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Blue Coat Systems, Inc. (NASDAQ:BCSI)

F3Q10 (Qtr End 01/31/10) Earnings Call Transcript

February 23, 2010 5:00 pm ET

Executives

Jane Underwood – VP, IR

Gordon Brooks – SVP and CFO

Brian NeSmith – President and CEO

Analysts

Ryan Hutchinson – Lazard Capital Markets

Jonathan Ruykhaver – ThinkEquity

Andrew Nowinski – Piper Jaffray

Anthony Carbone – Auriga

Sanjit Singh – Wedbush Securities

Mike Turner – FBR Capital Markets

Alex Kurtz – Merriman & Co.

Rob Owens – Pacific Crest Securities

Kevin Shea – MKM Partners

Alex Henderson – Miller Tabak

Scott Zeller – Needham & Company

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Blue Coat’s third quarter results conference call. At this time, all lines are in a listen-only mode. Later, there will be an opportunity for your questions and instructions will be given at that time. (Operator instructions) And as a reminder, this conference is being recorded.

I will now turn the conference over to Jane Underwood, Vice President, Investor Relations. Please go ahead.

Jane Underwood

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

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

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

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

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

Gordon Brooks

Thank you, Jane. Good afternoon. During my portion of today’s call, I will focus on what I view to be the key financial highlights and takeaways for fiscal Q3, followed with guidance for our fiscal fourth quarter.

Today, we are pleased to announce a record net revenue of $127 million for fiscal Q3, an increase of 6% sequentially and an increase of 16% compared with the same quarter a year ago. In Q3, we not only experienced the same robust business environment that many companies have already reported, but we specifically experienced a significant increase in revenue linearity within the quarter due to calendar-year IT spending.

Product revenue, which includes appliances and Blue Coat Web Filter, was $84 million, an increase of 10% sequentially and an increase of 16% compared with the same quarter a year ago. For the third quarter of fiscal 2010, PacketShaper product revenue was $15 million.

Service revenue, which is primarily composed of revenue related to support and maintenance, was $43 million, a decrease of 2% sequentially and increase of 16% compared with the same quarter a year ago. The sequential decline in service revenue is primarily due to an increase in long-term service contracts and the related discounts over the last several quarters. The service contract trend is illustrated by the continued increase in our long-term deferred revenue balance. Another factor impacting service revenue in the quarter was the reduction of end-of-life support extensions that we offered at a premium in calendar 2009.

On a geographic basis, net revenue in the Americas was $54 million and represented 42% of total revenue. Net revenue in EMIA was $50 million and representing 40% of total revenue, and net revenue in Asia Pacific was $23 million and comprising 18% of total revenue.

We had six deals in the quarter whose total value was greater than $1 million.

On a non-GAAP basis, gross margin grew to 76.3% in Q3 compared with 75.9% in the previous quarter due to an improvement in our services margin. This improvement was primarily driven by the changes to our services and support model and related head-count reductions as part of our restructuring program.

Non-GAAP operating expenses decreased to $71.7 million in the third fiscal quarter from $72.7 million in the previous quarter, and increased from $68.7 million in the same period a year ago. The sequential decrease in operating expenses was primarily related to a decrease in total employee head count from 1,481 as of October 31, to 1,356 as of January 31.

With regard to the non-GAAP functional expenses, sales and marketing decreased sequentially in absolute dollars to $41 million or 32% of net revenue compared with $44 million and 36% in the prior quarter.

R&D increased sequentially to $20 million or 16% of net revenue compared with $19 million and 16% in the prior quarter. The increase in R&D was primarily driven by our profit sharing plan. It’s important to note that we will not incur much of the expense benefit in R&D from our restructuring program until Q1 as the majority of the transitional head count is in our R&D organization. Lastly, G&A was flat sequentially at $10 million. As a result of the increase in gross margin and decrease in absolute operating expenses, our non-GAAP operating margin was 19.9% in Q3, which is up 440 basis points sequentially and 750 basis points year over year.

Due to the increase in non-GAAP operating profitability, profit sharing increased substantially in Q3 to $3 million compared with less than $500,000 in Q2. This amount is embedded in each of the functional expense lines.

On a non-GAAP basis, the company reported net income of $17 million or $0.37 per diluted share in the third quarter compared with $13 million or $0.29 per diluted share in the previous quarter, and $9 million or $0.21 per diluted share in the same quarter in the prior fiscal year.

Turning to the balance sheet; cash, cash equivalents and restricted cash balance as of January 31 were $188 million, an increase of $46 million over the prior quarter. Operating cash flow was $42 million, an increase of $24 million or 132% sequentially. The significant increase in operating cash flow was driven by two factors; one, an $8 million increase in deferred revenue; and two, an increased revenue linearity which gave rise to higher collections in the quarter and a commensurate decrease in account receivable.

Importantly, trailing 12-month operating cash flow was $76 million compared with $61 million in the prior year, an increase of 24%.

