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Executives

Steven Wideman – IR

Doug Garn – President & CEO

Scott Davidson – SVP & CFO

Vinny Smith – Executive Chairman

Analysts

Abhey Lamba – ISI Group

John DiFucci – JP Morgan

Tim Klassel – Thomas Weisel Partners

Derek Bingham – Goldman Sachs

Phil Winslow – Credit Suisse

Quest Software, Inc. (QSFT) Q4 2009 Earnings Call Transcript February 2, 2010 5:00 PM ET

Operator

Good day and welcome to the Quest Software fourth quarter 2009 earnings release conference call. Today’s conference is being recorded. With us today are, Vinny Smith, Executive Chairman, Doug Garn, Chief Executive Officer, and Scott Davidson, Senior Vice President and Chief Financial Officer.

At this time, I would like to turn the conference over to Mr. Steven Wideman. Please go ahead, sir.

Steven Wideman

Thanks very much, and thanks for joining our call for the fourth quarter that ended December 31, 2009. Scott, Doug and Vinny are here and will give some thoughts on the quarter that ended and we will open up the call for our Q&A.

The call is being webcast today from our investor relations Web site and you can get a copy of our press release that we just issued on this Web site as well. We offer replay on this call and on this site and instructions will be noted in our earnings release.

At this point, let me turn really briefly to our Safe Harbor statement. Some of the statements we make today may be considered forward-looking including statements regarding our anticipated revenue and operating margins and future periods and other statements about our plans, prospects and strategies.

These statements as well as a number of risks and uncertainties that could cause our actual results to differ materially is also noted these forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events.

Please refer to our SEC filings including our Annual Report on Form 10-K for the year that ended December 31, 2008, our first, second and third quarter 2009 reports on Form 10-Q as our Q4 earnings release as well. For more detailed description of the risk factors that may effect our results. Copies of these documents can be obtained from the SEC at sec.gov or by visiting the investor relations section of our Web site.

Also, please note that certain of the financial measures we will use on this call such as EPS, net income, operating margins and operating income are expressed on a non-GAAP basis and have been adjusted to exclude various charges, including the after-tax effective amortization of intangible assets acquired with business combinations, share-based compensation expenses, acquisition-related costs and expenses and litigation loss provisions associated with the pending settlement of the shareholder class action litigation 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 Web site at quest.com.

And with that it’s my pleasure to turn the call over to Doug.

Doug Garn

Thanks, Steven. Good afternoon, everyone, and thank you for joining our earnings call. I’ll first review our Q4 and fiscal 2009 results at a high level and then cover what we saw in the quarter and give a sense of what we expect going forward.

First, our financial results. Q4 was a strong quarter with license bookings increasing slightly year-over-year after four quarters of year-over-year decline. Maintenance renewal bookings were also very solid. Total revenues in Q4 2009 were $194.5 million, a 14% increase sequentially from Q3 of this year, but down 4% from Q4 of 2008.

Total pro forma expenses in the quarter of 146.2 million were down 2% from Q4 of 2008. Pro forma operating margins were 25% and pro forma operating income was $48.3 million.

For the full fiscal year 2009, total revenues were $695.2 million, a 5% year-over-year decline. We reduced expenses by 10% in 2009 to 539.6 million resulting in 2009 pro forma operating margins of 22.4% compared to 18.5% last year. The substantial margin improvement drove pro forma operating income up 14% to $155.7 million for the full fiscal year.

I’m very pleased with our employees hard work this past year to deliver these higher operating margins and income in the face of a very difficult environment. As usual, Scott will review the financials in far greater detail here in a moment.

Let me provide an overview. 2009 marks my first full year as CEO. I became CEO in October 2008. The last five quarters have been challenging as we have been finding major economic headwinds. Managing expenses and reducing the head count while necessary are not the activities that excite our management team. We do, however, get excited about delivering great products, growing market share and building businesses.

Given that for 2010, our plan is to grow the business by expanding in our core markets, leveraging cross-selling and developing or acquiring new and innovative solutions for our customers. This should lay the foundation for future growth and profitability. At the same time, we will maintain a focus on expenses and do not intend to compromise our operating margins to achieve our plans.

At a high level, we are a product-driven company. When looking at key areas for growth this year there are several areas I would like to highlight. First, our market soft active directory management products. In 2009, these products revealed relative strength and we believe that as the market leader, our continued investment will focus on expanding that position via new and enhanced products and functionality. A key element of our AV strategy is encapsulated within the Quest One Identity Management Solution.

We believe identity management and user provisioning are deep markets that are right for newer, simpler approaches. Even with tight budgets, customers are spinning more on security and compliance solutions.

Another opportunity for growth is virtualization, both at the desktop, VDI and at the server level. On the server side, via vision core, we are the market-leading independent software vendor and our VDI solutions are considered some of the most technically elegant within the industry.

The markets for these products are growing rapidly and we are working to position our portfolio to capitalize on this opportunity. Foglight, yes Foglight, could have a break-out year in 2010. We believe Foglight is very competitive with the leading next-generation application management products and have made great strides in getting the Foglight message out to industry analysts and other experts. Foglight’s applicability in both physical and virtual environment is a real differentiator.

