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Acme Packet Inc. (NASDAQ:APKT)

Q4 2009 Earnings Call

February 02, 2010 05:00 pm ET

Executives

Brian Norris - Director of Investor Relations

Andy Ory - President, Chief Executive Officer & Cofounder

Peter Minihane - Chief Financial Officer

Analysts

Simona Jankowski - Goldman Sachs

Paul Silverstein - Credit Suisse

Brian Modoff - Deutsche Bank

John Marchetti - Cowen Group

Greg Mesniaeff - Needham & Company

Catharine Trebnick - Avian Securities

Ted Jackson - Cantor Fitzgerald

Sanjiv Wadhwani - Stifel Nicolaus

Operator

Good afternoon, ladies and gentlemen, and welcome to Acme Packet's conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. During the Q&A portion of today’s call, we ask participants to limit themselves to one question and one follow up question.

(Operator Instructions). As a reminder, ladies and gentlemen this conference is being recorded. I would now like to turn the conference -- I would now like to introduce your host for today's call Brian Norris, Director of Investor Relations for Acme Packet, please go ahead.

Brian Norris

Thank you. Good afternoon, everyone. With me on the call are Andy Ory, our President and Chief Executive Office, and Peter Minihane, our Chief Financial Officer and Treasurer.

The format for tonight's call is as follows: Andy will begin with an overview of our fourth quarter financial and operating highlights followed by an update on the key growth driver in the business. Peter will then follow with a detailed financial review and a discussion of our updated outlook for 2010.

We will then open the call up for Q&A.

The press release announcing our fourth quarter results, along with our financial statements and a reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures is available on the Investor Relations section of our website at www.ir.acmepacket.com.

Please note that all results and projections we review this afternoon are on a non-GAAP basis, unless otherwise and explicitly described as GAAP. During this afternoon's call, we'll be referring to non-GAAP net income and non-GAAP net income per share which are non-GAAP financial measures that excludes stock-based compensation expense for all periods presented.

Non-GAAP net income and non-GAAP net income per share for the three-month period ended September 30, 2009, as well as the three and 12-month period ending December 31st, 2009, also excludes amortization of intangible assets related to the company’s acquisition of Covergence during the second quarter of 2009.

Finally non-GAAP net income and non-GAAP net income per share for the three and 12-month period ended December 31, 2009, also excluded the gain related to the Covergence acquisition.

Statements made during this call that are not historical facts may be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such forward-looking statements may relate among other things to expected financial and operating results and to future business prospects and market conditions.

Such forward-looking statements do not constitute guarantees of future performance, and are subject to a variety of risks and uncertainties that could cause our actual results to differ materially from those anticipated.

A discussion of these risks, uncertainties and additional factors that could cause actual results to differ materially from those projected or suggested in any forward-looking statements is contained in our recent filings with the SEC. Investors should not place undue reliance on these statements, which are current only as of the date that they are made and we disclaim any obligation to update them.

Before I turn the call over to Andy, let me briefly bring to your attention that we will be in San Francisco on February 23rd for the Goldman Sachs Technology Conference and then again on March 4th for the Morgan Stanley Technology Conference. We'll also be in Boston on March 10th for the Credit Suisse Networking Conference. One last calendar item, please make plans to join us at 5 p.m. Eastern time on Thursday April 29 for our first quarter earnings results conference call. For more details on our IR Outreach program for the first quarter, please feel free to contact me at 781-328-4790.

With that, I'd like to turn the call over to Andy.

Andy Ory

Thank you, Brian, and good afternoon, everyone. We are pleased to report strong fourth quarter results, which were highlighted by record revenues and solid earnings growth. Accelerating demand for our solutions over the last year has led to growing momentum in all areas of the business.

The business continues to perform very well, and I want to thank each of our employees for their collective contribution to our success.

Total revenue increased to a record $41.3 million, an increase of 14% compared to the third quarter. Gross margin was 82%, which again reflected strong customer adoption of our high margin Net-Net 4500. Operating margin expanded to 24%, up from 23% in the third quarter.

We reported fourth quarter non-GAAP EPS of $0.11, $0.01 above the first call consensus and we generated a record $15.9 million in cash flow from operations during the fourth quarter and ended the quarter with record cash balances of $175 million, further improving our already strong balance sheet.

Our fourth quarter results reflect growing momentum in all areas of the business, we are seeing accelerating demand for our solutions as more and more enterprises, service providers, contact centers and government agencies embrace session-oriented IT based communication which require session border controllers or SBCs.

Amidst the backdrop of the most challenging macroeconomic environment in the last 100 years, we have delivered six consecutive quarters of sequential revenue growth with solid earnings and market expansion. Based on the growing strength of the overall business, the growth drivers we are seeing in our key market and our improved overall visibility, we are raising our outlook for 2010.

We are updating our earlier outlook which calls for 20% revenue and earnings growth in 2010. We now expect revenue to grow by approximately 30% to a range of $182 million to $186 million. We now expect non-GAAP EPS to grow by approximately 30% to $0.44 to $0.47 per share. We are also this afternoon raising our long-term target operating model to include operating margins of near 30% by the end of 2010, up from our previous guidance of approximately 25%. We believe we can deliver all of this while also driving improved visibility in our business.

There is a fundamental shift in global communications that is fueling the growth of the SBC market. The largest service providers and enterprises in the world are upgrading their legacy network from century-old circuit switch technology to next generation network based on Internet protocol or IP. They are doing this to lower operating costs and introduce new service offerings only available via IP, such as Voice over Internet Protocol or VoIP. Since the advent of the Internet, service providers and enterprises have delivered voice and data services separately over the Public Switched Telephone Network or PSTN and the Internet.

