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Check Point Software Technologies (CHKP)

Q3 2006 Earnings Call

October 19, 2006 8:30 am ET

Executives:

Anne Marie McCauley – Director of Investor Relations

Eyal Desheh – Executive Vice President, Chief Financial Officer

Jerry Ungerman – Vice Chairman

Gil Shwed – Founder, Chairman and Chief Executive Officer

Analysts:

Sterling Auty – JP Morgan

Walter Pritchard – SG Cowan

Todd Raker – Deutsche Bank

Gregg Moskowitz – Susquehanna Financial Group

Shaul Eyal – CIBC World Markets

Robert Breza – RBC Capital Markets

Sarah Friar – Goldman Sachs

Edward Maguire – Merrill Lynch

Christopher Hovis – Morgan, Keegan and Company

Katherine Egbert – Jefferies and Company

Dino Diana – UBS Securities LLC

Ehud Eisenstein – Oscar Gruss & Son

Presentation

Operator

Good morning everyone, my name is Brianna and I will be your conference operator today. At this time I would like to welcome everyone to the Check Point Software 2006 Q3 earnings conference call. Operator instructions. It is now my please to turn the floor over to your host, Anne Marie McCauley. Ma’am, you may begin your conference.

Anne Marie McCauley – Director of Investor Relations

Thank you, Operator. Good morning and afternoon. I’m Anne Marie McCauley, Director of Investor Relations for Check Point Software. Thank you for joining us to discuss the Q3 2006 results. As a reminder, this call is being webcast live from our web site and is being recorded. To access the live webcast and replay information, please visit the Company’s web site at www.checkpoint.com/ir. The replay will be available through November 2. If you would like to reach us after the call, please contact the Investor Relations Department at 650 628 2050. On the call with me today is Gil Shwed, Chairman and CEO; Jerry Ungerman, Vice Chairman; and Eyal Desheh, Executive Vice President and CFO.

Before we start our management presentation I would like to read the following disclaimer. During the course of this call the Company will make certain forward-looking statements. Forward-looking statements include statements regarding Check Point’s expectations and beliefs regarding operating results for the fourth quarter of 2006; initiatives to increase revenue; the competitive position of and capabilities of Check Point’s products; trends toward larger transactions, Check Point’s ability to compete in sales to government agencies, and Check Point’s plans to enhance its product architecture and expand the specific accounts and partner program. Other statements which may be made in response to questions which refer to our beliefs, plans, expectations or intentions are also forward-looking statements for purposes of the Safe Harbor provided by the Securities Litigation Reform Act. Because these statements pertain to future events, they are subject to various risks and uncertainties, and actual results could differ materially from Check Point’s current expectations and beliefs.

Factors that could cause or contribute to such differences include, but are not limited to, the impact on revenues of general market conditions in the Company’s industry; the mix of sales of new products and long-term subscriptions; economic and political uncertainties; the impact of political change and weaknesses in various regions of the world, including the further escalation of hostilities or acts of terrorism in Israel; the inclusion of network security functionality and third-party hardware or system software; any foreseen and unforeseen developmental or technological difficulties with regard to Check Point’s products; changes in the competitive landscape, including new competitors or the impact of competitive pricing and products; rapid technological advances or changes in customer requirements to which Check Point is unable to respond expeditiously, if at all; a shift in demand for products such as Check Point’s; factors affecting third parties with which Check Point has formed business alliances; timely availability, features, performance and customer acceptance of Check Point’s new and existing products; the amount of equity-based compensation charges; the ability to recognize deferred revenues and other factors and risks discussed in Check Point’s annual report on Form 20-F for the year ended December 31, 2005, which is on file with the Securities and Exchange Commission.

Check Point assumes no obligation to update information concerning its expectations. Now, let me turn the call over to Eyal Desheh for financial review.

Eyal Desheh – Executive Vice President, Chief Financial Officer

Thank you very much, Anne Marie. Good morning and afternoon everyone. Let me share with you the results of a good quarter and provide some more details on the financials. Our Q3 results came in at the high end of our projections and demonstrated annual growth in revenues and non-GAAP profit. We experienced healthy interest in our new perimeter security product line, especially the UTM offering, which had favorable results, tied to enhancement we made through subscriptions, support and service initiatives which can be seen (inaudible) YoverY increase in service (inaudible).