CapEx was $5 million in the quarter; in addition, $4 million of cash, net of cash acquired was used to acquire controlling interest in S7 Software Solutions. Accounts receivable decreased to $60 million, a sequential decline of 21% which resulted in a decrease in DSO to 39 days at the end of the Q3 from 57 days at the end of Q2. Again, due to the linearity of revenue transactions being more front end loaded we are able to collect a much higher percentage of Q3 deals within the quarter. Going forward, I expect DSO in Q4 to return to our historical average range of 50 day to 60 days.

Total deferred revenue including both short term and long term increased sequentially to $141 million on January 31 from $133 million on October 31. Deferred revenue is composed primarily of unamortized support and maintenance contracts now that distributor inventory has been reduced to a nominal amount.

Now turning to the S7 acquisition; as we earlier announced on January 25, the company acquired 84.5% of the shares of S7 Software Solutions for $6.4 million in cash. We are awaiting regulatory approval for the share transfer by certain shareholders not residing in India to complete the acquisition of the remaining shares. As a result of the acquisition, we added 68 employees of which 57 are in R&D.

When we announced the S7 acquisition, we expected to close the transaction in December and to spend $1 million to $2 million of non-recurring expense in Q3 to build out a new facility in India. Since the acquisition only closed in the last week of the quarter, we did not incur that expense in Q3, and therefore realized greater profitability in the quarter than we had originally anticipated. That expense will now be incurred in Q4, and I will discuss its impact in a moment.

Now, regarding our restructuring program; in the quarter, we incurred approximately $9 million in restructuring charges, which was within the $8 million to $11 million guidance range previously given. We currently expect a total cost of the restructuring program to be $14 million and that the final elements will be completed in our first quarter of fiscal 2011.

Now, turning to guidance for fiscal Q4; we currently anticipate net revenue in the range of $129 million to $134 million. On a GAAP basis, we expect EPS to be in a range of $0.25 to $0.31, including $2.5 million related to our restructuring program. We expect a fully diluted share count of approximately 47.3 million.

On a non-GAAP basis, we expect operating margin to be between 19% and 21%, which translates to EPS in a range of $0.36 to $0.41 per fully diluted share at a tax rate of 30%.

This guidance includes the follow elements that will be accounted for within our non-GAAP operating results. First, the cost of approximately $2 million for the remaining employees on transition during Q4 as part of our restructuring program; second, a non-recurring negative impact of 100 basis points to the operating margin resulting from the build out of our India facility; and lastly, a sequential increase in sales expense for the quarter due to the seasonality of our annual commission plans and expected sales performance. This guidance is based on foreign currency rates effective as of this announcement and any material changes could impact the numbers provided herein.

In closing, the additional revenue delivered in Q3 combined with completion of the acquisition of S7 late in the quarter made our interim model more profitable than we had originally planned. It’s important to note that we are on schedule to deliver the Q1 operating model that we have previously discussed, which calls for minimum operating margins of 20% while allowing us to invest aggressively for growth.

Now let me turn the call over to Brian.

Brian NeSmith

Thanks, Gordy. I am going to use my portion of today’s call to discuss the highlights for the third quarter, followed by some comments on how we view our markets and growth opportunities going forward.

Q3 marked another quarter of solid growth for Blue Coat; strong market demand for our Application Delivery Network or ADN solutions helped derive upside to our top line results as customers continue to value the unique differentiation that we offer in the markets where we compete. As Gordy highlighted, we experienced a strong sequential increase in non-GAAP operating profitability which is an ongoing priority for Blue Coat.

Looking at the geographies; business was strong across all major regions as we benefitted from a moderate year-end budget flush. In the Americas, we experienced strengthened spending from our enterprise customers, but also saw a typical seasonality in the federal government’s portion of our business. In Q3, federal represented 5% of product revenues compared with 13% in Q2 and 4% in Q3 of last year.

As always, there were some great customer wins in the quarter. In the Americas, we saw a significant expansion in our business at HSBC Mexico for optimizing and securing applications and content to 40,000 employees across Latin America. In Europe, we saw a significant deployment of ProxySG appliances at T-Systems’ T-Online, the enterprise customer division of Deutsche Telekom, to optimize and secure applications delivery for more than 12 million users. In Australia, we had a great win at the New South Wales Department of Education and Training. This deal included the sale of ProxySG appliances and Blue Coat Web Filter along with deploying proxy clients to approximately 220,000 users over the next several months.

Proxy client leverages our WebPulse collaborative cloud defense which serves as the first line of defense against malicious Web threats and phishing, as a way to continuously categorize known and unknown Web sites. Once again, we were recognized as the market leader in both the Secure Web Gateway and WAN optimization markets. In Gartner’s most recent Magic Quadrant for Secure Web Gateway, Blue Coat was positioned in its leaders quadrant. Gartner’s positioning of Blue Coat in its leaders quadrant highlights our consistency in delivering industry-leading solutions to ensure that enterprises can protect users from evolving Web-based threats.

From a channel perspective, we saw a further pick up in the cross-selling activity in the third quarter as a number of our partners selling both ProxySG and PacketShaper appliances grew by 4% sequentially.

Over the last few months we've educated hundreds of hours on cross-selling at our partner conferences. Additionally in Q3, we signed 40 new WAN optimization partners around the world. Earlier this month, we launched a new channel program that enables partners to increase their service attach rates and margins. This program, which is called the BlueTouch Professional Services Partner Program, provides additional tools, certification and training that enables our partners to further develop strategic, consultative relationships with their customers.