Managing these two distinct networks is not a viable economic alternative today. Service providers and enterprises are instead migrating to a single IP network architecture to serve as the foundation for their next generation services and application. This migration requires a highly advanced network element that enables the delivery of trusted first class IP communication services. This element is a session border controller, which is deployed at the borders between IP communication network and serves to unify the separate and ever-increasing number of IP communication networks.

As we have discussed in our previous call, we believe that in the aggregate, there is a $2 billion market opportunity for our solutions from 2009 through 2013 in our core markets. We believe that we are well positioned to capitalize on this opportunity. There are highly-visible, demand drivers fueling the opportunity for our solutions across wireline, wireless and cable service providers.

We are seeing a growing number of tier 1 service providers who are placing their expensive gateways and Class 4 softswitches with session border controllers. As a case in point, earlier today, we issued a press release announcing that Phone Power, a growing VoIP service provider to the US and Canadian market has deployed our Net-Net 4500 SBC as part of a highly scalable SIP routing solution that eliminates the need for Class 4 softswitches in their network.

Customers like Phone Power are using IP to interconnect their VoIP network in order to extend network reach and revenue potential while minimizing termination costs associated with the PSTN.

We are seeing growing demand for our solutions on the access side of our service provider customers as more and more enterprises insist on SIP trunks from their service providers. We are seeing signs that the pool of global IPv4 addresses will soon be exhausted which in turn is driving demand for IPv4-to-IPv6 inter-working.

We are delivering solutions to enable seamless SIP interactive communications among end points and service elements located in networks using different version of IP addresses. Our customers are responding favorably to our IPv4-to-IPv6 inter-working offerings as a way to both yield significant cost savings and rollout new services.

We are seeing growing demand by service providers for higher performance solutions like our Net-Net 4500 platform which we introduced in 2008. The additional speed and capacity offered by our Net-Net 4500 platform is critical as our customers support an ever increasing number of users and increasing functionality.

We are seeing growing IMS deployment activity around the world and we are seeing wireless service providers deploy our solutions for both peering and core-session routing. We see the next areas of growth within wireless to be in fixed-mobile convergence, SIP over 3G with Rich Communication Suite, 4G voice and interactive communications and dual mode handset and femtocell.

We expanded our addressable market in 2009 as enterprises began to accelerate their adoption of IP based connections for their communication services. SIP trunking and IP connectivity are strong growth trends that are fundamentally changing the way enterprises communicate.

SIP trunking has received a lot of attention and budget support because of the compelling payback it can offer in a very short investment horizon. By converting from a TDM trunk to one or more IP trunks, an enterprise can reduce call termination costs by letting IP trunks route each call over the service provider IP backbone to the remote media gateway closest to the call’s destination, reduce capital and operating costs by eliminating media gateway and TDM trunks and by supporting voice applications on the existing data network. Add network geo-redundancy by provisioning multiple IP trunks to divert path and/or divert service providers, simplify operations by relegating media gateway and PSTN interconnection management to the service provider and cut the time to provision and deploy IP interconnect to a matter of days as opposed to the months typically needed to provision and deploy TDM services.

We are transforming these growth drivers into expanding market share and improving financial results. We estimate that our share of the rapidly emerging enterprise market is growing and that our share of the service provider market is near 60%, consider the following as proof points of our leadership.

We now have over 9,000 SBCs deployed, up from the 7,000 SBCs deployed a year ago. We've added 71 new end-user customers in the fourth quarter alone. We now have over 980 customers, up from 635 a year ago. We now support nearly 800 service providers and over 175 enterprises, contacts centers and government agencies in a 104 countries around the world.

Our solutions are now deployed at 90 of the top 100 service providers in the world and 11 of the fortune 25 enterprises. This broad customer adoption is important because our growth strategy has always been predicated on our ability to drive expansion within our existing customers.

After making our customers successful, we believe we have an opportunity to expand each of these deployments overtime to support additional IP based service offerings, and additional subscriber growth. Recall that back in 2007, we introduced a number of ways to measure our customer depth and breadth.

We intended to refresh the data annually in 2008 and then again in 2009, so that you can determine the progress that we're making. I'm pleased to report that each measure of customer depth and breadth improved again this year. The number of customers who have purchased at least 25 Acme Packet SBCs increased from 33 at the end of 2007 to 41 at the end of 2008 to 50 at the end of 2009.

The number of customers who have purchased at least a 100 Acme Packet SBCs increased from 10 at the end of 2007 to 13 at the end of 2008 to 16 at the end of 2009. The number of customers who invested at least $1 million dollars in Acme Packet products and services increased from 41 at the end of 2007 to 56 at the end of 2008 to 86 at the end of 2009.

Finally, the number of customers who have invested more than $10 million in Acme Packet products and services increased from 3 at the end of 2007 to 5 at the end of 2008 to 10 at the end of 2009. We believe that sharing this data over the last three years has provided insight into both the ramping nature of our customer deployment and the value of incumbency. I'm excited about our future.

In 2010, our objectives are to profitably grow our market and technology leadership. To be successful, we plan to continue to build additional predictability into the business, deliver the solutions that meet the rapidly evolving requirements of our customers, strengthen our position in the enterprise, government, contact center and wireless markets, leverage new technologies to enhance our product performance and scalability, invest in quality and responsive support, facilitate and promote interconnects among our rapidly growing customer base and leverage our distribution partnerships to enhance market penetration.

