect that as credit condition improve that we would see a restocking. Should we think of this as mean reverting or that this is kind of a one time phenomena that’s impacting?

Gordon Brooks

I think over the last couple of quarters the company started the endeavor to remove the stocking rights and they will be almost materially bled out of the system at this point in time. So I don’t see it as a unique item for the quarter. It will be continued through the fiscal year, just having eliminated those stocking rights.

I think what it does is it changes the complexion of a couple of elements in the balance sheet as far as apples to apples compare on the deferred revenue, but then in addition it allows us really that greater visibility because we don’t have inventory sitting out at distributors that we may not know when they are being sold through or not until the last moments of the quarter.

So I think behaviorally it allows us much more visibility into our pipeline in the leading up to the end of the quarter and I think that that, along with the complexion of the balance sheet, that behavioral change is what we wanted to emphasize over the last couple of quarters.

Anthony Carbone – Auriga USA

You said if it had not been for the destocking, your deferred revenues would have increased by about $1 million. Is that correct?

Gordon Brooks

That’s correct.

Anthony Carbone – Auriga USA

And then respect to, you said that your earnings were impacted by currency transitions. Do you do currency hedging right now?

Gordon Brooks

We do not do currency hedging. And just a clarification there; we do not invoice in local currency so that risk is completely on the expense side of the business. For me it’s just an ability to call out to everyone, number one what the impact is within the period, but also when we do do our guidance, we’re assuming certain rates and just so we’re all clear on the apples to apples when we’re putting our guidance together.

Anthony Carbone – Auriga USA

What did you say the CapEx for the quarter was and how should we think about CapEx going forward?

Gordon Brooks

The CapEx was $6 million in total. Generally we run between $3 million and $4 million a quarter which is why I noted that we had about $2.4 million related to a leasehold facility in Waterloo, Canada that is obviously done and we don’t expect to recur. But I would expect that to return back to our normal amount.

Operator

Your next question comes from Erik Suppiger – Signal Hill Group.

Erik Suppiger – Signal Hill Group

On the stocking inventory that was sold during the quarter, that’s all recognized on a sell through basis so there’s no reason to adjust for that in terms of looking at your normalizing your revenues, is that correct?

Gordon Brooks

That’s correct. The company has always recognized revenue on a sell through basis, the amount that was sold in but not sold through would have been accounted for in deferred revenue which is why that line is being impacted.

Erik Suppiger – Signal Hill Group

You don’t have anybody that you recognize on a sell end basis at this point do you?

Gordon Brooks

That is correct. We do not and we have not.

Erik Suppiger – Signal Hill Group

On the service provider product, how much of your business currently comes from service providers today?

Brian NeSmith

You have to be careful. We sell a couple of different uses of our product. So we sell, and it really varies dramatically in any one quarter, but we sell into the carrier infrastructure. This is a link between the carrier and the back load internet and this really dates back to 1999/ 2000, is one of the big value propositions that we sold to.

That is the new business unit, is focusing on that value proposition. The ADN business unit sells product into carriers where it’s sold as a managed service or sold as a capability where they basically install the products for the customer and run the products for the customer in a variety of different ways, not just managed services.

We also have some sales into some mobile operators into some ISP for providing filtering services as well. You add all of those up, it can get in any one quarter, it can be as much as 15% to 20%. If you look at the core carrier market, it tends to be 2% to 3% and as high as 7% to 8% in a particular quarter, but it really swings wildly because when a carrier buys for their core infrastructure, they tend to buy a lot and then they don’t for several quarters.

Erik Suppiger – Signal Hill Group

When you say core, did you say they’re typically using it as a caching device?

Brian NeSmith

Yes, primarily caching and what we call country based offering.

Erik Suppiger – Signal Hill Group

On the second scenario, the managed service, are you going to have a conflict with offering a Cloud service and also selling new service providers that are offering a managed service?

Brian NeSmith

I think the best way of looking at it, I think it’s fair to say if you look at it one way, but the political way to answer this question is we’re going to service the customers in whatever is the best way they want to be serviced.