You will also see us launch initiatives that will support cloud computing, SaaS and building upon our recent acquisition of Pack and Track [ph] which will allow us to move more aggressively and pursue opportunities surrounding the mid-market.

Now, let’s discuss our license revenues on a regional basis or on a geographic basis. North American operations contributed 65% of total revenues and the rest of the world contributed 35% of total revenues in the quarter as compared to 64% and 36% last year.

We saw year-over-year license bookings growth in our North American commercial larger accounts and our North American public sector operations. European operations again were week with year-over-year declines in the UK and continental Europe. Asia-Pac performance showed slight growth in license bookings, Australia and India were the standout in terms of license bookings trend.

Now, let’s talk about our transaction data. We completed 261 deals over $100,000 in Q4 '09 as compared to 219 deals last year, a 20% increase. The average deal size of over $100,000 deals increased slightly to 261,000 from 257,000 last year. We had eight deals exceed the million dollar mark versus eight in Q4 of '08 with the average size of a million dollar transactions and over deals decreasing to 1.28 million from 1.46 million last year.

We continued to see greater revenue contribution from $100,000 and over deals in Q4. The greatest year-over-year dollar increase was in the $100,000 to $500,000 deal band. The year-over-year decline in sub $100,000 transactions was not as bad as we’ve experienced in the previous three quarters, which was a positive.

Now, let me talk about our service revenues. Our service revenues contribution remains consistent with maintenance and support revenues contributing 90% of services revenue and our professional services 10%. Our support renewal bookings exceeded plan in Q4 and renewal rates remain solid.

Now, let me move to our product discussions. And I’m going to begin with our Windows Management products. Our Windows product family continues to perform well, especially considering the environment. We had a very strong second half of the year in this product family. We had four seven figure deals and 15 over 500,000 in Q4. Our Q4 was led by a strong showing from our Identity Management, Unified Communications and Windows Auditing Solutions. All finished over plan with year-over-year growth in Q4.

This continues to show that our strong Quest One Identity Management message combined with solutions that truly solve security and compliance issues are a winning combination even in a tough economy.

Product highlights included are two factor authentication solution defender, which ended the year with more than double its annual target. We strengthen our Windows Auditing products with our NetPro acquisition in Q3 of 2008 and these products grew substantially year-over-year in fiscal 2009. This should be a key growth area for us in 2010.

Within our Windows business, ScriptLogic had a record Q4. It was able to withstand the economic trend of SMB customers not spending money and actually grew its transaction volume for all of 2009 in the 2,000 employees and below customer set.

One of the great wins we had in Q4 was with a $0.5 million sale to a very large beverage company that chose Quest for a project to centralize all IT management into a single size with a goal of 60% productivity improvement.

Quest products enable provisioning, providing central management and self-service for applications and data owners and password reset with stronger password policies.

Let me move now to our database products. The database business reversed the Q1 through Q3 trend and grew year-over-year in Q4. Both Oracle and SQL Server performance products posted new releases that continue to leverage our Foglight architecture, providing better scale, web view accessibility and participation in our overall end-to-end transaction management offering to Foglight proper.

Over 2010, we expect that all of our database performance products across all platforms will see continued benefits from our Foglight technology integrations. TOAD for Oracle is also expanding its reach with the addition of TOAD extensions for Visual Studio which is now in beta and set to be released with Microsoft’s announcement of Visual Studio 2010 in a few months.

We have $3 million transactions in Q4 within the database family. The products purchased included are tools for replications, light weight monitoring and our tuning tools for both DBAs and developers.

Now, let me move on to our Desktop Virtualization business. We grew our VDI business substantially year-over-year from an overall booking standpoint in Q4 and added an impressive number of new customers. What was most encouraging is that we really saw the growth accelerate within VDI in the second half of '09.

The market is still in pilot mode but we saw some early larger deployments, particularly, in finance and healthcare. Both the U.S. and EMEA strong growth in Q4. We also released Version 7.0 to the market which has received very positive feedback.

Now, let me move on to Vision Core, which represents our products for server virtualization. Again, both IDC and Gartner confirmed that we are the largest independent virtualization management vendor in the market. We had one of our best revenue quarters ever across the 19,000 customer mark in Q4.

Our vFoglight revenues had tremendous year-over-year growth. It remains one of our fastest growing products within our virtualization business. During the quarter, we also released vFoglight Version 6.0 to the market. vFoglight is the only virtualization monitoring and capacity management solutions that meets the needs of both SMB and enterprise customers and service providers.

Now, let me move on to our Application Management business, which is both Foglight and our Change Management tools. Within North America, the North America commercial saw solid year-over-year growth for Q4, driven by significant improvement in our over $500,000 deals.

We had some key wins in Q4. We closed a large 6-figure deal in Q4 where Foglight will ensure greater than 500,000 employees will receive their paychecks on time by monitoring and diagnosing the user experience and service level for one of the largest PeopleSoft HR and payroll application deployment in the world. Foglight also drove a very large transaction where we will be monitoring the Oracle, SQL Server, DB2 and Sybase databases at a large financial institution.

