Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

McAfee, Inc. (MFE)

Q3 2006 Earnings Call

October 26, 2006 4:30 pm ET

Executives

Kelsey Doherty - VP, IR

Dale Fuller - Interim President, CEO

Eric Brown - CFO, COO

Analysts

Daniel Ives - Friedman, Billings, Ramsey

Sterling Auty - JP Morgan

Sarah Friar - Goldman Sachs

Philip Winslow - Credit Suisse

Gregg Moskowitz - Susquehanna Financial

Rob Owens - Pacific Crest

Walter Pritchard - Cowen

Brian Thackery - Deutsche Bank

Heather Bellini - UBS

Brian Pitz - Morgan Stanley

Chris Hovis - Morgan Keegan

Ed Maguire - Merrill Lynch

Matt for Rob Breza – RBC

Clay Border - Mansville Capital

Israel Hernandez - Lehman Brothers

Presentation

Operator

Welcome to the McAfee third quarter 2006 earnings conference call. (Operator Instructions) I would now like to hand the call over to Ms. Kelsey Doherty, Vice President of Investor Relations at McAfee. Ma'am, you may begin.

Kelsey Doherty

Thank you. Good afternoon and thank you for joining us. Today we will be discussing our preliminary results for the third quarter of 2006 to provide an overview of our strategic direction for 2007. With me are Dale Fuller, our Interim President and Chief Executive Officer; and Eric Brown, our Chief Financial Officer and Chief Operating Officer.

Today's conference call is being recorded and will be available for replay on McAfee's Investor Relations home page at investor.McAfee.com. A GAAP to non-GAAP reconciliation of the preliminary third quarter financial numbers discussed in this conference call is attached to the press release issued by the Company this afternoon.

We are pleased to provide summary revenue and bookings results attached to our press release and on the Investor Relations website at investor.McAfee.com, posted under quarterly results. We will post our prepared remarks to the website following the conclusion of today's call. I ask for your attention while I review some cautionary language and then I will pass the call over to Dale.

This conference call, including the question-and-answer session will contain forward-looking statements. These statements include those regarding our preliminary results for the third quarter of 2006, future growth margins and operating expense expectations, guidance on revenue expense and earnings levels for the fourth quarter 2006, expected stock-based compensation charges under FAS 123 R for 2006, expected new and future product introductions and the revenue opportunity associated with them, expected integrations of products and recent acquisitions with existing McAfee product lines, expectations regarding the cost of customer acquisition, expectations regarding McAfee's business segments, statements regarding future partnership opportunities, expected impact of recent acquisitions on McAfee's profitability and future periods, specific growth initiatives and outlined for 2007 and McAfee's consumer and enterprise segments, and plans regarding future strategic acquisitions and other uses of cash by the Company including its future plans for the resumption of its share repurchase program.

Forward-looking statements are based on managements current expectations and are subject to risks and uncertainties, including that McAfee will make adjustments to its unaudited preliminary second and third quarter results, as well as to its financial results reported for prior periods as a result of its review of past stock option grants, and that McAfee will restate certain prior year period financial statements.

In addition, McAfee may not achieve its planned revenue realization rates, succeed in its effort to grow its business, build upon its technology leadership or capture market share or benefit from its strategic alliances or partnerships as anticipated. McAfee customers may not responds as favorably as anticipated to the Company's product or technical support offerings and the Company may not satisfactorily anticipate or meet its customers needs or expectations.

The Company's product and service offerings may not continue to interoperate effectively with the newly developed operating systems including Microsoft Vista and further risks may arise from the review of our past option granting practices including, but not limited to, potential fines and penalties and disruptions to our ongoing business and significant legal, litigation, accounting and other expenses.

In addition, a number of operational and other factors such as new product introductions, the mix of products and services sold, the size of deals closed in the quarter, the amount of revenue deferred in a quarter, the integration of acquired businesses, changes in senior management, the competition we face in the market, to the greater macro environment to name a few, may cause our revenues, gross margins and operating results to fluctuate significantly from period to period.

We caution listeners that actual results may vary, perhaps materially, from the forward-looking statements referenced in this call, including any forward-looking statements made during the question-and-answer session. We encourage listen to review the risk factors contained in the Company's filings with the Securities and Exchange Commission including the Company's first quarter 2006 10-Q filed on May 2, 2006, for more detailed information on the risks and uncertainties related to the Company and its business.