Last quarter, Jim Harold, our Vice President of Worldwide Channel Sales was named Channel Chief by Computer Reseller News. This recognition is another indicator of the strength in our worldwide channel program. We are expanding our alliances with global service providers and systems integrators. The managed services portion of our business represents an important growth opportunity as customers seek new alternatives to deploy our ADN technologies.

We are please that Orange Business Services, one of the world’s leading telecommunication operators, recently added Blue Coat Web Filter to its secure gateway managed service offering. This addition expands our existing relationship with Orange, which also offers our ProxySG appliances for secure gateway and business acceleration managed service offering and PacketShaper appliances for its Applications Performance Analysis offerings.

Today, we announced a new global agreement with IBM. This agreement will provide a new managed security service offering to IBM’s clients that use Blue Coat’s Secure Web Gateway solutions to protect users’ information from Web-based security threats. This expanded relationship between IBM and Blue Coat provides enterprise customers the ability to use our Web filtering, antimalware and advanced proxy solutions in a turnkey service managed by the IBM Security division. This IBM managed security service offering will manage an on premise customer owned equipment, which means that any of our partners can sell the hardware underpinning the solution to customers. This will make the service more attracted to the IBM and Blue Coat channels who can make margin on both the hardware and software elements of this service.

Last quarter, we took the first step in integrating S7 by establishing our new Bangalore development center. With the Bangalore site and our development centers in Sunnyvale, California; Draper, Utah; and Waterloo, Canada, we now have a cost effective and diverse worldwide engineering organization to build on our ADN product portfolio.

Looking ahead to Q4 and fiscal-year 2011, while it is difficult to predict what Q4 and fiscal 2011 will bring from a macro perspective, we know that our industry is evolving rapidly. Importantly, we are well positioned to capitalize on these market transitions with greater speed and flexibility with our new product groups.

These growth initiatives will expand our opportunities in the large enterprise market as well as open the door to adjacent markets, particularly in the mid-market and carrier markets. For the large enterprise markets, we have induced the industry’s first IPv6 migration solution. This solution provides secure and seamless migration of application services and content between IPv4 and IPv6 environments. While the network infrastructure supports IPv6 is largely built out, Blue Coat is the first to provide a solution that will smoothly migrate existing applications and services to IPv6 without compromising network performance.

We have recently strengthened our WebPulse collaborative cloud-based defense solution by expanding our global network with the fifth new data center in Australia. This new data center enhances the speed of dynamic ratings for regional customers while increasing Web awareness and protection against rapidly evolving Web-based threats for the more than 62 million WebPulse users worldwide.

We are on schedule to release a new cloud-based offering in the second half of calendar-year 2010. This new solution will provide expanded security functionality, significant ROI benefits and will be more easily available and accessible to the mid-market.

In targeting both the large enterprise and mid-market, we will be introducing a new family of virtual WAN optimization appliances in the first half of calendar 2010. These virtual appliances will run on industry-standard servers. They have been designed to consolidate branch office IT infrastructure and optimize the delivery of advanced business applications while reducing operating costs and increasing infrastructure flexibility.

Also in the first half of calendar 2010, we will be introducing a new single purpose carrier appliance that utilizes our proven caching technologies. With the explosion of video, rich media and Web 2.0 applications, the amount of digital content transported by carriers is dramatically increasing. As a consequence, carriers must either substantially increase their bandwidth capacity or adopt other technological solutions by caching to reclaim existing bandwidth.

We believe that our appliance will provide a unique and cost-effective solution that will enable carriers to scale their networks in line with their service delivery models and subscriber demand. Importantly, we believe our appliance can help carrier serve two times the amount of content to subscribers utilizing their existing network bandwidth. Ultimately, this appliance can serve as a platform for other value-added services.

In closing, we are very pleased with the foundation we are building to capture market transitions in the industry, as well as our Q3 financial results. Going forward, we intend to invest in innovation to accelerate growth without sacrificing the bottom line.

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

Jane Underwood

Thank you, Brian. That concludes today’s prepared remarks. Before opening the call to questions and answers, I would like to request that analysts please ask one question and if necessary only one follow-up question. If you would like to ask additional questions, please return back into the polling queue.

Cathy, we would now like to open up the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And our first question comes from Ryan Hutchinson with Lazard Capital Markets. Go ahead please.

Ryan Hutchinson – Lazard Capital Markets

Hi, good afternoon, a couple questions. First off I liked how you ended that last line there, Brian. I think that’s what I’m looking for here. So, on that note, just the EPS at the midpoint that equates to roughly flattest operating margins. And I missed part of the prepared remarks, but I was hoping maybe you could walk through the mechanics of what’s left in the restructuring? And then, when we should see the $120 million revenue run rate equates to the 20% operating margin target that you guys outlined?