Let me close now. Overall, we, at Quest, weathered a tough year and ended up on a very nice upswing. I’m excited as I see significant opportunity in 2010 to upsell and crosssell our customer base in the product areas where we have market leadership

And we have a great opportunity to grab market share and customer footprint for newer markets like desktop and server virtualization. I must also tell you I’m fired up about our new leaders that have recently joined Quest. Steve Kahan, Carl Eberling and Alan Fudge. Having their fresh perspectives in energy is very, very exciting. I know to me and Vinny and to Scott.

So, with, that I would now like to turn it over to Scott to provide some greater detail on our financial results.

Scott Davidson

Great, thanks, Doug, and good afternoon, everyone. The Q4 was the strongest quarter during the year of many challenges. As we exited the year we’ve gained some confidence within certain areas of the business and we plan to use this as a base to build upon for 2010. So while Doug touched on some of the highlights I will give you a little bit more detail on the financials.

The Q4 license revenues decreased 5% to 88 million. Term license fields in the quarter were 6.7 million. If you adjust the license revenue number for the term deals instead of the reported 88 million the actual adjusted number would be about 91 million per license revenue for the quarter. License revenues were up sequentially by 20.6 million or 31% versus a 6.3 million or 7% uplift going from Q3 to Q4 back in 2008.

Service revenues, which is primarily maintenance renewal declined 2%, is the result of four successive quarters of year-over-year declines and new license bookings. This is expected and as mentioned on last quarter’s call as well.

From a product perspective, the Windows and Virtualization Management products continue to show good growth on the services line. License revenues comprise 45% of the total revenue while services generated the 55% balance. The total Q4 non-GAAP expenses were down 2% on a year-over-year basis to 146 million, were down 4% excluding the impact from currency.

We continue to contain head count and discretionary expenses which offset expense increases due to year-over-year weakness in the US dollar. During the quarter, our expenses were approximately $3 million higher due to fluctuations in FX rates, relative to Q4 '08. And we also incurred severance costs of about $2.2 million in Q4.

Sales and marketing expenses were 75 million or 39% of total revenue as compared to 77 million and 38% of total revenue in the same quarter a year ago. In the aggregate, the year-over-year change is related to lower headcount and lower commissions, partially offset by some impact from foreign exchange.

R&D expenses in the fourth quarter were 35 million or 18% total revenue, compared to 37 million or 19% of total revenue in Q4 of a year ago quarter. The decrease is driven by core labor cost reductions.

G&A was 19 million or 10% of total revenue, which compared against 18 million or 9% of total revenue Q4 of last year. The only increase is primarily related to professional services fees including very targeted projects related to the Oracle

R12 implementation for a financial system.

The GAAP operating margins were 23.4% in the quarter and the GAAP operating income was 45.5 million. The non-GAAP operating income was 48.3 million, which generated an operating margin of 24.8%.

Other income was 800,000 of expense versus 1.4 million of expense in Q4 of '08. The year-on-year difference is driven primarily by the interest expense of our mortgage plus the fees on our credit line during the period which offset interest income earned from our investment portfolio.

The balance sheet hedging programs manage volatility in our non-U.S. dollar-denominated assets resulted in a successful reduction in volatility from foreign exchange and the other income line to the tune of about $600,000.

The GAAP income tax rate for Q4 was 17.1% compared to 19.6% in Q4 of '08. The GAAP effective income tax rate for '09 was approximately 18% compared to 17% for the prior year. The difference is really the result of several factors, including the mix of income between geographies that resulted in the increase in the effective tax rate during '09 and the closure of an internal revenue service examination of the prior period returns that resulted in a reduction to the effective tax rate back in 2008.

The Q4 non-GAAP tax rate was 22.2% compared to 22.9% in Q4 '08 and the non-GAAP tax rate for 2009 was 25.6% compared to 23.6% in 2008, primarily due to the mix of pretax income.

Both the GAAP and the non-GAAP net income and earnings per share in the quarter were 37 million and a diluted $0.40 per share respectively. Fully diluted weighed average shares outstanding were approximate 93 million shares versus 105 million in Q4 of 2008. The reduction in the shares is a result of the increased share repurchase activity including the two tender offers we completed in July of 2009 and December of 2008, offset by any new issuance from option exercises during this year.

From the cash flow statement in the balance sheet, the cash and investments balances were approximately 386 million at year-end. The $100 million line in credit is still undrawn at this point and CapEx for the quarter was $3 million.

Cash flow from operations was strong at $37 million. And the Days sales outstanding was 75 days, a five day increase over the 70 days from Q4 of 2008. I also want to note that the cash flow from operations number of $37 million doesn’t have the adjustment in that for the $19 million that was paid out for the shareholder litigation. So, if you wanted to adjust that back, you’d add the $19 million back into the $37 million and get the real operating adjustment cash flow. Deferred revenues increase 11% to 372 million, up 33 million year-over-year.

In summary, there were no easy quarters in 2009. When we look back at the year, there are several themes that we focused on during the year, all of which were very shareholder friendly.