These are exciting times at Acme Packet. Our business is well positioned for strong growth. In 2010, we will be focused on executing against this plan and expanding our addressable market opportunity.

Let me now turn the call over to Peter Minihane for a closer look at our fourth quarter results and our revised outlook for 2010. Peter?

Peter Minihane

Thank you, Andy. This afternoon I’ll review our financial results for the fourth quarter of 2009 and then discuss our updated outlook for 2010. As a reminder, all financial results or projections reviewed this afternoon related to our statement of income are on a non-GAAP basis unless otherwise and explicitly described as GAAP. Our discussion of sequential changes in our financial result compares the fourth quarter to the third quarter of 2009.

Finally please note that all earnings per share results reviewed this afternoon are on a fully diluted basis. With that, I’ll begin with a brief review of our fourth quarter results. Total revenue was $41.3 million, an increase of 14% sequentially. Product revenue was $32.1 million, an increase of 16% sequentially reflecting a favorable product mix.

We continued to see strong customer adoption of our platforms with higher average selling prices including our Net-Net 4500. Maintenance, support and service revenue was $9.1 million, an increase of 6% sequentially, primarily reflecting an increase of maintenance revenue related to growth of our installed customer base.

No direct customers accounted for 10% or more of revenue in the fourth quarter. While we have not had a direct customer count for 10% or more of our quarterly revenue since the fourth quarter of 2008, we expect to have at least one such customer during 2010. The distribution of revenue in the fourth quarter was 35% direct and 65% indirect consistent with prior quarters and further evidence of the large and diverse nature of our customer base.

Two channel partners accounted for 10% or more of our revenue, Alcatel-Lucent and Nokia-Siemens Networks. Each of these partners represented 13% of our total revenue in the quarter. As we’ve stated previously, these channel partners like many of our channel partners represent dozens of end user customers.

Geographically, 53% of our revenues came from the United States and Canada and 47% came from our international customers. Gross margin was 82% consistent with prior quarters. Longer term, we continue to model gross margins in the upper 70s. Product gross margin was 81% and continues to reflect adoption of our higher capacity, software-rich products including the Net-Net 4500 as I mentioned earlier.

Service gross margin expanded slightly to 82%, consistent with our prior quarter guidance. Total operating expenses in the fourth quarter were $23.9 million, an increase of 10% sequentially. This primarily reflects an increase in compensation and employee benefits companywide. Our effective non-GAAP tax rate in the fourth quarter of 2009 was approximately 31% reflecting the use of additional research and development tax credit in a more favorable effective state income tax rate.

Net income on a non-GAAP basis was $6.8 million compared to $5.7 million in the third quarter of 2009 reflecting an increase of 20% sequentially. Earnings per share on a non-GAAP basis was $0.11 compared to $0.09 in the third quarter of 2009 reflecting an increase of 22% sequentially.

Net income on a GAAP basis was $9.1 million or $0.14 per share compared to $3.6 million or $0.06 per share in the third quarter of 2009. Non-GAAP net income differs from GAAP net income in the fourth quarter of 2009, as it excludes the gain of $4.3 million or approximately $0.06 per share related to the Covergence acquisition. It also improves stock-based compensation expense and amortization of acquired intangible assets of $2 million or approximately $0.03 per share.

We ended the fourth quarter with 450 employees compared to 440 at the end of the third quarter.

Moving onto the balance sheet, we ended the fourth quarter of 2009 with record cash, cash equivalents and investments of $175 million compared to $158.8 million at the end of the third quarter of 2009. The balance sheet as of December 31, 2009 includes for the first time, three separate cash-related line items, the long standing cash and cash equivalents, which are invested in government institutional money market funds, and two new line items, short-term investments and long-term investments, which are managed at no greater risk, but with a higher yield compared to our traditional cash and cash investments.

These represent investments in direct obligations of the United States Treasury including treasury bills, notes, bonds and government agency securities and have no maturity beyond 15 months, from the end of the year.

We generated a record $15.9 million in cash from operations during the fourth quarter. Cash flow provided by financing activities was approximately $2.1 million, primarily related to proceeds from stock option exercises. Total capital expenditures in the fourth quarter were $1.1 million consistent with prior quarters. Accounts receivable net was unchanged from the third quarter at $25.6 million. However we did see an improvement in the overall aging of our receivables.

Day sales outstanding were 56 days at December 31, 2009 compared to 63 days at September 30, 2009. Due to the standard terms and conditions of our customer contracts, our targeted DSO range continues to be between 60 and 70 days. Finished goods at customers at the end of the fourth quarter of 2009 was $3.4 million compared to $1.5 million at the end of the third quarter of 2009.

Inventory at the end of the fourth quarter of 2009 was $4.4 million compared to $6.8 million at the end of the third quarter of 2009. This results in inventory churns in the fourth quarter of 2009 improved to 4.6 compared to 3.3 in the third quarter of 2009.

Finally, deferred revenue was $33.3 million at the end of the fourth quarter compared to $25.4 million at the end of the third quarter of 2009. This reflects a $9.8 million increase in deferred product revenue offset by $1.9 million decrease in deferred service revenue related to amortization of maintenance contracts.

As we've discussed on previous calls, deferred revenues can fluctuate from period-to-period simply based on the timing of revenue recognition and it should not necessarily be relied upon as an indicator of the health of the business. To help you better understand how we're looking on our growth plan; let me close with a few forward-looking comments.