Our agenda for today's call is as follows: Dale will begin the call by giving you a brief update on his first two weeks at McAfee. He will then turn the call over to Eric to discuss preliminary third quarter performance and Dale will then conclude the call.

Now it is my pleasure to introduce Dale Fuller, our Interim President and Chief Executive Officer.

Dale Fuller

Thank you. Let's try to put some more winds back in the sails. Thanks for being with us hear today and for giving us this opportunity to discuss our third quarter results and our business strategy. A special thank you to all our employees listening around the world -- great job this last quarter.

As many of you know, besides being an independent member of the board I was also on the special committee that reviewed the Company's stock option granting practices. I participated in many of the boards discussions about corporate strategy and I know McAfee very well. As Interim President and CEO, I am now completely immersed in our day-to-day operations and expect to implement the strategies that the Company has been putting in place for some time now. My focus is 100% on running the Company and working with our teams to optimize performance going forward.

What we are focused on is, growing our business, our customers, our partners, our products, our go to market strategies, initiatives to strengthen the McAfee brand and efforts to enhance our financial and our operational controls.

My message internal has been simple: stay focused on your job and continue to execute. My message to others ranging from our customers to investors, is that McAfee remains the only major company focused solely on security. We have almost two decades of experience with more than 3,600 employees around the world who, without distraction from other businesses, know the complex field of security. Their job is to make security comprehensive, integrated and simple, to protect our customers and their assets from known threats today, as well as unknown threats of the future.

My experience in the industry and as a board member tells me that with this focus and our resources, McAfee has meaningful competitive advantages that are translating into solid performance today. Our business model generates cash and has a deferred revenue stream that gives us visibility into future quarters. I'll go into the strategic direction in more detail later in the call; I will just add one more thought at this point before I turn the call over to Eric.

In the past few weeks, we've announced two acquisitions to build out our security risk management portfolio. Security risk management alone opens up a $1.3 billion incremental opportunity for McAfee and its partners. We believe that the strategies that we have been developing continue to make sense and we look forward to telling you more about it.

Now I will turn the call over to Eric.

Eric Brown

Thank you, Dale, and welcome to the team. We are pleased with our third quarter 2006 results. Q3 consolidated net revenue was $288 million, representing a 14% increase year over year versus the $253 million reported in Q3 2005. North American revenue of $162 million accounted for 56% of third quarter 2006 revenue compared to 58% in Q3 2005.

Foreign currency movements positively impacted revenue by $4 million in Q3 2006 versus Q3 2005. Consistent with prior quarters, 83 % of revenue during the third quarter came from the balance sheet. Perpetual plus pricing in our corporate business, combined with our subscription based suites in consumer have created a highly ratable model with visibility into future revenue streams.

On a GAAP basis, Q3 2006 net income was $30 million, or $0.19 per share on a diluted basis compared to $23 million or $0.13 per share on a diluted basis in Q3 2005. Non-GAAP net income for the third quarter was $58 million compared to Q3 2005 non-GAAP net income of $63 million. Non-GAAP net income per share for the third quarter was $0.36, compared to $0.37 in Q3 2005.

Bookings for Q3 2006 were $349 million, compared to $301 million in Q3 2005, an increase of 16% year over year. 58% of third quarter bookings came from North America. Please note that we are now reporting retail bookings gross of contra revenue.

We closed 264 deals in Q3 over $100,000 including 29 deals over $0.5 million and five deals over $1 million. We did not see incremental discounting or lengthening of contract terms in the quarter.

Revenue from our consumer business in the third quarter was $120 million, up 14% year over year. Overall consumer bookings in the third quarter were $166 million, up 28% year over year. Retail revenue was $14 million, down 19% year over year, and retail bookings were $21 million, down 20% year over year.

Online consumer revenue was $106 million, up 20% year over year. Online revenue during the third quarter was 88% of total consumer revenue. Online consumer bookings were $144 million, up 40% year over year. During the quarter we added 1.7 million net new subscribers bringing the total number of online subscribers to 22.5 million.

During the quarter we continued to implement our strategy of profitable partner expansion, online business growth and beyond the shelf retail presence. We signed 15 new agreements and launched nine new online partners. Examples of partnerships include Best Buy, where we will offer custom built VirusScan to customers serviced by the GEEK Squad.

Dell, where from August through October, 2006, McAfee is featured as Dell default in North America and both Dell recommended and Dell default in the rest of the world. In addition McAfee has secured both recommended and default status outside North America for the November through January Dell quarter. Comcast, where we have renewed and extended our agreement, and finally BSkyB and Baidu where we launched partnerships that were previously announced.