Our consumer business generated nice growth and is now available in all major retail stores, and we have noted for many quarters that we have experienced continued success in our SmartDefense program. As a reminder, our quarterly results for 2006 include the impact of SFAS123R, the inclusion of equity compensation in expenses in the P&L and our GAAP financial results. In our press release, which has been posted on our website at www.checkpoint.com, we are presenting GAAP and non-GAAP results and reconciliation tables which highlight this data. Let me share with you the financial details for Q3 2006. Revenues for Q3 were $142.5 million compared to $141 million in Q3 2005 and $139 million in Q2 this year. GAAP net income for Q3 2006 was $71 million compared to $79 million in Q3 2005 and compared to $66 million in Q2 this year. Equity?based compensation expenses accounted for $6.5 million in this quarter. Non-GAAP net income was $79 million compared to $80 million in Q3 2005 and grew 3% over Q2 this year. Operating expenses for Q3 were $72.1 million. Non-GAAP operating expenses were $64.1 million compared to $58 million in Q3 last year and compared to $64 million in Q2 this year. The annual increase in expenses is a result of growth in head count mostly in R&D, sales and technical services. Our total headcount grew by more than 100 employees this year and is now over 1,500.

Total operating income was $70 million and non-GAAP operating income was $78 million, down from $83 million in Q3 2005 and up 5% from $75 million last quarter. Our effective income tax rate was stable at approximately 17%. GAAP earnings per diluted shares for Q3 of 2006 was $0.31, the same as $0.31 last year and was up 15% from $0.27 last quarter. Equity-based compensation had a $0.03 impact on GAAP EPS. Finally, non-GAAP EPS for Q3 2006 was $0.34 compared to $0.32 both last year and last quarter, an increase of 6%. Deferred revenues this quarter were $173.4 million, an increase of $29 million or 20% over Q3 2005, and only a slight decrease of $3.1 million or 2% compared to last quarter which was less than our historical seasonal decrease.

DSO for Q3 were 60 days compared to 54 days in Q3 2005 and 55 days in Q2. In Q2, we generated cash from operations of $75 million excluding share repurchase. Our cash and investment balance at the end of the quarter was $1.6 billion. During Q3, we purchased approximately 11.5 million shares for a total cost of roughly $201 million as part of our expanded share repurchase program. Our Q3 revenues again were well diversified, with America contributing 46% of revenues, EMEA contributing 41% and Asia Pacific and Japan region contributed 13% to our revenues this quarter. For Q3, our emerging products contributed approximately 30% of our product revenues. In Q3 our large orders which are greater than $50,000 accounted for roughly 27% of total orders. In Q3, we had seven deals between $500,000 and $1 million and five deals which were greater than $1 million. This brings the large deal count for the year to 18 deals in the range of $500,000 to $1 million and 12 deals greater than $1 million. This is from the beginning of the year.

These kind of large deals are a result of successful initiatives with large accounts whereby Check Point becomes the major provider of network security solutions. We’ll continue to grow our install base, adding 21,000 gateways, bringing the total to over 528,000 security gateways. In summary, we are pleased with the financial results we posted this quarter. Our working environment has not changed dramatically in 2006 and we believe that our performance and execution has improved and we are headed into the final quarter of the year with a robust product portfolio. I will now let Jerry and Gil speak more about our business and our plans. Jerry, please go ahead.

Jerry Ungerman – Vice Chairman

Thank you Eyal, hello everyone. Thank you for taking the time to be on the call with us today. Following Eyal’s review of our financial highlights, I would like to focus my comments on some business highlights for the quarter that we think are important aspects of our growth strategy. First, we have collaborated with Intel in developing high performance security. Working together, our software engineers and Intel’s hardware engineers modified the Dual?Core Intel Xeon Processors 5100 bios to deliver optimized performance for our security solutions. As a result, Check Point has achieved an industry first 10Gb per second using an open server approach, a speed unmatched by any other software security vendor. This approach allows customers the flexibility of software with the higher performance of hardware at an unbeatable price performance ration.