I remind you that the comments I'm about to make are based on the current indications of our business, which may change at any time. We undertake no obligation to update these comments.

During our last call in October, we discussed our high level framework for 2010. At that time, we laid out our initial expectations which called for revenue and earnings growth of approximately 20%. Since then we've had the benefit of completing another quarter highlighted by record revenues and earnings.

We've seen continued improvements in our overall visibility and entered 2010 with very strong growth drivers for our business. We are therefore raising our outlook for 2010 revenue and earnings to approximately 30%. We now expect revenue in 2010 to grow by approximately 30% to a range of $182 million to $186 million compared to our earlier outlook of $166 million to $168 million.

We now expect non-GAAP EPS to grow by approximately 30% to a range of $0.44 to $0.47 per share compared to our earlier outlook of $0.41 to $0.42 per share. We expect capital expenditures to be approximately $7 million to $8 million in 2010. This does not reflect any investment related to the relocation and expansion of the company’s headquarters in June.

Our earnings projections assume a full year non-GAAP effective tax rate of approximately 37%, which reflects the expiration of the federal R&D tax credit. If the R&D tax credit is reinstated, we estimate that our effective tax rate will be approximately 33%.

Finally, we expect our full-year weighted average diluted shares outstanding to be approximately 64 million shares. To summarize, we had a strong fourth quarter highlighted by record revenue, gross profit, visibility, and cash and investments. The business continued to perform very well and our visibility continues to improve. During our next earnings release conference call in April, we will share with you the highlights from the first quarter of 2010. And with that I will turn the call back over to Brian.

Brian Norris

Terrific; thank you, Peter. Janet, at this time we would like to open the call up for Q&A please.

Question-and-Answer Session

Operator

(Operator Instructions). The first question comes from the line of Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs

I wanted to ask you first about your higher target operating margin here for the model, can you just comment a little bit on structurally what is driving that, is it the Covergence impact, is it your competitive position getting stronger, a more software mix, if you can just kind of outline the biggest drivers of that?

Andy Ory

Sure, I mean clearly the more software content in our products, whether it’s features or it’s capacity, the higher the margins and we are finding that people are purchasing both higher capacity systems and they are also purchasing systems with lots of software. We are being asked as a session border controlled product to do more at the edges of these networks and that’s being reflected in our margins.

Additionally, we do believe that our competitive positioning is continuing to improve and I think that’s also reflected. And lastly we have said for a while that long-term, we look at companies like F5 and we think, gee, if we could operate in the upper 70s for gross margin and in the 30% for operating margin, that would be a great business. We don’t see any near-term margin pressure because of the software content. We also don’t want to become “addicted” to 82% margins.

The biggest influence I think in terms of our business impacting our decision to increase our operating margins is the fact that we are just getting more wind through the engine. As more revenue comes in on a quarterly basis, it has a positive impact on our operating margins.

Peter Minihane

I think consistent with that, Andy, the product gross margin at 81% which has been pretty much that rate for the past four quarters combined with our controls of operating expenses and again 70% to 75% OpEx are people and people related. We have tremendous controls on hiring, on replacement requisitions and things of that nature that if we continue to maintain the strong product margins coupled with our operating expenses, I don’t see any reason why we can’t continue to grow the operating income quarter-to-quarter consistent with what I think we’ve outlined historically.

Simona Jankowski - Goldman Sachs

And then second question is that on my math at least when I look at Alcatel-Lucent and Nokia-Siemens, it looks like about $3 million of the sequential $5 million revenue increase came from increased revenues from those two customers, which both seems to have been up above 40% sequentially. I guess my question is what visibility do you have into their sellthrough and what is driving their increase in particular?

Andy Ory

Remember, both Nokia-Siemens and Alcatel-Lucent have consistently combined been around the mid-20and so we have 13 and 13 here, that’s 26%. Neither Nokia-Siemens nor Alcatel-Lucent are an end customer, nor are they stocking distributors. They are partners of ours that act as fulfillment and integrators.

So if and only when a customer wants to issue a purchase order that something go to either of those partners and then come to us. So the driver is 100% our end market. Whether the fulfillment is directed through one of our 100 partners is not really material as to what the driver is, if the customer wanting to buy the gear.

Simona Jankowski - Goldman Sachs

Yes, I think they were 10% and 11% last quarter, so just the math kind of works out to a 40% increase, I mean will it represent more IMS deployment in Europe or what do you think is driving their strength in particular?

Andy Ory

No, I think that if you look at only one quarter, if you look at only Q3 to Q4, you come up with something kind of skewed. 10% and 11% was probably a historic low, I think that anywhere from 11% to 13% is probably where we've been on the last four or five quarters. So I would say that Q4 performed much more in line than Q3 did in terms of what my expectations would have been.

Operator

The next question comes from the line of Paul Silverstein with Credit Suisse.

Paul Silverstein - Credit Suisse

On the guidance, am I correct in assuming that you are using the 37% tax rate and that you are also assuming gross margins come down to the high 70s in coming over that 44 to 47 range?

Andy Ory

Peter would want to talk about it, but we are assuming the 37% effective tax rate and we’re only reiterating the upper 70s as a longer-term gross margin. That's not something that we expect to see in the short term nor do we have any indications that it’s going to happen.

Peter Minihane

Right, and the 37% is reflective of the R&D tax assumption, that the R&D tax credit goes away. The 33% that we mentioned assumes that it gets approved by Congress.