But the answer is yes, there’s going to be some overlap just like we have among some of our existing channel partners where we get some overlap in different solutions. Some who buy managed service, if they have concerns about privacy or the integrity of their data or other items, Cloud service may not meet their other feature requirements, so the managed service I think is going to be a feature set and more capable.

There’s going to be a full set of capabilities where the Cloud service may in some ways have different limitations or maybe be more simplistic configuration targeted at the mid market.

Erik Suppiger – Signal Hill Group

How big is the sales force that you currently have for your service provider team.

Brian NeSmith

I think at last count I want to say there’s roughly seven to ten overlay sales reps. I can’t give an exact count. There’s a few of them that in certain countries where we don’t have overlay but there’s a substantial portion of our sales is carrier, so it’s on the order of ten, a little bit less than that.

Erik Suppiger – Signal Hill Group

Would that be growing as you introduce the newer products or is that probably where you hold it?

Brian NeSmith

I think early on it will probably stay at about that number, but depending how successful that product is, obviously we’ll grow in response to that. But early on I don’t think we feel a need to make a big investment or really any kind of incremental investment to take that product to market.

Operator

Your next question comes from Rohit Chopra – Wedbush Securities.

Rohit Chopra – Wedbush Securities

I want to get a sense of how big web filter was this quarter.

Gordon Brooks

From a product standpoint, it was $6.4 million in product revenue for Blue Coat web filter.

Rohit Chopra – Wedbush Securities

You mentioned some WAN eval’s last quarter. I thought maybe you could talk a little bit about where you are on the WAN only side this quarter. Are you working with any systems integrators right now to get deeper into Telco’s? I know you have relationships there but are there other people or maybe some people you could mention that you’re working with?

Brian NeSmith

We do a fair amount of work with system integrators. I don’t think in most cases they actually go after carriers. We do work with some system integrators, mainly focused on large enterprise and we do some work with specific integrators with the Federal market. I think there’s two or three that we focus on, but we do a lot of business with ES, with IBM, with HP and different market segments in different parts of the world, but not focused on carriers.

Carriers generally have been more of a direct touch type of relationship. We fulfill through distribution partners, but is a very direct touch relationship with most of our carrier customers.

As far as our tier one optimization revenue, it’s still a relatively small number overall. It actually grew reasonably well this past quarter, but still a relatively small number. A lot of that goes to we obviously are emphasizing to our potential customers the idea of the application network is a second generation optimization solution.

If you just want to do steps, if you just want to deal with storage and email, that’s fine, you can buy any number of different competitor solutions. But if you want to deal with video, you want to deal with CDN’s, you also want to get security and acceleration, if you want to get a better understanding from a visibility perspective.

As we emphasize any one of those elements in the application delivering network storage and capability that we offer, we up sell customers to that, and I think we’re very successful in doing that as we illustrated in the market share gains we’ve seen over the last year.

But the answer specifically to your question, our pure WAN op revenue as defined by just storage acceleration and general acceleration is I think less than a couple of percent of our overall product revenue.

Operator

Your next question comes from Richard Sherman – MKM Partners.

Richard Sherman – MKM Partners

I had a question about the guidance and maybe back to this Packet tier question. In terms of your guidance were you assuming about a $23 million contribution from Packet tier products and services in your guidance now looking ahead to 3Q?

Gordon Brooks

I don’t think it’s quite that high. We haven’t broken down the guidance into that specificity by product.

Brian NeSmith

What’s worth highlighting coming out of here, is there’s situations where even in our forecast somebody may be anticipating a Packet product, and then we also end up as we understand there are requirements that are selling them across the SG. Or vice versa, we have a PacketSG forecast and we find out it’s mainly an issue about visibility or delivering appropriate capabilities for voice and video.