Number one, we drove operating margins in a tough environment. Number two, we drove record operating cash flow after adjusting for the one-time litigation settlement as I mentioned earlier. Number three; we brought back $112 million worth of stock in the year improving the capital structure. And Number 4, we were active and more visible on road shows and conferences throughout the year.

So exiting the quarter in the year, things seem to be continuing on a path of improvement and we feel like we’re set up well for 2010. That concludes my remarks. I’ll turn it over to Vinny.

Vinny Smith

Thanks, Scott. I’m going to speak to some markets, influences that are affecting Quest and just kind of a higher level set of information. First of all, I wanted to congratulate the management team at Quest and this wasn’t very choppy here and executed very well with a very well solid margin story. And the thing is lacking is license growth. And so, with that I wanted to talk about it, how I view license growth and how we view here at Quest.

One is we’ve got our current markets, the enterprise customers we can sell more of the enterprise products to. And there’s a plenty of opportunity for us to continue to grow in doing what we’ve done with what we have. And so we continue to optimize our business, continue to improve our practices and I think that will show good results in 2010.

The other thing that we have done historically a nice Java, I feel anyway is we have slid to the adjacent market segments very gracefully and with some real assertiveness and that’s allowed us to continue to grow our business and we do that through both organic investments as well as acquisitions and this has been a really healthy way for us to continue to expand our market opportunity and allow us to grow our company.

Another thing that we haven’t spoken much to on this call that we have been brewing a mid-market business at Quest. And this is really a new customer target for us. This is customers that have a couple hundred users to a couple thousand users. Because historically introducing we were assigned more of an enterprise organization with at least several thousand users up to many more than that. And so we’re already well passed the $100 million mark in our mid-market business and we’re continuing to push this. And this drives the number of different effects inside the company.

One is we’re bringing a couple of SaaS-based management solutions to the market in the first half of 2010. The other thing it does is that forces you to build simpler to use, simpler to buy, simpler to license products and I think as they hit the mid-market, they’re easy to market, they’re easy to sell, they’re easy to use, I think many of these things will cycle back into our enterprise products.

But when this business, I’m very excited about. I think we can double or triple this business over the next couple of years and that opportunity should help us continue to maintain some license growth in the business.

I wanted to address some other things that are happening. Not just inside of Quest but in the IT kind of landscape as a whole. I view that there’s three major themes that are occurring right now that we’re living within at Quest and other IT providers are also living within.

The first is the viral and rapid success of server virtualization inside a company. Second is there’s one top of that server virtualization of the clouds, many different clouds and I’ll speak about it in a second. And the third effect that we see in the IT community, especially on the vendor side, is consolidation and the sheer size of some of the IT providers out there.

So, one is server virtualization. This is an area where we, several years ago, saw this as a big theme and we invested in it. And that was nice investment on Quest part, but server virtualization really redefine much of what IT management is about. It provides totally new solutions for disaster recovery, for back-up, it redefines monitoring, you can weave monitoring and provision together to do dynamic fabric management to optimize your resources in your data center.

Server virtualization redefines compliance and also, if client computing goes towards virtualization as we think it will, it will redefine the entire management in of client computing and actually even the purchasing of end points and what you need to hear end point we begin to virtualize your client.

So server virtualization is the powerful way of coming through the IT world. And we have two opportunities here. One is there is the opportunity to manage the virtualized world itself and we’re up over 20,000 or almost a 20,000 customers now with the virtualization management suite.

And then, another key thing is the virtual world changes how you manage your workloads and Quest has got a vibrant business in helping customers manage key workloads like Oracle databases, SQL databases, AD exchange. And so not only do we have the opportunity to manage the virtual world, we have the opportunity to bring solutions that allow you to manage your key workloads in a virtual world and so it gives us the opportunity to reinvest in their products and bring them more value for our customers. So, server virtualization to me is a pure opportunity for us to run with our current products and move them forward as well as to address just managing the virtual world.

The second theme was cloud. And cloud, to me, the really cloud movement really took off when server virtualization got embedded in some of the organizations. And there’s many different clouds now being serviced to the customer. And the differences there are important and interesting for us at Quest because they’re going to change our future opportunities.

The first cloud wave you’re seeing is something like out of Amazon, where you’re basically providing cheaper infrastructure than you get host internally, providing cheap virtual machine. We haven t introduced much in the way of products that actually manage Amazon, but we’re starting to use Amazon as a back-end resource for some of our solutions.

The next wave of clouds that I think is really significant is the platform clouds. That’s where you might have a database or an application server, identity management, authentication and those services reside in the cloud and you can use those services to build application. And in fact, we’re writing applications now that are built on a platform cloud so that we can deliver a SaaS-based management solution to our customers.

So, if our applications at Quest and inside the company that we sell to start to use these platform services out of this cloud this is going to be a big deal. It’s going to change the IT world as we know it today and it’s going to change how we manage it. So we’re really closely watching these platforms, we’re actually utilizing them to provide service to our customers and it’s quite exciting.