Second we announced that we were awarded the EAL4 US Government certification for all four critical network security categories: firewalls, VPN, IDS/IPS and remote management. Check Point products meet and exceed the stringent requirements established by government standards, government approval processes and security industries test. With this certification we believe we are the only security company to offer government agencies a complete certified, unified security architecture. This should allow us to compete more effectively and sell to government agencies all over the world which highly value this certification.

During the quarter, we also hosted the Check Point Experience Event for partners and users in Asia Pacific, which included technical and business discussions and product demonstrations to improve technical know-how and expertise for attendees. We had record attendance at close to 700 participants. Our new collaborative enterprise support program, CES, was expanded into the Asia Pacific region during the quarter based on the initial success of the new support program we launched in Europe in Q2. This is the new support program and is a combination of subscription and support delivered jointly by Check Point and our partners. It is designed to add more value to customers and partners by improving the support our customers receive.

Finally, we won a number of awards during the quarter, for both our consumer products and new UTM solutions that are focused on providing not only the best security but also solutions that are easy to use and cost effective – a compelling combination. While we still have much to as we move into Q4 and the next year, we are pleased with the initial success across a number of new initiatives. A key component of our growth strategy is our unified security architecture, which is resonating not only with customers and partners but is a concept being embraced by many industry analyst firms. In fact, just last month Gartner held a conference focused on the importance of customers having a security architecture and the need for flexibility to deal with the dynamics of evolving security threats. The initial acceptance of our new VPN?1 UTM solution was positive and we were also pleased with our results across all geographical and market segments, especially with the improvements in our business results in Japan, which is primarily the result of the restructuring we began implementing this year in addition to bringing on our new country manager this quarter.

Europe also turned in a very nice performance during the quarter. In summary, we still have to focus on our execution of these many new initiatives as well as launching some additional ones that we believe over time will result in the top line growth consistent with our strategy that we have been discussing with you this year. Thank you again for being on the call with us today and I would now like to turn the call over to Gil Shwed.

Gil Shwed – Founder, Chairman and Chief Executive Officer

Thank you, Jerry, and good afternoon everyone. We’re pleased with the solid results generated in Q1, especially given that it’s specifically a seasonally low, slow quarter. Many of our highlighted financial metrics increased compared to last quarter and we had annual growth in key areas, including revenues, deferred revenues and non-GAAP EPS. Furthermore, we came in at the higher end of our projection. Another favorable trend in the quarter was the continued success of our unified security architecture. We have been working with many customers around the world to endorse the Check Point Unified Security Architecture as the framework for their security infrastructure. During Q1 we saw an increasing number of major customers endorsing it and placing multi?year procurement projects with us.

These include customers from different sectors and different parts of the world. Examples include one of the world’s largest global financial institutions, one of the world’s largest publishing sectors, a nationwide utility company, a global sales chain, one of the world’s largest shipping companies and a few government agencies where we displaced competitors. These are a few examples of customers that participated in our strategic program.

Going forward, we intend to continue to enhance our architecture. We will extend our architecture to additional security segments and we will expand our strategic account programs around the world. Finally, we intend to continue and work with our channel partners to deliver these values to customers of all sizes.

Now let me share with you our results of financial targets for Q4 2006. We expect Q4 revenues to be in the range of $153-166 million. GAAP EPS is expected to be between $0.34 and $0.37 and non-GAAP EPS, excluding the effect of stock-based compensation and exposition related charges is expected to be in the range of $0.37 to $0.41. In summary, we will continue to execute on our architectural plan and hope that these efforts will drive our business in the coming quarters and coming years. Thank you again for participating in this call, and with that I would like to open the call for your questions.

Question-and-Answer Session

Operator

Operator instructions. Our first question comes from Sterling Auty – JP Morgan.

Q – Sterling Auty – JP Morgan

I missed it as you went through, can you describe the geographic performance that you saw? Specifically what you saw in north America and what you saw in Europe?

A - Eyal Desheh

First of all, I’m very pleased to say that all our geographies performed well this quarter. I think most notably we had a very nice performance coming from Europe. In Q3 (inaudible) is usually slow in Europe. We had a very nice pick up in business over there. We have had a very nice improvement in Japan, Jerry mentioned, due to a management change that is already delivering. Our Japan business is beginning to grow again. Asia, mostly, or China, Korea and Taiwan is all very well. America has done fairly well also, but I think the geographical highlights were Europe and Japan.