Paul Silverstein - Credit Suisse

Just not to beat the dead horse, but the guidance assumes 37, since it is not re-adopted.

Andy Ory

It assumes 37.

Peter Minihane

That’s right.

Paul Silverstein - Credit Suisse

Andy, I think you just said it, but I just want to make sure, you don’t see any evidence that gross margins are coming down meaningfully this year?

Andy Ory

No. In fact, some of the initiatives we have is I would like to see us continue to develop our software practice and integrate it into other people’s network elements as well, so I would like to think of Acme Packet as a software company, and if we are able to continue to build that kind of a practice, we ought to be able to maintain margins, but I think from an operating point of view, the way we think long-term about the business is, let's try and run an upper 70s, bottom line 30%.

Operator

We have a question from the line of Brian Modoff with Deutsche Bank. Please go ahead.

Brian Modoff - Deutsche Bank

You mentioned earlier about the enterprise space, can you talk about the drivers there, SIP trunking, is it video collaboration, video web and competitors, what are you seeing out there from efforts by players like Cisco to embed SBC function?

What do you see competitively and you talked about pricing environment on that side as well?

Andy Ory

I'm really glad, Brian, that you asked that call, because I'm so darned excited about the enterprise market. I've to tell you that it is just taking off, and it has such a positive impact on the rest of our business. Peter and I flew the entire sales organization, customer facing organization to Montreal for a global field kick-off and we sat for two days and listened to every customer facing person with a quota, talk to us about what they see happening in 2010, and I would say that wherever there are SIP trunks being offered by service providers, it is a robust market for us in both the enterprise and the service provider space.

They are truly synergistic and the enterprises are racing to adopt it because it’s a quantifiable ROI, it improves their redundancy, it leverages their data network, it enables them to offer new applications where they don't need to wait on their network service provider or their equipment manufacturer. It lowers their connection cost. It just takes them where they want to be, and it's really exciting.

Now we've several different ways we get to the market, we have a direct sales organization because I think projecting thought leadership is really important, understanding the value proposition and priming the pump for our distribution partners is really important.

We know that medium and long term, we want to engage distribution and we have several strategic relationships or relationships that we have had historically focused on the enterprise market that are becoming truly strategic where Acme Packet is a part of what they need to do medium and long term and to see them invest and to see their sales organizations being compensated and [quoted], it’s really just a great thing to see. And because of how we are getting to the market and because of the size of the enterprises that we are targeting, we really don’t expect to see much margin dilution even as the enterprise market will continue to pick up steam and be a larger portion of our overall business.

And from a competitive point of view, it’s never been better. We have only seen this market take off from the acquisition of Covergence, we have established ourselves as one of the two leaders in that market. We are singularly focused on the requirements that are rapidly emerging in that market and I think that Acme Packet has a real opportunity to be as a dominated player medium and long term in the enterprise market as we have been for the last seven years in the service provider market.

Brian Modoff - Deutsche Bank

AT&T, talking about wanting to re-architect their network away from POTS and such, can you talk about how that trend positions you and does this change your growth trajectory over the next couple of years?

Andy Ory

Sure, it’s all good. We are hearing companies like that that are talking about taking their TDM interconnect and making them IP, it’s all good. We are seeing all sorts of trend where people who were thinking about transitional TDM technologies either for interconnect or Class 4 transit are basically scuttling those plans and moving direct to all IP.

We are also seeing an interesting trend where there is a disaggregation of network connectivity from services and so you see companies like Telefonica buying Jajah or British Telecom buying Ribbit. What's going on is that this new world is going to have service islands and network transport and enterprise customers and mobile network and they all are going to try and provide end-to-end connectivity for interactive IP communication and session border controllers are necessary at every one of those edges to provide security, control path selections, enforce all sorts of service classes to resolve IPv4-v6 addresses, basically to make something complex work simply and it seems that the future is coming very quickly.

I always say that the definition of a disruptor is somebody that can't wait to see the future and as you look at companies I think a simple way to figure out which companies make sense and which companies don’t, look at the ones that can’t wait for the future, and I’ll tell you, Acme Packet can’t wait for the future.

Operator

The next question comes from the line of John Marchetti with the Cowen Group.

John Marchetti - Cowen Group

Could you guys talk a little bit about maybe right now what you are seeing in terms of revenue from the service provider versus the enterprise split and whether or not that has any impact on margin, that kind of mix there.

And then secondly you are talking, Andy, of your viewing Acme as a little bit more of a software company than an appliance company, as you are getting further into this enterprise market, what are your plans I guess to offer Acme session border controllers essentially as a virtual machine that can sit on other hardware as that adoption curve continues to ramp?

Andy Ory

I am little surprised, it actually held steady at around 85-15 between service provider and enterprise and I think part of that is that believe it or not, the service provider business grew a little bit more then I would have expected. We are seeing the enterprise business really grow. There is a large amount of activity. Usually, we see a little bit of a fall off from the end of Q4 into the beginning of Q1, and I feel like I got to get the flywheel turning again to get everybody revved up, and I think that 2010 feels like the year without that, the activity level just continued to pick up and continues to do so today.

I would expect to see the enterprise market grow faster than the service provider market partly because I think it’s the law of small numbers. But right now we are tracking 85-15, even if the enterprise market does grow faster than the service provider market, I would expect it to be margin neutral in terms of what we are seeing and Peter can comment on that.