The third form of the cloud is what most of you think is a cloud and that’s like an application cloud or a SaaS cloud and salesforce.com or hosting e-mail or delivering help desk solution are all examples of a SaaS-based cloud. These are actually more dangerous to Quest, because you use an application cloud; you’re less likely to buy as much on from management software. So there is a danger if these application clouds become a dominant technique for delivering your applications to our customers.

Now, there’s also opportunity, because with application clouds, many things change like how to monitor, how to do compliance, how to do mix hybrid identity management. So there’s opportunity, but there’s also a danger with these clouds. So that is the second wave of change I see happening in the IT space.

The third thing is we’re starting to see these mega companies form and they have been forming for a while through acquisitions. But it’s not just Microsoft and HP and IBM and Dell any more, it’s the combination of how Cisco and EMC are trying to work together or Oracle moving in the market, buying Sun and BEA.

And so obviously Oracle’s message is hey, from a single vendor, you can buy a single stack and that’s going to be more effective, more manageable, cheaper, and they’re trying to push right into the face of the best of breed providers like VMware, salesforce.com, Red Hat, Quest, where we provide fantastic solutions at a particular layer in the application stack. And so there is this, situation in the market that we don’t know how it’s going to play out.

Obviously, whenever you get big vendors, they leave wide openings that you can come in and deliver great solutions. But the message is very much an attack message on the best of breed. So, that’s obviously a force in the marketplace. And so I see those three things, the server virtualization, clouds and vendor size and consolidation as a major themes in the market right now and it’s a fact the challenge and the opportunity for Quest.

Because we got Pack [ph] to navigate giving these trends and if we do it well it’s a remarkable opportunity. But one thing for certain we can’t stand still. We’ve got to move our company forward, deal with these new trends, embrace them and deliver new world-class solutions for our customers. One example as I mentioned is we’re up to close to 20,000 customers running our ESX management suite on VMware. It’s fantastic.

So, moving to clouds again, I do concern myself about the impact of clouds and how they’re going to effect the IT industry for vendors like Quest and so, we’re building solutions that embrace clouds, providing SaaS solutions, we’re also providing solutions that allow you to embrace clouds so that you can move from onprem [ph] to a cloud, possibly move from one cloud provider to another and then possibly move back. So, although they’re somewhat concerning to us there’re also opportunities as I mentioned.

And so, we’re going to provide robust management suites that allow you to really run with what we think is going to happen, hybrid solution, where you will use mostly onprem [ph] solutions like you do today and you will begin to take where it makes sense these cloud-based solutions and use them as part of your arsenal as an IT manager, and we’re trying to provide the manageability of that, for that hybrid situation.

So the net of this is we have a rapidly changing IT landscape and I think the pace of change is only going to accelerate. And we at Quest have this awesome opportunity to take our current customers and new customers, embrace these new trends and help the customer realize real benefit from these trends. And help these IT organizations deliver reliable, continuous compliance, high-performing applications for the users at a better price. So that’s my comments for the day. Let me open up the call now for questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We’ll go first to Abhey Lamba with ISI Group.

Abhey Lamba – ISI Group

Yes, thanks. You just gave a good qualitative commentary on what to expect in 2010. Can you tell us should we expect licenses to go this year and also how about maintenance, can it go this year or given the lack of licenses last year should it continue to decline on a year-over-year basis?

Scott Davidson

Hey, Abhey, it’s Scott Davidson. So, while not given specific items as you know sort of on a qualitative basis, yes, we fully expect and would actually hope that licenses will grow in 2010. That’s the plan. As we saw a little bit in Q4 of 2009, the services revenue, the growth of the services revenue, in particular, the maintenance component of that has slowed down considerably because of the preceding quarters of maintenance revenue. So we think what we will see in 2010 is the growth is going to come from the license line and the services line will probably trend down a little bit.

Abhey Lamba – ISI Group

Got you. And in terms of expenses, you mentioned you don’t want to sacrifice profitability. Should we expect your margins to go up or kind of stay where they are through the year? Thank you.

Scott Davidson

As Doug said in his comment, we’re very much diligent on margins and so, in 2009, we had a 400 basis point increase in the margin, again sort of back to the mix between license and maintenance, the way the math works, I think you know well enough, the maintenance revenue comes in at a higher margin, to the extent that we’re getting more license growth and we’re managing the expense profile similarly. We expect to see some increase in the margin, but clearly nowhere near the magnitude we saw this year of 400 basis points.

Abhey Lamba – ISI Group

Thank you.

Operator

We’ll go next to John DiFucci with JP Morgan.

John DiFucci – JP Morgan

Yes, thanks. Actually, on those two points, it looks like all the margin compression year-over-year in this quarter had to do with foreign exchange. I think one you did mentioned something about G&A expense. And I’m just curious what we should be looking for going forward with G&A. And like Abhey mentioned, Doug had said, you’re not going to sacrifice margins here.

And I guess, Scott, you gave us an idea you will see some improvement in license. But on the maintenance side, maintenance grew sequentially and we know that’s where a lot of the profit comes from, but it was down year-over-year. And even though license was weak this year, it’s not common at all to see maintenance down year-over-year. And I would be surprised to see maintenance for most any company be down year-over-year on a consistent basis. Can you tell us how much of that maintenance revenue decline year-over-year had to do with foreign exchange?