Q – Sterling Auty – JP Morgan

If you gave the geographic splits I’ll get them off the transcript, if not if you could repeat them that would be great. The other question is on worldwide sales – there have been some articles in North America about potential changes that you might consider here. Can you review what you’ve done here in North America so far and what additional changes we might expect?

A – Gil Shwed

I don’t know what this article refers to, but generally we intend to keep the structure that we have and we intend to keep investing in our channel partners to put a lot of focus on some of our strategic accounts. I don’t know, Jerry, about major changes other than that.

A – Jerry Ungerman

I’ll address it, because I’ve been working on it and been involved with a lot of our partners on it. As we said before, it’s just a continued evolution. It’s not North America only, this is all worldwide, it’s all global. We had consistent programs of what we’re doing regarding our relationship at the partner level. The investment we make, the investment they make and how we’re doing. It’s just an ongoing continuing thing that we’ve been doing for my eight years here. I don’t know if the article said it that way, but I read it that way because that’s what we talked about. It’s just a continuation of – you know, being 100% indirect, our channel partners are very important to us as we always focus on them. If the world changes, the dynamics, the flexibility you need to have requires changes and modifications and improvements in programs and that’s what he’s doing and that’s what we’re doing, but it’s all over the world. It’s not just North America.

Q – Sterling Auty – JP Morgan

Then lastly, can you address the competitive landscape? It seems like Juniper may still be struggling with some of their IDT types of initiatives. Does that give you an opportunity to pick up a little market share?

A – Jerry Ungerman

I was going to say, the competitive market share is about the same. Maybe we are there specifically, but I still think Cisco still is our number one competitor in the marketplace. I don’t think we see Juniper as much as we used to. I don’t think they’re doing as well. I don’t know about any specific product area, because we generally just look at ours and how we’re doing and what we’re doing in the marketplace and our competitive wins etc. It’s still a very competitive marketplace but there’s not many of us out there any more. With us being left as the only true, major software security vendor for the network infrastructure, I think we’re in a very good position. We need to keep on putting together our programs and our execution plans and executing to them. Gil talked about some of the new things we’ll be doing down the road at a high level. I think it well positions us in the eyes of the customers on a global basis, as we can see in some of our very large orders we’re winning and I think we’ll continue to win to expand our offering in the months and the quarters in years to come.

Operator

Our next question comes from Walter Pritchard – SG Cowan.

Q - Walter Pritchard – SG Cowan

Jerry, you mentioned off hand some changes in (inaudible) in Asia. We’ve started to hear a little bit about how that will be rolled into North America I believe maybe in this quarter or the beginning of 2007. Could you go into more specifics on the changes there and specifically how it impacts your numbers. It appears that line has been relatively flat for quite a while and it picked up a bit this quarter.

A – Jerry Ungerman

Yes it did, Walter. We don’t know what we’re going to do on North America. On the support programs, we have multiple support programs on each region. It depends upon the customers, the environment, the partners and who is providing what. It’s all focused on how to get the highest levels of customer satisfaction which I think we do a pretty good job on in North America and the rest of the world. It’s a new program that combines partner support and Check Point support. I think traditionally, either the partner would give support or we would give support. We always provided the underlying software subscription, as you know. What we did, and in Europe it was very well received, and it went into Asia Pacific this last quarter, is we offered a new option which is a combination of getting support from both the partner and Check Point. The subscription still comes from us but now the support is combined it makes it very seamless and easy for the customers. We’ll evaluate that in North America too. If it makes sense here, we can either roll out that program or some modified program that is applicable to the specific market, but yes, that did drive the growth of our support revenue. We think it’s improved customer satisfaction significantly and the partner satisfaction, in that we can work so closely together to provide frontline support as opposed to just back line support.

Q - Walter Pritchard – SG Cowan

Eyal, on the buyback, you bought back more this quarter than you had in the past couple. You had about (300 or so million?) left on the buyback. Could you just tell us of the $1.7 billion or so in cash you have on the balance sheet, how much do you look at it as needing to reserve for operating the business and keeping options open on acquisitions?

A - Eyal Desheh

This money and additional cash flow that we generate every quarter is there to increase and expand our business status, that is primarily the reason why the money is there. The improvement can come from bottom line EPS (inaudible) or from possible acquisitions in the future so I don’t think it’s relevant to discuss how much exactly that we need to run the business. We’re cash flow positive on every day and every week, the money is reserved to invest in the future and I think we’ll be able to do this wisely.