Gordon Brooks

Sure Ryan. This is Gordy, a couple of items. There is approximately $2 million of transition expenses in the non-GAAP P&L still in Q4. Those will be eliminated walking into Q1. In addition, we did highlight the fact that we had expected much more expense coming out of our transition to India and some one-time items that we thought that would occur in Q3 that will happen in Q4 that will not be recurring. So, by the time we walk into Q1, which is our original expectation, all of those unique expenses will be out of the system.

Ryan Hutchinson – Lazard Capital Markets

Okay. And just to clarify, that is within the non-GAAP operating guidance on the EPS front, right?

Gordon Brooks

Yes, that is correct.

Ryan Hutchinson – Lazard Capital Markets

Okay, great. And then just a quick follow up, can you just walk through maybe the mechanics of how the profit sharing program works? I think it was $3 million in the quarter. What the expectations are for next quarter? And then I will jump back in the queue.

Gordon Brooks

Yes no problem. The operating profit is a range. So the program sets in at 15% operating margin before considering the impact of the profit sharing program itself and scales to – I think we have mentioned before, it is approximately $4 million in total at its peak at 25% operating margin. So if you get to the 19.9% operating margin we had here in Q3 the actual operating margin before profit sharing was approximately 23%. And so we go through and then determine that and apply that to figure out the pool for profit sharing. Going into the next period, given that the operating margin guidance at the midpoint is relatively flat, you can see the impact from the calculus on profit sharing which is approximately about at the same level from an absolute dollar standpoint.

Ryan Hutchinson – Lazard Capital Markets

Great. Thanks guys.

Operator

Next, we will go to Jonathan Ruykhaver with ThinkEquity.

Jonathan Ruykhaver – ThinkEquity

Hi guys. Congrats on the performance. Brian, you have talked over the last several quarters about the focus on realigning sales to better target large strategic customers and also on the differentiation you have with ADN, and I just wondered if you can point to other metrics, I know you cited the sequential increase in number of partners that are cross selling, but is there any way you can disclose maybe a percent of total partners or percent of total transactions that reflect cross selling just to show that ADN strategy is starting to resonate in the marketplace to give evidence to that occurring.

Brian NeSmith

I don’t know – just looking to see. I don’t think I have any of that data right at my finger tips. I’ve looked at different reports; I don’t think we disclosed anything. We will look through Jonathan to see if there is something that we can provide to the world more broadly about a broader base to see the uptick on the cross-selling side.

Jonathan Ruykhaver – ThinkEquity

You talked about – ADN is been the next generation WAN optimization. So it would be good to be able to try to gauge what kind of success you’re having. And you cited some significant wins in the quarter. Can you just talk about the nature of those wins and if they included both PacketShaper and ProxySG. I think you mentioned the Web filtering capability, but not sure about the PacketShaper.

Brian NeSmith

Yes. I think the wins that I talked about on the call, I don't think any of them fit the profile of what you're talking about. They tended to be an expansion of existing network infrastructure. So of the publicly announced wins that we talked about, I don’t think we’ve described any on this call.

Jonathan Ruykhaver – ThinkEquity

Okay.

Brian NeSmith

You got to be a little careful here too because there is – some of the situations aren’t simply just selling ADN but in some cases it is simply selling our ProxySG where someone had a PacketShaper or vice versa and it is two-point solutions as opposed to an ADN solution. But I think you are interested more broadly speaking, understanding in how much cross selling are we getting between PacketShaper and ProxySG.

Jonathan Ruykhaver – ThinkEquity

Yes. If that’s the metric you can disclose over time, I think it would be helpful.

Gordon Brooks

I think one of the things, we had tried to do with the larger deals is to note that those have a higher propensity of having multiple products involved. But we will try to get more specific about that impact to your point.

Jonathan Ruykhaver – ThinkEquity

Okay. Just one other question, you mentioned Gordy in your earlier comment that you had some premium support services that have been extended last year and looks like you ended support on those products. Did that drive some conversion opportunity in the January quarter?

Gordon Brooks

Not out of line with the other quarters during the year. So we did see over the last year that as people came to end of life some decided to continue and accept the premium support; others actually converted earlier. So I don’t think that from an uptick on the product side that there was anything out of the line with what we have seen in prior quarters.

Jonathan Ruykhaver – ThinkEquity

Is there anymore of that premium support being extended today or is that mostly done at this point?

Gordon Brooks

That is mostly done at this point. So there is a nominal amount of revenue to be bled out of the system, but it is not material.

Jonathan Ruykhaver – ThinkEquity

Okay, good. All right, thanks guys.

Operator

Thank you. We will go to Andrew Nowinski with Piper Jaffray.

Andrew Nowinski – Piper Jaffray

Good afternoon gentlemen. Just a quick question regarding your win rates in competitive bake offs, just wondering if they improved this quarter due to the ease of installation with Version 5.4 or are you just getting more advanced so to speak.

Brian NeSmith

I didn’t see any data that talked about any kind of material change in the win rate. That being said, I think it is probably fair to state that we didn’t – even though we announced it early in the quarter and delivered it, I don’t think we got a full quarter’s benefit of that effect. So I wouldn’t necessarily treat that as an indicator of change in the win rates. But I didn’t see anything material for as the change in the win rates. I would expect 0.4 for us to be doing slightly better on both getting more opportunities as well as on the win rate side of things. But I don’t see anything this last quarter.