Scott Davidson

Actually, most of the maintenance revenue specifically doesn’t have anything to do with foreign exchange. The reason for that is because we’re a U.S. dollar functional company. And so what that means is the maintenance revenue gets booked in a particular quarter and is held at historical cost. So what happens is there sort of a self-averaging mechanism in the maintenance revenue because it gets booked and sits on the balance sheet and when it comes in, it comes in at a historical cost that it was booked at, it doesn’t get translated into the current rate and that’s because we’re U.S. dollar functional on a worldwide basis. So that’s a little bit of a difference entity or construct, I should say.

To your first question, maybe let me help you understand in this way. In Q4, the impact to the margin from FX was fairly neutral. The revenues were impacted about 3 million to the negative. And the expenses were impacted 3 million to the negative. And that changes quarter-to-quarter, but it just still happened in Q4, it was net neutral to us.

And so, going into 2010, what we’re going to get is we’re going to get maintenance revenue that comes in off the balance sheet. That was booked at a different FX rate on average than the FX rate that it was booked at when it rolled into the income statement in 2009. The easier way to understand that is that which was recognized in '09 maintenance revenue came in at a higher rate because the FX rate was more favorable when it was booked in '08. In ’09 the Euro was weaker and so in 2010 it’s going to come in at a lower FX rate. So that’s partially where the FX going to impact us next year. Does that make sense?

John DiFucci – JP Morgan

Yes, I think so. I think so, but I’m a little perplex on, I understand and you said this before, Scott, that with the relatively soft license across the industry this year, that’s going to have an impact on maintenance growth next year and I can understand it having an impact on growth, but to anticipate, I can understand having an impact on less positive growth than it would otherwise. But as long as your renewal rate is not changing dramatically to the negatives, you’re just building off of relatively secure and stable base.

So, no matter what kind of license you should be adding to that maintenance space and we should be able to figure out everything you just talked about when, given the foreign exchange impact or given at what rate it was booked at. Because that’s what, those are the numbers that we can look at the license over the past. I’m a little confused as to why and maybe I misunderstood your answer to the last question. Bu I’m a little confused as to why this would have a major impact on maintenance growth next year.

Scott Davidson

I think you got it. There are two pieces of it. There’s the maintenance growth piece, which I’m in agreement with, right? Because maintenance growth is going to slow down. Because new license was lower. So, I agree with what your comment was there. As far as recognize maintenance revenue, the easiest way to explain it is the maintenance revenue that we’re going to recognize this year during 2010 was booked in 2009. When it was booked in 2009, it was at a lower rate on average FX rate than what it was in 2008. So what happened is? '09 maintenance revenue benefited by a higher FX rate, FX rates moved against us, in '09 when this new maintenance for the book so, a lower rate is going to be recognized during 2010 on maintenance.

John DiFucci – JP Morgan Okay. Just a lower….

Scott Davidson

It’s a delayed effect, right, everything is sitting in deferred rolls in over the next four quarters, it rolls in at a lower rate. Because it comes in at the historical cost, it doesn’t adjust to the rate at that particular quarter.

John DiFucci – JP Morgan

I hear you. I hear you. But it’s still incremental. Do you expect maintenance to grow year-over-year in 2010 versus 2009?

Scott Davidson

No.

John DiFucci – JP Morgan

You do not. You expect maintenance to decline in 2010?

Scott Davidson

It could be flat the decline. I don’t want to get into a specific guidance on maintenance line, but since the maintenance growth rate has slowed down as we’ve gone through each quarter of 2009, I would expect that it would flatten out in 2010. Until we start to book much more license growth we can sell more maintenance into. That trend has been prevalent over the last four quarters. You can see it. The maintenance growth rate has slowed down.

John DiFucci – JP Morgan

Right. And it’s logical, but it’s still being growing. Okay, I’ll let someone else to ask the question

Scott Davidson

Okay. We can talk offline, John.

John DiFucci – JP Morgan

Okay.

Operator

We’ll go next to Tim Klassel with Thomas Weisel Partners.

Tim Klassel – Thomas Weisel Partners

Yes, sort of a question across the product line. Doug, you mentioned that Foglight could see a breakout year, which would be a change from the last few years. What is your thinking there if this ends up being a disappointing year again for Foglight? Could we see a strategic move with that product or the focus of the company towards other product set?

Doug Garn

You always have good, interesting questions in that regard. I know because, first of all, we do expect to have the improved performance this year. I mean our sights; we haven’t set numbers that are unreasonable. I think we’ve set very achievable goals for the Foglight group this year that will help us move that business, that BU into a very close level of being almost profitable and then when you look at how many other products we’re building on top of Foglight, it really has an underlying impact within Quest across virtualization, database, so many other areas that it would almost be impossible for us to abandon or diminish what we’re doing there.