Operator

Our next question comes from Todd Raker – Deutsche Bank.

Q - Todd Raker – Deutsche Bank

Given the strength in Europe and Japan, can you comment on any FX impact this quarter and what the impact would have been on the revenue line?

A - Eyal Desheh

The foreign exchange impact in the quarter on the revenue line is minimal. Most of our sales are denominated in US dollars. We did have some impact from the (inaudible) which was re-evaluated and that’s stronger versus the dollar this quarter as part of our expenses of course in Israel. That probably had an impact of about half a million dollars on expense increase, but that’s basically it.

Q - Todd Raker – Deutsche Bank

Large deals really picked up nicely this quarter relative to your trends in the first two quarters. Can you give us a little bit more insight in terms of customer verticals or geographic verticals in terms of where you’re seeing the larger deals?

A – Gil Shwed

I think I might have alluded to that in my text and I gave a few examples. I think if you remember the examples, the examples were from all over. We had the major shipping company, one of the world’s largest financial institutions, one of the worlds largest food companies, a few government agencies and a few more so I mean as you can see it’s not necessarily one – it’s all over the matter. We had a few technology companies, one or two in the quarter and bigger ones in previous quarters. It’s not coming from just one sector.

A – Jerry Ungerman

It is global.

Q - Todd Raker – Deutsche Bank

Last question. If you look at your unified security architecture, clearly you guys tried to buy (inaudible) and you couldn’t get that done for rhyme or reason. Are there any product holes within your offerings today and how do you guys look at smaller technology acquisitions for the end of year strategy here longer term?

A – Gil Shwed

I’ll try to answer that. First, I mean, architecture doesn’t necessarily mean that we need a supermarket that has everything. If you look at the industry we are in, there are 600 security companies. We’re not trying to say that we’re providing the framework or the architecture or we’re going to compete or have what each one of these 600 companies have. We are going to add the framework, we are going to add the basics, we are going to get something that through our optic alliance can connect to many, many other products. Included in the detection prevention is a technology that we did put on our roadmap and it’s still there and we’re still committed to that architectural solution. It will get there sooner or later. What we are looking at right now is not just to strengthen the existing framework, but to expand the framework and for additional areas that we can add. We cannot discuss which areas yet, but we are researching multiple areas. We are starting to have more time for execution and I’m sure that in the next – every quarter out of the next few quarters, we are going to see more and more and more progress coming in that direction.

Operator

Our next question comes from Gregg Moskowitz – Susquehanna Financial Group.

Q - Gregg Moskowitz – Susquehanna Financial Group

Getting back to Europe and the strength you saw there, from what I can tell it looks like about a 5% sequential increase and that’s the first time that you have seen growth in Q3 sequentially in about six years. I’m sure the support program did help somewhat, but I’m just wondering if you can give any more color in terms of what else you would attribute that strength to. Also, if there are any particular reasons within Europe that kind of drove more growth?

A – Gil Shwed

I must say it’s a little bit hard for me to quantify the extra strength we saw, because in Europe it was still the summer quarter, people were still on vacations and we saw that as well. I think some of it is attributable to the new collaborative enterprise support programs that we had. That was still growing the support revenue. I think they help in having a better relationship with the channel and working better with the channel and the customer presenting a more unified front, being closer to the customers and so on. This has additional benefits that are hard to quantify. Some of the strength in Q3 was things that didn’t come in Q2, because I think Q2 wasn’t the strongest we wanted. I have something that came from the first half of the year. Overall, because in Europe we sold very nice growth YoverY and QoverQ, even beyond that. Part of that would be the ongoing build up that we have in our programs and products. Jerry, I don’t know if you have more?

A – Jerry Ungerman

No, I think that’s spot on exactly what’s happening in the marketplace about execution and timing and things are happening. We need to continue to stay focused in the same regard and continue with new initiatives and new programs. I like the direction we’re going.

Operator

Our next question comes from Shaul Eyal - CIBC World Markets.

Q - Shaul Eyal - CIBC World Markets

Good quarter, guys. A couple of quick questions, for the next quarter are we still expecting the same breakout between the product subscription and services for the most part?