Personally, I don’t really care if they buy ProxySG or PacketShapers. As long as they’re buying from Blue Coat, we’re happy with that. But I don’t actually know that actual breakdown on that forecast. I don’t think we’ve broken down the guidance from a standpoint of PacketShapers versus ProxySG.

Richard Sherman – MKM Partners

So maybe just bubbling up at the higher level, in terms of the guidance next quarter, are you expecting PacketShaper to be an additional negative from their direct contribution when you think about that guidance, when you look at that pipeline and double that up to a guidance number. Are you assuming that Packet tier revenue, is that at or around these current levels or are you thinking that would be down sequentially from where you are on a product basis?

Gordon Brooks

Since I haven’t forecasted it or broken it out, I actually couldn’t tell you directly one or the other. I think it could go up slightly. I think it could be down slightly. I don’t think it’s going to move a huge amount one way or another.

Richard Sherman – MKM Partners

Could you talk about how business was in the U.K. and maybe also then provide some color on the large transactions, the million dollar deals, kind of the vertical market and the geographic dispersion of those.

Brian NeSmith

The U.K. business was actually very good business so I don’t know if there’s much else I can add there. Europe in general performed very well. We know that France and Germany remain strong, but we also say I think in general across Europe, we had a good business everywhere.

As far as the large deals, we highlighted five over $1 million but none more than $5 million. In general these tend to be I think, four of the five were large enterprise and I think one of them was a carrier customer. So I think when we broke it out we highlighted a couple in the U.S. and I’m not sure how many were in Europe.

But it’s spread out. I think we made clear about this before. You have to be careful. When we look at our forecast, we’re a little more cautious when we get to big deals because they create some lumpiness in the business, but this is fairly typical for us, having this many deals of this size.

If you look at the pipeline you see similar sorts of things that we can look forward to in the future.

Gordon Brooks

I think one of the ideas of breaking out this metric this way is to show that this quarter wasn’t due to extreme lumpiness from big deals, that it was relatively consistent over the last four quarters.

Richard Sherman – MKM Partners

In terms of the costs on the support side coming down, you were talking about earlier in the call. I’m trying to figure out how much is coming out of cost of goods sold. Are you talking about lower services related to technical support and help desk lines for your customers or are you talking about lower sales engineering costs?

Gordon Brooks

I think the former. We talked about the fact that one of our focuses coming out of the restructuring is to bring those support margins, cost of service margins back up to where we feel they are in line with the competition. So it’s really in the cost of goods sold area that you would see that continued improvement.

Operator

Your next question comes from Alex Henderson – Miller Tabak.

Alex Henderson – Miller Tabak

Did you provide a book to bill number for the quarter?

Gordon Brooks

We have never done it and we did not do it this quarter.

Alex Henderson – Miller Tabak

Can you give a sense of what the deal processing length looks like? Do you see any stretching out or contraction in the amount of time it takes to do transactions?

Brian NeSmith

We don’t track it in an analytical sort of way but anecdotally I didn’t notice anything.

Gordon Brooks

There’s no difference from Q1.

Brian NeSmith

It’s been generally consistent over the last three or four quarters.

Alex Henderson – Miller Tabak

And the closure rates. I know you made a comment on it. Could you just reiterate? Your closure rate in the quarter sequentially were comparable or improved?

Gordon Brooks

They were a little better than the previous quarter.

Alex Henderson – Miller Tabak

But in your guidance you’re assuming the same level as the current quarter.

Gordon Brooks

We assume a range because obviously we give a range of guidance. The pipeline number we know and the range comes from what we think the closing rates are going to range between.

Alex Henderson – Miller Tabak

The guys over at Cisco have opened up an opportunity for a lot of the small players in the space by basically poking IBM, HP and Dell in the eye with their decision to compete with those former partners of theirs. Have you seen a change in your system integration revenues and sales through those three partner channels?

Brian NeSmith

We have but not for the reasons I think you highlighted. I think prior to Cisco’s announcement of trying to get into the service side of the business, or in certain parts of the data center infrastructure, we have always been cultivating, and we knew as our business grows we got more strategic with certain customers, that business was going to become more through systems integrators, and I think we’ll see continued growth for exactly those reasons.