Andrew Nowinski – Piper Jaffray

Okay, thanks. And then on the – with regard to the fed sector, where any of the $61 million [ph] deals within the fed sector?

Brian NeSmith

I know one off the top of my head.

Gordon Brooks

There is only one. Yes.

Brian NeSmith

Yes, so there is one.

Andrew Nowinski – Piper Jaffray

I guess, could you maybe just address or provide any color on what drove the solid results in fed this quarter then if it wasn’t big deals?

Gordon Brooks

Yes. I think there is an ongoing set of businesses we talked about the – we generally have 4% to 5% per quarter except for the end of our Q2 or the end of fed period and where we see a strong surge in federal business. But we generally have 4% to 5% every quarter in federal business from a product standpoint. So I don’t think that anything this quarter was significantly more than what we expected.

Andrew Nowinski – Piper Jaffray

Okay, great. Thanks guys.

Operator

Thank you. We have a question from Anthony Carbone with Auriga.

Anthony Carbone – Auriga

Thanks for taking my question. I have a question for Brian and then a follow up for Gordy. So Brian, you highlighted quite a few new products that you are going to be coming out with in the first half. Can you give us some indication – a lot of times you come out with new upgrades that almost features that are not directly monetizable, while others you can charge the customer for. Can you give us your perspective of – it sounds like you announced a significant amount of new products compared to last year. From a monetization rate, how would you compare this to kind of where we were last year? And then also with respect to the expense side, should we see expenses change somewhat after these products rolled out?

And then a follow up to Gordy; Gordy with respect to cash flow, you had a phenomenal quarter this quarter and it seemed like there were obviously some issues that were one time in nature. Can you kind of talk about how do you think this should – what we should expect from cash flow from operations going forward relative to revenues? I ask this in light because your cash flow generation has lagged here historically. We had a phenomenal quarter and wondering to what degree some of these performances indicative of some of the changes that you have made. Thanks.

Gordon Brooks

I think and answer that on the cash flow, couple of things. One is, we certainly put a lot of emphasis on the mechanics of managing the cash flow. So there is certainly a change in the business linearity this quarter but also huge emphasis on optimizing our cash collection and our management of cash. So I do – there is certainly a one-time element of that this period, and I looked last year, and actually we had a similar type of dynamic last year between Q2, Q3 and Q4 as well from the end of calendar year and the type of linearity of deals.

So I do expect that Q3 to have a uniqueness to it going forward, but from a overall standpoint I do expect our cash flow generation going forward to be much more in line with, I think what you had expect. I haven’t put together an overall kind of guidance for that but I think that from the revenue we generated, the higher profit margin, the capital is usually in a pretty normal line that we should cash flow generation equal to what we are doing in the P&L. Did that help answer the question?

Anthony Carbone – Auriga

Yes it is.

Brian NeSmith

So in regards to products, there were three distinct products that I talked about. All three will ultimately have a fairly significant effect on revenue over time. Let me talk about each independently. The first was a new purpose-specific caching appliance for the carrier market. Blue Coat, dating back to days that we were known as cash flow, was heavily in that market. We de-emphasized the focus there. The reason we decided that that’s a market that we can focus back on is we are seeing a fairly dramatic shift in the nature of how the Internet is being used, an explosion of the Symantec Web, Web 2.0 type content as well as a lot of video contents, and the caching algorithms that we historically had we can modify them to give a fairly significant improvement and balance usage for a typical carrier.

So we were modifying the existing ProxySG product, building a purpose-specific box for the carriers that will give them, we believe, a 50% reduction in balance utilization or a two times multiply on their existing balance, depending on how you choose to look at it and I view these ultimately as an incremental opportunity as we go forward.

The second is new cloud services that we would be delivering towards the end as we get out further in time. These also would be incremental because the main focus to those cloud services would be medium enterprise, which would be really expanding the market opportunity.

And then the third, which we talked about in the first half of the calendar year, is a software solution that runs on a virtual machine. So we would be selling a software product which is focused at WAN optimization to run on a particular type of virtual machine, which we think bodes very well to the growing commoditization of vanilla WAN optimization, gives us an opportunity to be aggressively selling into that market in that part of the world.

All three of those I look at as really incremental revenue opportunities and the way we are grilling our business. Timing of it is still a bit of a question and we haven’t been that specific in this call on the exact month when we will be delivering it. But I do think that all three of them will have some impact on this coming fiscal year.

As far as incremental expenses, I don’t think they are going to materially change as we introduce these products. The only challenge that I think we might see is with the cloud. It will most likely be sold as a ratable service and there will be a lag between the booking and the revenue that will create a bit of a challenge on the expense side. But I think that is something we have already factored in and manage from an overall profitability standpoint.

Operator

Is that all Mr. Carbone? Okay. We will move on to Rohit Chopra with Wedbush Securities.

Sanjit Singh – Wedbush Securities

Hi guys. This is Sanjit Singh for Rohit Chopra. I had two questions. First one, if you had WebFilter product revenue and Packeteer service revenue, do you had those numbers for us? And then as a follow up, Brian, if you could describe the deal pipeline if that changed this quarter? You guys had a nice increased in deferred revenue. How is the pipeline look going into the next quarter and maybe you can describe changes in close rates this quarter, did they improve? Thanks.