The other thing I wanted to comment on was your whole notion of the SBC as an appliance versus software. I would like to dissect that and talk about it two different ways. When we talk about session border control, we do talk about a network element that’s true. But we are starting to approach it more as an architectural approach where borders need to be managed in concert and inside network borders need to be managed and between networks borders need to be managed, it’s end to end and that management needs to be extensible for the third party application platform.

So we are very quickly seeing our technology morph into a class of product that provides largely border control, but it’s end to end and you see our products like the MSG which deals with the fixed mobile conversion. You see our core session routing proxy, you see our session load balancer which can balance multiple IP addresses on the access edge.

So things that you don’t necessarily think of a core SBC product are part of the overall architecture. As far as how it’s delivered, we have felt for the last four to six quarters that session border control is a technology and a function. It is not a piece of hardware. Now it is true that people that want best-in-class, high availability, feature-rich, high-price performance service provider and large enterprise platforms are going to buy specific pieces, purpose-built pieces of hardware to run the proprietary software, but we do believe that we are going to see emerging general purpose computing supporting our session border control software technology.

And to that extent, we do have something called the Net-Net OSE, it was a big part of the value that we received from Covergence. We do have relationships where people are reselling our software on general propose computing, you will see us talk more about that. It allows us to leverage distribution into the medium and the low end of the market.

Additionally, I believe strongly that there are OEM opportunities for this business and that's where there are other pieces of purpose-built elements in network where our session border control software could be leveraged and I think you will hear us talking about that over the next 90 days as well, so we are excited about all that.

Operator

And the next question comes from the line of Greg Mesniaeff with Needham & Company.

Greg Mesniaeff - Needham & Company

Question on the backhaul market in the US. I was wondering if you can give us some color as to what percentage of your domestic business was tied in some former fashion to the wireless backhaul market and what the opportunity is for you in that space going forward? That's my first question.

Andy Ory

So Greg, the first thing is that we are seeing wireless continue to grow. Clearly, wireless peering is going to really emerge to be a segment because so much of the traffic originates and terminates on cellular phones and these cellular networks, so these wireless networks, I am dating myself calling them cellular networks, they don’t really have their own Class 4 networks coast-to-coast. So often times they select a carrier and that causes all sorts of issues including cost, and we believe that bill and keep in the United States for wireless network is going to continue to drive our business.

You're seeing it now; I think that if you are a service provider and you don't originate or terminate subscriber traffic, you're going to find an increasingly thinner value proposition. We think that transport of IP across these networks with no transcoding if possible, is cheapest way to do it. The backhaul issue has more -- in my opinion has a lot to do with whether or not you're providing core functionality to devices that are at the edge, and we've always felt that voice is unfortunately in architecture on TDM networks where it’s dumb edge, smart core and backhaul as a requirement.

But on an IP network, voice is an application and IP networks have smart edges and dumb cores and we think that you're going to see networks emerge where backhaul isn’t really required and that the functionality will exist at the edge and it can dispatch ingress and egress at the edges.

Greg Mesniaeff - Needham & Company

Got you, now when you look at the SIP trunk opportunity, you mentioned markets being driven in tandem or in concert with different segments. I'm wondering do you see that as an opportunity driven primarily by the enterprise segment of your addressable market or by the carrier or both or how?

Andy Ory

It's a beautiful thing because it's both, they each want it and they each need it. The enterprises want it because they can lower their cost. They need it because they need to manage their unified communications. They need to deal with mobility. They need to deal with wireless and they want to offer new services. They can't to do that unless it's IP origination and IP termination. The service providers need it because if they don't, they could lose their enterprise customers, and they run the risk of being commoditized. So the service providers -- and it really happened over the last 90 to 180 days.

The service providers realize that if they loose an enterprise customer to a competitor, they may loose that customer for a five year life cycle. Additionally, if they are not front and center, helping the enterprises understand why moving to SIP is valuable for them and the enterprises instead approach them, they run the risk of being commoditized into just network transport. And so, we are really seeing this being driven by both sides and that really is a great thing.

Operator

Next we’ll go to the line of Catharine Trebnick from Avian Securities. Please go ahead.

Catharine Trebnick - Avian Securities

My question actually has to do, if you look at the pipeline, is there a way to slice it in a approximate level by the technologies that are a key part of this transition such as the IPv6, session load balancer, SMS over LTE, SIP proxy. Is there a way that you could say approximately or even take it towards the addressable market, right, and say we see these technologies really taking off end of 2010, early 2011?

Peter Minihane

We haven’t broken it out that way publicly. We put together a 2013 plan with the board, Seamus Hourihan who runs marketing and our product management, he took that on and we've looked strategically at those different segments and what we think they'll contribute over time and some of them can indeed be pretty big. Clearly wireless access is a real opportunity because we see that continuing to grow. We think the government sector is going to really grow, we think that the enterprise sector and the contact center will continue to grow. When we break it down into products like the load balancer and other things, there are more enablers for more session border control management and products at those edges. So, it’s kind of hard for us in our funnel right now to figure out, if we do a 0.5 million piece of business, how much of it is apportioned to one or the other. We probably will take it on to provide some clarity as we break this market out over the next six months.

Catharine Trebnick - Avian Securities

And then on the government side, how much are you giving a forecast like enterprise government service provider, are you looking to split that out the next year or not?