A - Eyal Desheh

We hope to increase the product line so I would try to make a precise forecast. We would like to see some more products and licenses in Q4.

A – Gil Shwed

Q4 is a little bit stronger, usually, on the license products side and on the other hand, we expect to continue to see growth in the support side. I think we’ll just see the continuous trends that we’ve seen.

Q - Shaul Eyal - CIBC World Markets

As you look at the number of wins you’ve had this quarter, are these mainly displacements or just new customers being brought on board?

A – Gil Shwed

It’s a combination. I think we have all of that. There is some of it in displacements of competitors, most of it is new projects and some of it is architectural wins that are very important. It’s not just the size of the initial order that we get, it’s the fact that these customers commit to a three year procurement plan from us and that’s very helpful in forming the relationship. All the cases I mentioned all generated between hundreds of thousands to millions of dollars and over the last quarter they also generated over a million dollars in revenues in the quarter. It wasn’t necessarily the end game, there is much more to come in the next two to three years.

Q - Shaul Eyal - CIBC World Markets

What’s the current status with Sourcefire? Obviously the acquisition didn’t take place, what is the current thinking and status?

A – Gil Shwed

As I said before, we are still committed to our roadmap in terms of intrusion detection, intrusion prevention technology and having the best parts of our portfolio and parts of our products in different and various ways – right now we don’t have a specific announcement to make, but I hope that we’ll have something soon and we will notify how we intend to deliver then.

Operator

Operator instructions. Our next question comes from Robert Breza – RBC Capital Markets.

Q - Robert Breza – RBC Capital Markets

Jerry, you talked about some of the new initiatives – could you talk about maybe at a high level what those might be and where you’re going? Do those initiatives, when you look at the guidance range, it widened this quarter relative to the last couple of quarters. Is it predicated on these new initiatives taking hold or what was the main driver behind the widening of the guidance range and what might it impact you at the high or the low end?

A - Eyal Desheh

I will take the last one and Jerry will take the first part of the question. Regarding guidance, this is not unusual. This is more of the ranges we have been providing. The future is hard to predict so we want to be careful. We wanted to try and beat you guys each time with our reporting, so that’s why we’re having a broad guidance. Just to make sure that we see what you see and the predictability in this market is not becoming simple, it’s not becoming more complicated. I’ll let Jerry talk about the initiatives.

A – Gil Shwed

One more think, Q4 tends to be the most back-end loaded quarter with a very strong finish and that poses a big reach factor, it also poses the biggest topside, it’s also expected to be good. We are very optimistic going into it but once you get a quarter like that, it obviously decreases the range of guidance and that means we have to take multiple scenarios into account. Hopefully we will be within that range. Hopefully we will be at the upper end of the range, but none of that is guaranteed, as we all know.

A – Jerry Ungerman

I agree with everything Eyal and Gil just said, because it is a very dynamic business, and you guys know this. That’s not a surprise. We have a number of initiatives and we talked about them not only during the remarks we made – the prepared remarks and in advance, but also in the last few quarters. It stems off the macro view, our vision of this unified security architecture. But then, we’ve done a number of things, both on the consumer side and the enterprise side with new products, technologies and solutions, UTM, the power. There have been more options this quarter with some of the new suites that we have, but it’s not only products, it’s also our restructuring that we’ve done and new initiatives we’ve put in place, like the CES program that the talked about, the collaborative enterprise support, the new strategic account program that we talked about just briefly and Eyal and Gil both talked about the number of very large transactions, multi-year transactions that we’re winning, that provide a much broader set of security technologies. That’s what we’re focused on. We have to continue to execute on all these fronts, not only the ones we’ve already announced and had in place, but additional ones that you’ll see this quarter and going into next year, where there’s a lot of things we’re going to be doing to take advantage of our market position and where we are, and our relationship with our partners and our customers. It’s a challenge, but it’s a good market. We’ve got a good company with good technology and good people and we just need to execute accordingly.

Operator

Our next question comes from Sarah Friar - Goldman Sachs.

Q - Sarah Friar - Goldman Sachs

Just a bigger picture question around what sort of growth rate we could look at for Check Point. Obviously this year has been a changing year for you where you have had to regroup. You are talking about the new initiatives you are putting in place. It is still a decelerating year from a growth rate perspective. As you look at 2007, can you give us any sense for what you think is a more long term, stable growth rate that you can think about for the company?