And again, I really think that the expectations we’re setting for that business unit, they’re higher, they’re not ridiculous. And I think the group would tell you that they’re very favorable and we’re really getting some great positive feedback in the marketplace right now or the strength of our pipelines are looking really good and it’s just we’re feeling pretty darn and good about it.

Tim Klassel – Thomas Weisel Partners

Okay, good, and jumping over to margin, so, what with maintenance being flattish and getting margins to go up, either you have to be maybe taking to more expenses out, you mentioned something on the call about that or maybe moving more into higher margin distribution. So can you hit us first on what we should be thinking about for expenses just qualitatively and seems like a lot of these initiatives move over to more distribution type software with the strength and Script and Vision Core and Windows what have you, will we see a greater percentage of revenues going through the indirect channel and how does that fundamentally change the margin structure of the company?

Scott Davidson

Tim, in the interim, I’ll answer the first part of the question margins and follow it on with what we talked about on the last quarter, which was as we’re asked, what are you guys feel in terms of headcount to be able to support growth in 2010. We said at the time that we don’t foresee massive increases in head count for us to get higher license growth in 2010. So what we’ve done is we sort of spent a large part in 2009, refining headcount in all different areas, moving people into higher performing business units or products and what have you. So on the expense side, clearly from Q4 to Q1; there is a down step in the expenses. There always is, but we don’t think there’s going to be a significant change in the expense structure for 2010 as of right now for us to get to where we want to be.

So I think to answer the question directly we expect license growth, some strategic investment as required, but less though than in the past to be able to continue to move margins a little bit in 2010. With that being said, in order to sort of manage the margins, there are other things that we’ve talked about in the past in terms of getting at the sales and marketing line and the cost of sales in terms of other delivery vehicles such as channels and making out a larger proportion of our total revenue mix than it has been in the past, so, maybe Doug, you want to….

Doug Garn

Yes, we started initiative a couple of years ago, both internally with driving more business through channels plus with the acquisition of the script and then when you look at the amount of distribution strength that Vision Core brings to the table, all of these combined are allowing us, we’re in the third year of this program of really beginning, of really pushing towards more and more distribution. And I think that’s going to continue to allow us to not have to add more heads, sales heads and to be able to increase growth going through these other methods.

The Script we’re pushing this acquisition we recently made and we’re using their distribution model as a way to more cost effectively and more efficiently and quickly reach that market and the early results that we’re seeing there are really strong, it’s very exciting to watch. So I think you’re absolutely right. That is what we’re trying to see is much more of a blend here at Quest as compared to the four, five years ago, we were almost entirely direct.

Tim Klassel – Thomas Weisel Partners

Okay. And then one real quick follow-up, Pack and Track, the first time gone there, is that something we should see more of or did you acquire them more for the distribution channel?

Vinny Smith

It’s a blended too. We’re excited about having. This is Vinny speaking. We’re excited about complimenting other monitoring solutions with the network piece. That’s been lacking in our offering. The other thing is that we really feel this is an integral part to the mid-market approach and that we needed to have this piece to complete our suite. The other piece that they offer which is exciting for us, which is a little bit new is they have a very differentiated product for MSPs to deliver network management services across multiple clients within a single console. So, we like the asset, we like the people very much and we think it’s going to fit really well within our business.

Doug Garn

The key part of the thing is very, there’s some real opportunity there and we’re learning a lot about it too. We had already launched our own internal MSP initiatives, but Pack and Track is helping us to quickly up the game there and have a broader reach than we had two months ago.

Tim Klassel – Thomas Weisel Partners

Great. Thanks, guys.

Operator

We’ll go next to Derek Bingham with Goldman Sachs.

Derek Bingham – Goldman Sachs

Hey, everybody. I wonder this much into the new year, if you’re seeing a meaningful difference and buying behavior now that people are working off of their 2010 budgets and maybe some pent-up demand shining through for the productivity tools that you offer.

Scott Davidson

We’re waiting on the final January numbers at this point. I haven’t seen all the detail underneath it. I can tell you that in terms of speaking with sales reps or just general attitude, it seems better or good on a relative basis. But it’s still pretty early. I don’t know if I ever seen any concrete there yet. But clearly much better than it was in January of last year.

Derek Bingham – Goldman Sachs

Okay, great. Could you tell us what your year-ending headcount was?

Scott Davidson

3365.

Derek Bingham – Goldman Sachs

Okay. And then the thought is that pretty modest incremental headcount adds going forward?

Doug Garn

Very small.

Scott Davidson

Very modest.

Derek Bingham – Goldman Sachs

Okay.

Doug Garn

We made some additional tweaking in the first weeks of January and we’re pretty happy with where we’re at right now from a headcount perspective. Certainly, we’re going to allow some critical hires here and there, and so, we’re not segment at all. But, we’re not going to go out and hire couple hundred people. I got to tell you, our people was in Quest have done just an amazing job at managing this business and getting it I think well-positioned for taking advantage of the opportunities that are ahead of us this year. I can’t think of a time where we’re sitting as well aligned, and is well-positioned, if you will, for if we capture on the opportunity, it will be a real positive.