Peter Minihane

It’s something that we should consider. I mean we've been working in the government side for a long time. It’s not a new initiative. It takes a long time to get on the right lift, have the right approvals, getting the right budgeting cycle. And while we did seven figures of government business last year and we expect it to grow significantly this year, I think that 2011 and 2012 could be pretty large. We haven’t broken it out. To give people the sense of the size of the opportunity, I saw a 2008 census in the US Bureau of Labor Statistics. It has something like 114 million employees of businesses from one all the way up to the Fortune one. In the federal, local and state government, there were 22 million employees. And so what you begin to realize is that the federal government opportunity could be one fourth, one fifth of the size of our total enterprise addressable market, and the decision making is far more centralized. The government is racing towards all IP, they are racing towards lower cost in new services, and they are very sensitive on security. And so that plays very, very well to the Acme Packet session border controllers.

Operator

Next we will go to line of Ted Jackson from Cantor Fitzgerald. Please go ahead.

Ted Jackson - Cantor Fitzgerald

Two things. Andy, I had some computer glitches and I just wasn’t paying attention. I didn’t get all the data. Relative to the number of SBCs deployed and number of enterprises, I was wondering if you could just go through that portion of prepared comments. And then my second question had a do, if you could review the competitive landscape, given how well the company is doing and continues to outperform over the last couple of years. I just can't believe that some of your peers are redoubling their efforts in terms of trying to make themselves more competitive in your end markets.

Andy Ory

Sure. I mean first of all, Ted, what we'll do is we'll email you those statistics since they are publicly available, someone can get them off the call here. So we'll make sure you get those tonight. Secondly as far as people redoubling their efforts, well who? Right, I mean if you really think about it, in my opinion, the last truly great startup in this space was Covergence and after 2008 October hit and their investors said well this is a problem and they found a home in Acme Packet. I don’t think you're going to see many startup dollars going to session border control. We've been working this opportunity for almost a decade. So I think from that point of view it would be very difficult. There are the folks that manufacture, we call them the network equipment vendors, and there are partners and they make all sorts of TDM infrastructure as well as transport infrastructure and transitional TDM infrastructure like softswitches and gateways.

And as big as this market is right now and as exiting as this market is, it’s still very small relative to the hundreds of billions of dollars of CapEx that's just attenuating away, and so I think there are many, many other issues that they are all dealing with. I think it’s very hard to innovate and focus on a small high growth market space. So we haven’t seen much more redoubling of efforts. In fact I think that Acme has an opportunity to become increasingly strategic to those folks.

And then you run into some companies like Cisco and I think that Cisco is a very large company and they are focused on $34 billion collaboration market and so forth and in fact they’ve had three different session board of controllers since 2005, and the competitive disposition for Acme Packet has only improved on each and everyone of these quarters. What we are seeing, Ted, is that this is becoming a more mission critical element and it’s having more and more rapidly emerging requirement, and as it becomes end to end, the importance of having Acme from origination, transport and termination, actually is valuable. And so I think that the train may have left the station for people to try and really challenge us in this particular market.

Nonetheless, you saw our guidance, there's a lot of growth there, and even though we are talking about 30% top line, we are only growing the bottom line 30% because we are investing. We are investing because we want to stay relevant in our core market, we want to make sure that we are the right solution, that our customer acquisition translates into customer growth. Additionally, we believe that there are more adjacent market opportunities that are going to emerge as a result of a whole session oriented architecture and we think that we are uniquely positioned to invest in those opportunities. So we ought be able to continue to take ground in the marketplace.

Ted Jackson - Cantor Fitzgerald

And Peter just quickly, since you brought the Covergence and (inaudible) how did you get a gain on the acquisition of the business?

Peter Minihane

So we have, from the accounting rules and regulations up to one year from the date the deal closes to finalize all the evaluations. So we’ve the Section 382 review done, it got completed in the December, January timeframe, and we think we are now done with the economy as opposed to letting it roll on into January, February, March and April of 2010. And basically you have tax assets that was acquired, particular R&D cost, that we will be able to deduct in the future. And again, it's a tax asset, and I think there are also other items that just turned out to be adjusted during the term of the -- May 1 and April 30 up to and including last week effectively.

Ted Jackson - Cantor Fitzgerald

It's not a performance issue relative to the acquisition or anything? That's a bunch of accounting treatments.

Peter Minihane

Right, we paid them $22.8 million, we issued 2.9 million shares approximately of our stock, great deal for us, almost paid for itself actually the day one. It was a great deal for their preferred shareholders.

Andy Ory

And for their employees, 39 of the 54 found home here and are important members of our community.

Operator

Next we'll go to line of Sanjiv Wadhwani from Stifel Nicolaus. Please go ahead.

Sanjiv Wadhwani - Stifel Nicolaus

Two questions, first, Peter, just from the inventory point of view, and I missed part of the call, so I apologize if you’ve addressed this, declined quite a bit sequentially, can you just give some color there? And then second, Andy, confidence in business in 2010, any particular geography that's standing out or is it fairly broad base for you? Thanks.

Peter Minihane

I think we wound up for the first time breaking out finished goods inventory at customers which is directly related to deferred revenue. And secondarily, we have certain amount of inventory here in Burlington, and basically what has happened is our manufacturing organizations once again increased their inventory turns and even if you go back in pro forma, this adjustment back for the past two or three years, you’ll find that they had 4.55 inventory turns in the December quarter. Very simple math calculation, take your 9/30 inventory, your 12/31 inventory, take an average and figure out what your product cost-to-good sold is, that would give you your inventory turns.

These guys have done a very, very good job in managing finished goods and spare parts inventory that we here in Burlington. They have no control over the finished goods of customers. December 31, it was $3.4 million, not an insignificant piece of our total inventory of $7.8 million. So, that’s how we wind up, I think continuing to improve, it’s not perfect, but I think we can continue to improve it. It was a 40% improvement from September 30 to 12/31. If we can continue that kind of an improvement over the next four quarters, I think we could have inventory turns approaching six by December 31, 2010.