Gordon Brooks

Let me start with first one. Service revenue for Packeteer related products was $9.7 million in the quarter and Blue Coat WebFilter service revenue was $2.3 million.

Sanjit Singh – Wedbush Securities

Two other questions, now I am forgetting one of them, there is the –.

Brian NeSmith

As far as pipeline, I think pipeline was – close rates and tight. I don’t think there was a material change from last quarter to previous quarter. It actually improved a little bit, but not a significant change. If I remember right, it was actually I think somewhere on the order of 0.5% improvement in close rates. And then going back to I think Q2 was particularly a good quarter just for the federal sector and other environments in there. So I think that when you kind of factor those two things in and out I think we saw the close rate was probably a little bit better but not in a huge way. As far as pipeline overall, I believe it was up again but not in a huge way.

Gordon Brooks

But I think one thing is – I think we talked about in last earnings call, when we do guidance, we do assume that prior quarter’s close rates apply to the next quarter unless we have some indication of material shifts. So we did assume that in that guidance as well which is the prior period’s close rates would be applied into Q4.

Sanjit Singh – Wedbush Securities

And on OEM deals, last quarter you mentioned there could be some OEM deals heading into over the next couple of quarters. What’s the status on potential OEM relationships?

Brian NeSmith

We have a number of ongoing activities with different companies. I don’t think we are in a position to announce anything at this point in time. (inaudible) I think we'll have to go back to the questions from the operator.

Operator

Thank you. We will go next to Daniel Ives with FBR Capital.

Mike Turner – FBR Capital Markets

Hi guys, this is actually Mike for Daniel. Do you guys – I am not sure if you could you break it out or you just speak to it, but you made a mention that the strength, especially the linearity was due to the calendar year. Can you maybe just speak to what you saw maybe the strength in the quarter was due to the year-end versus maybe stabilization that you are seeing in the field? Can you just speak at a high level to that, and then I just have one quick follow up.

Brian NeSmith

I think in general if you look through past quarters, December for us is a month that is generally fairly strong because it reflects the calendar year end for most other organizations and that’s been generally true for us over the past six or seven years. I think what Gordy had talked about in his prepared comments is that given that we book a higher than normal in December that helps us obviously collect and then close and improves our cash flow in general in that just the Q3 period. I don’t think there is anything that different from other periods as we look past over the last six or seven years.

Gordon Brooks

I think the other item we were trying to do is to correlate to much of messaging that other companies have given who have 12/31 year-end about the activity they had seen that we thought that we were seeing the same type of activity ourselves up through the calendar-year ahead.

Mike Turner – FBR Capital Markets

Okay. Then just one other question, in terms of the margins, I know you mentioned of having maybe like the base of a 20%, maybe like on a high level again on the mid-term expectations or mid-term – what do you think those can grow like over the next, let’s call it few years, whatever, maybe just expectations around that. Thanks.

Brian NeSmith

Yes. I think one of the things we’ve talked about over the last quarter as we did the restructuring was the choices we would have as we got the baseline to 20%. So the math would obviously tell you those margins can accelerate. We had pointed out that if we look at some of the comparables in the market, we’ve seen upwards of 25%, 28%. I think for us it's establishing that baseline at 20% and then being able to decide where we are making investments to drive future growth and how we trade off of profitability. So I think that the baselines or the floors where we want to be at 20% and then have the option going forward to either deliver more profit or to invest for future growth.

Mike Turner – FBR Capital Markets

Thanks. Do you think they were at the baseline rate right now, do you think that going forward that they're going to continue, that we see, that in 1Q and beyond of at least 20%? I'm not sure you can really probably talk to, but if you can. Thanks.

Gordon Brooks

I think as we mentioned in November when we announced the restructuring program, our intent was to be at a baseline of 20% and $121 million of revenue and so with the one-time items that we will slush out in this fiscal Q4, we plan to be there, again, in our fiscal Q1. So that baseline will be achieved in Q1.

Mike Turner – FBR Capital Markets

Thanks a lot. Good quarter, guys.

Gordon Brooks

Thanks.

Operator

Thank you. We have a question from Alex Kurtz with Merriman & Co.

Alex Kurtz – Merriman & Co.

Yes, thanks for taking the question. So just looking at the geographical results here, EMEA looked like it was up pretty strongly sequentially, but Americas off a bit and obviously APJ up. Can you just give us a little color on what happened between the three different geos and just how they performed during the quarter?

Gordon Brooks

I think if you look at the Americas, really you’ll see the impact of the federal business so that decline from the 12% to 13% we talked about in Q2 down to 5% was offset by strong enterprise business in the Americas. So that’s kind of a normal seasonality that we see between Q2 and Q3 with our federal business. I believe that in Europe, the two areas that we saw some strength were in the UK, albeit off of weaknesses from prior quarters and then also in France and Spain. So in Southern Europe, we had seen some strength. Otherwise in China we saw a little bit of – kind of flattening in Japan and some strength in China. So I think those are probably some flavors around the key countries in each of the region.