Derek Bingham – Goldman Sachs

Scott, on the G&A line, you mentioned a couple things, some severance costs in the quarter and also Oracle implementation. How are those two things comparing in Q1, do those drop back down or they’re ongoing?

Scott Davidson

Yes, there’s about 2.2 million in severance that’s across spread across all lines in Q4, not just G&A. That’s 2 million of the increase. And then also, we’re in process of implementing Oracle R12 financial system, so there is some extra costs associated with getting that, that process begun, if you will, in Q4 as well so that will be mitigated over this. So the G&A numbers should go down sequentially a little bit. Total number should as well presuming we don’t have a big severance number in the first quarter.

Derek Bingham – Goldman Sachs

Is there any reason why there should be some severance dollars in the first quarter?

Scott Davidson

Not to that magnitude.

Derek Bingham – Goldman Sachs

Okay. And then does the Oracle project ramp-up as we go into the year?

Scott Davidson

Yes, the initial go-live is a multiphase project. The initial go-live is some time in late summer. And what we’re doing is we’re re-implementing Oracle R12 and aggregating through the years as we sort of grown as a business, the initial implementation was 10 years ago, we’re a much smaller company, we’ve done a lot of acquisitions. The geographic footprint has changed; the business model to be able to account for the multiple licensing models we have is changed. So this is an opportunity for us to sort of build it for what we’d like to do for the next 10 years.

Doug Garn

I must tell you there’s nothing more exciting than doing an R12 implementation. Fire you up.

Derek Bingham – Goldman Sachs

You have a good strategy for pushing back on Oracle and the maintenance?

Scott Davidson

No, Tom.

Derek Bingham – Goldman Sachs

All right. Good luck with that.

Scott Davidson

I don’t know if it’s a good one. Good being the operative word.

Derek Bingham – Goldman Sachs

All right, thanks.

Operator

(Operator instructions) We’ll go next to Phil Winslow with Credit Suisse.

Phil Winslow – Credit Suisse

Hi, guys, good quarter. Just have a question on go-to-market side; obviously you had some changes and sales management announced on the last conference call. Just curious anything whether be on the direct or indirect side that we can see difference in 2010 year. And then also just one housekeeping item. Just that interest and other income line is sensitive, bouncing around a little bit quarter-to-quarter. Scott, what are your expectations for the full year there? Thanks.

Scott Davidson

I’ll answer them in reverse I guess. Doug, you could probably take the indirect question. On the any line I think, it’s bounced around a lot more in the past. We talked about hedging that. Q4 was actually the first full quarter where we hedged that and we knocked about 600K and what would have been incremental out of that related to FX. So right now the biggest component that runs through that OINE line are the fees associated with our $100 million line of credit, which is undrawn, but the fees of OINE fees there and the costs associated with the mortgage on our physical property here in Aliso Viejo. They’re typically offset by interest income on the investment portfolio but we all know where rates are these days. It doesn’t really make much of a scratch against that. So we haven’t given specific guidance on the OINE line, but I’d say it’s probably going to be flattish for the next year and we’ve taken a lot of the noise out on edging it.

Doug Garn

Alan Fudge has been here for five months at this point and the only real key head or hire that he’s looking to make is to bring in the head of worldwide channels, which by the way, reverts back to Tim’s question, bit of about our commitment to distribution and our desire to leverage or manage cost through going third parties. We’re knee deep in the middle of interviewing folks. We have not hired that position. But that is the single one position that he’s looking to bring in from the outside.

I think the other thing that is really impressive this year that’s never happened before here at Quest is within the first two weeks, three weeks, I believe it was, we had all of the reps with comp plans, they knew their territories, they’re basically in their shares, ready to go and with all the information they needed to go essentially within two weeks of the beginning of the year. Normally that takes more time than we care to share with you. And Alan and team has just done a tremendous job and making sure that all our whole sales ward was geared up and ready to go. Having him here has been just a breath of fresh air. It’s great. We needed that focus.

Phil Winslow – Credit Suisse

Great. Thanks, guys.

Operator

There are no other questions in queue at this time. I’ll turn it back over for any closing remarks.

Doug Garn

As usual, we want to go ahead and thank our shareholders who have patiently remained with us and remain committed to Quest. I think as Scott really put well we tried this past year to do the right things for our shareholders in many of the decisions we made, but those decisions also have affected others, which include our partners, our customers and also our employees.

And I want to say with a few comments to the Quest folks that are on the call today listening. I think at times it may seem that Scott and Vinny and I are up here kind of just messing around and we’re truly appreciative of the hard work, the investment, some of the pain that you guys all went through in 2009. And we look forward and are excited about working together with you in 2010 to structure and have a great year and have some fun and enjoy the ride together. So, I just genuinely want to thank the employees. They’re a delight to work with. So, I don’t know. Vin, Scott, you have anything you want to say or?

Vinny Smith

Thanks, everyone, for listening and it’s a pleasure to work for the company and get to work with all of these people. Thanks.

Doug Garn

All right.

Operator

This concludes today’s conference call. Thank you for your participation.

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Source: Quest Software, Inc. Q4 2009 Earnings Call Transcript
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