Alex Henderson – Miller Tabak

Can you give us a sense for what the scale of the revenue stream from those type of partners are?

Gordon Brooks

I don’t know off the top of my head actually what it is, so it’s probably indicator of how it’s not a significant piece of what we’re doing right now.

Brian NeSmith

You have to be careful because what we do is, when we talk about different routes to market and how we serve customers, we generally look to be fairly channel neutral for our different partners. So a particular partner may have a special relationship with a customer and they have a special account or capability or special geographic focus, and that can then dictate the situation as opposed to broadly speaking strategic use of system integrators versus resellers versus carriers, that sort of thing.

I’d say we’re more focused on the former and finding the particular situation that drives things to something strategic at this point in time.

Alex Henderson – Miller Tabak

Is there any plans to expand the efforts in that arena to take advantage of the opportunity that’s been lent to people that used to compete with Cisco?

Brian NeSmith

I’m not sure I would agree with the statement that there’s an advantage for it. I think that we do see expansion in the systems integrators but not really due to anything of what Cisco’s behavior has been at this point. I think it’s primarily there are certain enterprises that want a relationship with one organization on a worldwide basis, and in that particular case we tend to find systems integrators are more a part of the equation.

As we’ve gotten more strategic and we’ve gotten broader geographic deployments, I think we found that systems generators integrate our relationship growing in importance but just gradually over time I see that trend continuing. But I don’t think anything to do with Cisco.

Alex Henderson – Miller Tabak

Any sense of change in linearity over the course of the quarter?

Brian NeSmith

No.

Alex Henderson – Miller Tabak

I think earlier on the call a number of people have been asking questions about relative performance and obviously you don’t really want to talk to what other people are doing, but as analysts we’re always forced to compare them. I look at your comps, Riverbed at 5, Cisco, Juniper’s Enterprise business, just to give you a sampling of their results, 11.9% growth at Riverbed, Cisco at 5.7%, Juniper’s Enterprise business up 10%. And you’re up 3.8%. I think that’s why some of the people are reacting the way they are to the growth numbers. And then the guidance is 3.7%, 2.5%, 2.5%, and yet your guidance is .5% to 4%. You’re a little less growth than the prior quarter. Their book to bill is all above one, and you’re a little bit less guidance on the fourth quarter. Why the discrepancy in the rates of growth there? I would think you’d be gaining some share given the strategic moves you’ve done.

Brian NeSmith

You have to be careful just looking at one quarter and then another quarter snapshot. You need to look at these numbers over the previous year. Look at Cisco’s numbers. Look at Riverbed’s numbers. Look at Juniper’s numbers and their enterprise business and they’ve been sequentially down in several quarters.

That being said, it’s just impossible for me to compare. It’s just not an apples to apples comparison. We’re in different market segments. Maybe with Riverbed for one portion of our business we’re probably most comparable, but in every other case we’re just a completely different company. I just wouldn’t be able to draw a broad comparison.

Alex Henderson – Miller Tabak

Obviously a big part of this story is margin expansion. Can you give me an idea of what you think your target structure would look like longer term in terms of the three operating expense lines assuming your gross margins don’t change much? What kind of margins are we targeting here?

Gordon Brooks

I think we were pretty clear on the call on November 5. We’re not giving longer term guidance at this point in time, but I think with the data that we have provided through the fiscal year of how many folks are in transition and our revenue expectations that the arithmetic around those margins is pretty clear.

And expansion beyond that time frame is really contingent at this point in time on continued acceleration of revenue.

Jane Underwood

I think that’s going to conclude our question and answer session.

Operator

Do you have any closing remarks?

Jane Underwood

I’d just like to thank everyone for joining us for today’s call. A replay will be available at 800-475-6701 beginning on November 24, 2009 at 5:00 pm Pacific. An audio archive will also be available on our website. Have a great day. We look forward to speaking with you again.

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