Alex Kurtz – Merriman & Co.

Brian, just a quick follow-up for you. As you try to build out your capabilities in WAN optimization market, going after more partners you can really push that product. Would you consider getting a little bit more aggressive on pricing to take footprint in that market or do you guys feel like you have the right marketing incentives in place to take share?

Brian NeSmith

Pricing as a potential option I think there are other incentive programs that you can do. We are open to probably any variety of those different things. We are not in a hurry I think to use pricing as a primary vehicle. It’s something to consider, but I wouldn't say it's the first thing that we're looking at doing. We believe we can differentiate ourselves around video capabilities, around broad-based capabilities, specific applications that we can accelerate better. Generally, we look for product differentiation before we would look to anything to do with price or discounts.

Alex Kurtz – Merriman & Co.

Okay. Thank you, guys.

Operator

Thank you. Next we have Rob Owens with Pacific Crest Securities.

Rob Owens – Pacific Crest Securities

Great, thank you. Could you guys address the product gross margin and the sequential downtick there? Is that a function of mix or is there something else at play.

Gordon Brooks

Yes, down probably about what 0.4% or 0.5% primarily due to mix; so no trend differentiation there for Q3.

Rob Owens – Pacific Crest Securities

Again, back on North America and I realize it was flat sequentially because of the mix shift away from the Fed, but it looks like North America results have actually been flat for the past two quarters. So assuming that the Fed was about 5% as you said probably back in the July time frame and we got the push here in North America. Why didn’t we see more of an uptick? Was there an aberration in July as well?

Gordon Brooks

I don’t know the answer to it. I know from Q2 to Q3. I am not sure that I could correlate exactly. I've said this in prior conference calls that we’ll see shifts in revenue between regions where they show spurts and moves ahead and backhauls compared to other things that – and I wouldn’t necessarily draw a trend on any item in that area. I think if we looked out going forward I think you see that Americas as a good region that’s getting lots of forward momentum, and we saw similar sorts of things that all the other companies saw in North America. And I think if anything, as we look over the course of next year we think North America is in general going to perform fairly well.

Rob Owens – Pacific Crest Securities

Great. Thanks.

Operator

Thank you. We will go next to Kevin Shea with MKM Partners.

Kevin Shea – MKM Partners

Hi, guys. Thanks for taking my question. Just wondering, are you having more success just landing some WAN-optimization deals outside of your installed base? And is this improving as you add more WAN-optimization focused resellers, if you could just talk about that? And how you plan to broaden that sales strategy? Thanks.

Brian NeSmith

Well, in the large enterprise the hard part about saying landing new customers is the large enterprise that we are probably installed in the great majority of the larger corporations in the world, so a rare situation I think that we could say that it is a complete Greenfield account. In many ways we internally might look at it as Greenfield because we sold them a security solution, but we are selling to a different part of the organization for WAN-optimization solution.

As a result, what we find even if you go down into the mid-market that we have to invest energy in selling to a different part of the company with occasionally some synergy. And so I – we’ve gotten reasonable success outside of our installed base in the mid-market as much as we've seen inside our install base. I haven't noticed anything in any reports or internally that show any material difference in success with one versus the other.

Kevin Shea – MKM Partners

Okay. Thank you.

Operator

Thank you. Next is Alex Henderson with Miller Tabak.

Alex Henderson – Miller Tabak

Great. I’d really like to go into the margin numbers a little bit more concisely. You're at 99 as a starting base here coming out of the current quarter. You identified, I believe, two items that are going to hurt you in the upcoming quarter, $2 million in transition expenses and then $1 million to $2 million in R&D related facilities build outs in India. Just to start with, that's the baseline. Correct?

Gordon Brooks

That's correct.

Alex Henderson – Miller Tabak

And then you said I think that your cost-cutting programs would roughly offset that in the fourth quarter, hence the guidance, if I understood it correctly. So the guidance is simply flat to up presumably on margins.

Gordon Brooks

I think that most of the cost-cutting benefit that we’ve seen before we get those $2 million in transition expense out in Q4 has been realized in Q3. There's not incremental cost reductions to offset those incremental expenses in Q4. So we'll have incremental expenses in Q4. We’ll have incremental revenue, which will drive a bit more incremental profit offset by some profit sharing. So basically the midpoint of guidance is slightly up from an operating margin standpoint.

Alex Henderson – Miller Tabak

Then the $3 million to $4 million, which were these two one-time expenses, fall back out in 1Q?

Gordon Brooks

That’s correct.

Alex Henderson – Miller Tabak

So that $0.06 to $0.08 a share pre-tax obviously that would imply a pretty solid improvement in margins in 1Q, and if I understood it correctly, the bulk of the R&D benefits from the cost cutting that you are doing on there also accrue in 1Q, is that correct?

Gordon Brooks

That’s correct, but you have to be careful because any incremental profitability will then be offset by additional profit sharing that will kick in. So every dollar of incremental reduction does not fall into an absolute dollar of reduction. It's actually tempered by additional profit sharing.

Alex Henderson – Miller Tabak

And the magnitude of that tempering, it would be what, 10, 20, 50?