Andy Ory

Sanjiv, in terms of the confidence in 2010, geographically our business has been relatively stable of 55% US and Canada 45% the rest of the world. I have to say that the activity level has never been higher in every single geography. It’s all over the place. Now granted Cal is an important market but it’s going to be a relatively small geography in terms of revenue contribution compared to even APAC and EMEA has always been a pretty big market for us. But all four of these geographies I think have a real opportunity to over perform.

Peter Minihane

Right. And Cal is also very strategic to it, as it relates to…

Andy Ory

Absolutely.

Peter Minihane

… a lot of our EMEA distribution.

Andy Ory

Absolutely.

Operator

Our final question comes from the line of Paul Silverstein from Credit Suisse.

Paul Silverstein - Credit Suisse

Couple of questions, they are very discrete (inaudible) quickly. The 10% customer you referenced in 2010, Andy, do you expect that to be dramatically above 10% or you talking marginally about 10?

Andy Ory

It’s really unclear at this point, Paul. We felt it was important that we had an entire year. That is 2009 go by and not have a 10% direct end user customer, and we wanted to make sure that people understood that it is part of our [fiber] that we do have some very large end user customers. So it was important for us to make sure that you understand that it’s not done right now as to what that number is. We really don’t know. As I think we've mentioned on our deferred revenue piece, a number of these items are completely out of our control, installation and/or acceptance, and we just can't do anything about it. So deferred revenue grew, it grew in the fourth quarter. It has been very strong all year, but it had a dramatic increase from Q3 to Q4, Q2 and Q3 was relatively flat and so I don’t think we have any one isolated, but we will have much better advantage point on this in the next 90 days.

Peter Minihane

I can also provide some additional color on that, Paul. When you look out over our 2010 landscape and what we would expect to do, for the total year of 2010, I don’t expect any unnatural acts from any end user customer. One of the…

Paul Silverstein - Credit Suisse

Andy, is it 10% customer question, is that a new project?

Andy Ory

Well, I mean here is the deal. Right, I referenced a thing here that the number of customers who have invested more than 10 million in Acme Packet product and services increased from 3 in 2007 to 10 in 2009. We are starting to see customers that are laying down multiple millions of dollars for projects. And if you look at our $41.3 million that we just had, someone laid down $5 million for a particular project that would make them a 10% customer for that quarter, but I don’t see any real customer concentration throughout all of 2010.

Paul Silverstein - Credit Suisse

Okay. The enterprise customers, you mentioned 11 in the top 25, can you give some benchmark a year ago, a quarter ago, what would that have been?

Andy Ory

I think we were at 8 of the Fortune 25 the quarter ago.

Paul Silverstein - Credit Suisse

So you picked up three. Alright third question, I apologize if you already said this but…

Andy Ory

We are here, you can ask all the questions you want.

Paul Silverstein -Credit Suisse

IPv4 to IPv6 transition, it might have come up earlier in the call, but can you give us some sense for RFP activity or what that opportunity represents?

Andy Ory

It keeps growing. We are not positioning ourselves as a number resolver for mismatch v4 - v6. I mean clearly people want to see a v6 access infrastructure, so that they can run all these applications on these new devices, and they not going to be able to fix their v4 core very easily, if ever. So you are going to have a multi-mode environment, if part of the function that further justified session border control as an architectural element, and absolutely it is an important part about what we do, and we do see an increase in terms of that as one of the software features that's required in our SBC

Paul Silverstein - Credit Suisse

Okay, alright. New platform, the gateway, the load balance through the proxy, are they still a year out or 6 months out from making a decent contribution to revenue, can you give us some benchmark?

Andy Ory

Yeah, I think that they may take a little while to impact revenue, partly because people, particularly the service providers take a fair bit of time testing things, planning their networks, and rolling things into live service. But yeah, I would expect that they would have an impact in the second half of 2010.

Paul Silverstein - Credit Suisse

And finally, I know you limit your guidance to the year as opposed to the quarter which is the exact opposite of everyone else. But for the quarter in terms of seasonality and normally the low CapEx budget you see in the first quarter, can you give us any thoughts, insight, for what you are seeing in your business?

Peter Minihane

I think it’s a combination that we'll take. Obviously, some of the deferred revenue will fall into our first quarter, we don’t envision that being down sequentially or any seasonality in our Q1 and Q2 as of now. So if you were to think about Q1 over Q4, we would expect a sequentially up quarter.

Andy Ory

First of all, I want to thank everyone for joining us this evening. To summarize, we had another strong quarter with record financial results, strong new customer adoption and an upwardly revised outlook for 2010.We believe we are extremely well positioned to extend out leadership in what is expected to be an aggregate $2 billion market opportunity in our core market. We look forward to seeing as many of you as possibly during this out reach period and updating you on our continuing progress during our next conference call. Thank you and good night.

Operator

Ladies and Gentlemen, this conference will be available for replay beginning today at 7 PM Eastern, running through Tuesday, February 16 at midnight Eastern Time. You may access the AT&T Executive Playback service by dialing 800-475-6701 and entering the access code 140323. International participants should dial 320-365-3844 with the access code of 140323. Those numbers again are 800-475-6701 and 320-365-3844 with the access code of 140323.

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Source: Acme Packet Inc. Q4 2009 Earnings Call Transcript
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