A – Gil Shwed

First, this year I think we are running at a relatively stable rate compared to last year in terms of revenues, and we do see growth in EPS which I think is always positive. We are putting together right now all of our work plans for next year. It would be a little bit premature to put down both the new initiative or new strategic areas and the core business projections or how they come together. I hope that we’ll be able to do more of that at the beginning of Q1 as we finalize those plans and we will be able to share more of them. Obviously we’re doing everything we can to both improve execution, expand our leadership in our core market as well as invest in additional security markets that will make our unified security architecture broader into multiple segments.

Q - Sarah Friar - Goldman Sachs

Quickly, on COGs in the quarter, your cost of goods went up. Is that a facet of more appliances being sold, or was it the uptake in support and training? I guess the question is for next quarter, should we expect a similar level for gross margins or should we expect that to pick back up again?

A - Eyal Desheh

The level and the percentage wise, we could expect something similar. We have some (inaudible) solutions and we are beginning to see some more demand for that. That is the result of the small up tick that we had in cost of goods. Q4 is expected to be like this proportionately but probably it will be a little hard to predict the exact mix. It shouldn’t make a substantial difference on the percentages.

Q - Sarah Friar - Goldman Sachs

Okay, so similar to what we saw in the third quarter?

A - Eyal Desheh

Yes.

Operator

Our next question comes from Edward Maguire - Merrill Lynch.

Q - Edward Maguire - Merrill Lynch

A question on the US federal government business. Have you had previous EAL 4 certifications for the business? And could you talk about any plans to invest around the business to take advantage of or increase your sales to the US government?

A – Jerry Ungerman

Yes we have, and I think I’ve said this before, but our tipping of sectors is on a worldwide basis, not just the US government. The worldwide governments are very important. The certification is used all over the world. I think our two largest sectors are government and financial. We do have a very big team of not only our people, but also partners in Washington DC, that work with all the agencies, both civilian and defense. We’re just excited about this, because like I said it’s the first one to get all four different levels certified. We’re even going for additional certifications beyond this that I think well positions us in all governments around the world to be the primary, premier, major supplier of the unified security architecture that uses different technologies incorporated in it. This is a big step for us in enhancing the certifications that we do have and have had, and we’re going to go beyond that. This is going to be a very good sector for us on a worldwide basis.

Q - Edward Maguire - Merrill Lynch

Just a follow-up on investing in the business, you know, your head count is up. Could you talk about where you’ve been adding heads and where you hope to build out the organization over the next couple of quarters?

A - Eyal Desheh

Most of the people were added in R&D or in our sales. That’s across the map in all geographies. We’ll be hiring most of those people and we’ve talked about a plan to do this at the beginning of the year. We’re executing and also in our services and support. We have a very nice increase in our service business and service revenues and we are hiring some people to make this happen. It’s – in the business producing area, as you would call it, that’s where most of these people were. Next year, I think we’ve said it a number of times on this call already, we’re talking about next quarter and right now, and come the end of the year we’ll talk about 2007.

Operator

Our next question comes from Christopher Hovis – Morgan, Keegan and Company.

Q - Christopher Hovis – Morgan, Keegan and Company

Nice quarter. A couple of quick questions – one, I think, Gil, you mentioned that you had multi year commitments for some of the unified security architecture wins. Can you talk to us about what that implies. Does it mean future product purchases or just technical support and subscriptions?

A – Gil Shwed

It’s a combination between various levels, but we do have a strategic program in which the customer does a multi-year procurement agreement, and this agreement usually they get it every year. Of course, the subscription service is usually a service at a relatively high level. They also get every year additional products for their procurement, so most of these contracts are like this. Sometimes you will see the subscription and services portion – that depends on the deferred revenue, the products which are not in the deferred revenue, but are generally structured on such things.

Q - Christopher Hovis – Morgan, Keegan and Company

So future product does not show up on the balance sheet or income statement?

A – Gil Shwed

No, future product does not.

Q - Christopher Hovis – Morgan, Keegan and Company

Eyal, on operating cash flow, it was down YoverY. Can you talk about what’s going on there?