Gordon Brooks

For every dollar it’s about $0.35.

Alex Henderson – Miller Tabak

So, 65% of every dollar is passed through.

Gordon Brooks

Yes.

Alex Henderson – Miller Tabak

Okay. So it does sound like you feel comfortable that you are at the 20% margin currently and that there are two fairly solid slugs of benefits still coming down the pipe for Q1.

Gordon Brooks

That is correct.

Alex Henderson – Miller Tabak

Okay. Just want to make sure I got that straight. I'm getting a number of people on the buy side pinging me with the questions. So I better pass it through or they'll be mad at me which is the question revolves around seasonal pattern of December to January. Obviously, the December quarter closed for most enterprises. Therefore, you get a seasonal budget flush for 4Q as people push to close deals before the year end. January is the weakest month of the year in many respects at lot of companies in terms of spending, the budget's not out. What is your historical normal pattern versus – and how would you characterize that versus what you saw this quarter in terms of those two months. And I assume that February is normally a better month than January, is that reasonable approach?

Brian NeSmith

Yes. Excluding last year, which was an odd time in general, I think in general what you described is what we would see. December is typically fairly strong. January is a bit softer. We actually will see in the last week of January very often budgets get freed up. So it doesn’t come quite as hard. January overall is a little bit softer as far as the months go through the course of the year. I’d say from the perspective of excluding last year which was a complete anomaly in my entire career, compared this December/January period to the previous December/January periods and it felt it was more similar to those and it’s online with what we normally expect with end of the year budget processing and budget start up in the coming calendar year.

Alex Henderson – Miller Tabak

And then generally it would sequentially improve month to month into February, March, April, then I would assume.

Brian NeSmith

Yes. Because normally what we find is that our Q3 and our Q4 fiscal tend to be the strongest quarters. So we have November, December, January, December being a strong month in that period, and then you get February, March, April which usually means the beginning of budgets for most corporations.

Gordon Brooks

Well, in addition for us, we are on annual comp plans, so the February, March, April quarter is the end of our sales organization’s comp plan. So that also helps to strengthen our internal activity.

Alex Henderson – Miller Tabak

Sure. Let me cede the floor, but let me get one clarification because I thought you had said something and then I thought you said something that conflicted with it. The three products that you mentioned I thought you said were launching in the first half, the revenue generation might be pushed out from that because of timing lags, but I thought you'd said they were first half of the fiscal year. Is that correct?

Brian NeSmith

They're first half. The virtual appliance for WAN optimization and the carrier caching product are both first half of this calendar year. In the cloud, I don't think we were too specific other than it's coming the second half of this calendar year. And what I was highlighting there is no real lag as far as the first two products. They are fairly normal, but the cloud based product will be sold as a ratable product solution. So there is a bit of a lag between bookings and revenues for the ratable product.

Alex Henderson – Miller Tabak

You switched there between calendar year and fiscal year. The two were in the first half of your fiscal year or first half of the calendar year?

Brian NeSmith

First half of the calendar-year 2010.

Alex Henderson – Miller Tabak

Okay, great. Thank you very much. I'll cede the floor. Thank you.

Operator

Thank you. We will go to Scott Zeller with Needham & Company.

Scott Zeller – Needham & Company

Hi, thank you. Could you tell us – we had a question earlier about gross margins for the current period, but could you tell us about your expectations looking forward and some commentary about mix?

Gordon Brooks

I think we’ve talked about the fact on the product gross margin to be in the range of 75% to 80%, with 80% really being on the high side. Over the last couple quarters we've gravitated between about 75.5% and a little over 78%. So we don’t see any material mix change there. On the service side, again, that where there's been an emphasis coming out of the restructuring program as a more efficient services group. Last quarter that was below 72%, this quarter almost 74%. That where we really see the incremental improvement coming through on that particular line. So I think in the – right now those two combined in the 75% to 77.5% for the total gross margin is probably a fair target for us.

Scott Zeller – Needham & Company

Okay. And then a bigger picture question. Brian, when you look at the deals and the discussion with the sales teams, is there any difference in prioritization or spending when people talk about WAN optimization projects versus like a broader project ADN type project? Do you see people looking at like a shorter term band aid and then down the road they want to do ADN? How do people talk about those two dynamics?

Brian NeSmith

I don’t know if I could draw a correlation or not – that people would prioritize one over the other. It's so different in each customer case and even when you talk about an ADN solution, maybe a specific point within that that they are looking for from a standpoint of what they are looking for. But I haven’t seen anything that I could point to as one being prioritized over the other in some sort of linear list. Actually I don't think I could really help you with that question.

Scott Zeller – Needham & Company

Okay. Thank you.

Operator

Thank you. We have no further questions in queue. Please go ahead with any closing remarks.

Jane Underwood

Okay, thank you. I would like to thank everyone for joining us for today’s call. A replay will be made available at 800-475-6701 beginning today, February 23rd at 5:00 p.m. Pacific. An audio archive will also be available on our Web site. Have a great day. We look forward to speaking with you again soon. Thank you.

Operator

Thank you. Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and choosing AT&T Executive Teleconference. You may now disconnect.

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