A - Eyal Desheh

Yes. Nothing much. As you probably noticed, the end of the quarter happened to be on a weekend. We’ll probably collect on what – or I’ve already collected some of what was missed immediately at the beginning of Q4. This is just in between quarters, nothing dramatic. The quarter wasn’t more back end loaded than usual. It was even a little less back end loaded than usual. It’s just some collection that moved from one quarter to the other because of the weekend it happened to be.

Operator

Our next question comes from Katherine Egbert – Jefferies and Company.

Q - Katherine Egbert – Jefferies and Company

Quick question on the OEM side, you didn’t mention what percentage they were of business, so if you could do that? Then also, as you roll out some new initiatives, would you say that you were doing more through the OEM channels?

A – Gil Shwed

The OEM channel has not been a significant channel for us for many years. We do work with what you can call OEMs or what we call (compliance partners?) to supply joint solutions, usually through what we call a ‘meeting the channel’ model in which the channel buys the hardware, the client provider buys the software from Check Point and we sell very little to these companies directly. As a percentage, I don’t remember what was the appliance percentage of our business. Eyal, do you have a sense?

A - Eyal Desheh

The ones we sold directly or the ones that…?

A – Gil Shwed

No, overall?

A - Eyal Desheh

Overall from product sales, about 70% of that is in conjunction with partners. Actually, we sell most of the software.

Operator

Our next question comes from Dino Diana – UBS Securities LLC.

Q - Dino Diana – UBS Securities LLC

You were able to reverse a prior negative trend in the first half of the year. It was total bookings, it was down 5% in the first half of the year and now it’s up 6% in Q3. Part of that was just getting total revenues to stabilize, but the bigger part than deferred revenue, can you talk to us about what contribution was, say from SmartDefense and the changes you made in support? And what the other moving parts in that was?

A - Eyal Desheh

All our annuity based sales are moving into deferred revenues when they’re booked and then they’re being amortized over the period of the agreement, which is mostly one year. Very few are over (inaudible) in one year and what we have on the SmartDefense, we had a record quarter this quarter. Of course we’re getting more business than we’re recognizing because it’s growing all the time. It always lags and there’s more in deferred than we had recognized this quarter, but we’re never breaking down these numbers precisely. So we’re not going to start now.

Q - Dino Diana – UBS Securities LLC

Is it fair to say that SmartDefense was the bigger driver of the deferred revenue increase?

A - Eyal Desheh

I don’t think so.

Q - Dino Diana – UBS Securities LLC

In terms of your long term operating margin model, when you look a few years out, some people would argue that mid-50% margins are hard to maintain. What is your overall view on what these should trend to longer term?

A - Eyal Desheh

First I would say we’ll probably have a lot of the highest margins in our industry or maybe the highest, which is a result of our very efficient business model, very well-run business model. We know that a very high margin depends on the type of business model that we’re running and could change with the mix of products. Right now it is reflective of the type of product and the mix of products that we sell. This could change, if that mix will change in the future.

Q - Dino Diana – UBS Securities LLC

Are you any more willing to give up operating margins to get revenue growth?

A - Eyal Desheh

It’s not a trade off.

A – Gil Shwed

It’s not a trade off, we will invest in whatever we think makes sense. The focus is on things that are increasing, things that generate more business and that will go for the top line and the bottom line. Luckily for us so far, in the softer business, things that grow top line also grow bottom line in a pretty nice way. We’re not married to or don’t have necessarily a target where we need to be X percent profitable. We are committed to running an efficient and effective business.

Operator

Our final question comes from Ehud Eisenstein – Oscar Gruss & Son.

Q - Ehud Eisenstein – Oscar Gruss & Son

Do you have any updates on the VP marketing position?

A – Gil Shwed

In general, I don’t comment about internal affairs. That I think summarizes that.

A - Eyal Desheh

Thank you very much, everyone. We were happy to have you participate in our conference call. If you want to speak to management or investor relations following this call, please call our investor relations department at 650-628-6250 and we’ll be happy to take your calls and call you back. Thank you very much and have a nice and a wonderful day.

Operator

Thank you. This does conclude today’s Check Point Software conference call. You may now disconnect, and have a wonderful day.

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Source: Check Point Software Technologies Q3 2006 Earnings Call Transcript
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