At the end of July, 2006, we introduced four new consumer suites to the McAfee subscriber base, McAfee VirusScan Plus, PC Protection Plus, Internet Security Suite, and Total Protection. We staged this roll-out months ahead of the competition starting with our direct subscriber base in North America and progressing to subscribers worldwide. You will see our partner base starting to offer our suites over the coming months.

We have been working to monetize our acquisition of SiteAdvisor. All of our 2007 consumer suites feature SiteAdvisor technology and later this quarter, we plan to launch a premium version of our McAfee SiteAdvisor consumer product. For the enterprise business, SiteAdvisor will be integrated with ePolicy Orchestrator and included with Total Protection Advanced later this quarter.

In late August, 2006, we announced that SiteAdvisor safety rated on average more than 100 million unique web safety queries every day. SiteAdvisor is being recognized by leading publications including a mention as one of Time Magazines 50 Coolest web sites and a five-star rating from CNET’s Downloads.com.

Turning to our corporate business, revenue was $168 million, up 14% year over year. Bookings for McAfee SMB business were $73 million, down 5% compared to the third quarter of 2005. One of our important initiatives in SMB is our new Total Protection Solutions product line. TPS for SMB was designed with our partners in mind and is gaining traction in the market. TPS S&B allows partners to provide incremental services around the McAfee solution, increasing partner margin. We believe that this strategy will open opportunities for McAfee, particularly at the small business end of SMB.

Bookings for McAfee's large enterprise business were $110 million, up 16% compared to the third quarter of 2005. In Q3, our network business performed very well led by IntruShield. Of note this quarter was the performance of our secure content management appliances. Initiatives to simplify our message to the market and a refocusing of the sales force are paying dividends. In North America, Foundstone products and services are continuing to have success.

During our second quarter earning call, we talked about our Total Protect at Launch and mentioned that we were encouraged by early customer reaction. Total Protection sold well in the third quarter and with just over five months in the market we believe that TPS represent a significant opportunity in the corporate market. Customers clearly recognize the value of a comprehensive, integrated approach that leverages a common agent a single management console.

Examples of important customers wins are: a large U.S. defense contractor which purchased Total Protection Enterprise Advanced because of the powerful product suite and compelling price point; and Agva in Europe, which purchased a Total Protection Solution Enterprise for the central management and integration of these solutions coupled with a highly effective and efficient security solution.

At the beginning of October, 2006, McAfee announced appointment of Roger King as Executive Vice President of Worldwide Sales. In this role he will lead a dedicated worldwide sales and channel team and oversee the Company's sales operations and channel development. Roger brings channel experience as well as previous success at building a financially successful global organization. Prior to joining McAfee, Roger was President of Software Spectrum, a large reseller of enterprise and SMB technology solutions.

Now we would like to transition to a review of our Q3 2006 P&L. GAAP gross profit margins for the quarter were 81%, non-GAAP gross profit margins for the third quarter were 83% compared to the Q2 2006 results, which were 85 %, and Q3 2005 results, which were 87%. This margin decline is due to a continuing shift of product mix toward hardware and a steady growth of consumer subscribers acquired through partners where the revenue shared is paid through cost of goods sold.

We expect that GAAP gross profit margins for the fourth quarter will range between 79% and 81% and non-GAAP gross profit margins will range between 81% and 83%.

Total non-GAAP operating expenses were $171 million, or 60% of revenue in the third quarter of 2006, compared to $143 million, or 57% of revenue in the third quarter of 2005. GAAP sales and marketing expenses were $94 million, or 33% of revenue; non-GAAP sales and marketing expenses were $88 million, or 31% of net revenue within our target range of 30% to 32%. GAAP research and development costs were $58 million, or 20% of revenue.

Non-GAAP research and development costs were $52 million, or 18% of net revenue within our target range of 17% to 19%. GAAP G&A expenses were $36 million, or 12% of revenue. Non-GAAP G&A expenses were $31 million, or 11% of net revenue at the lower ends of our target range of 11% to 13%. Our GAAP operating income for Q3 was $36 million our GAAP operating margin for the period was 12.6%. Our non-GAAP operating margin for Q3 was $67 million, and our non-GAAP operating margin for the period was 23.3%.

Other income for the quarter was $13 million, compared to $8 million in Q2 2006 and $7 million in Q3 2005 reflecting year over year increased cash balances, improved cash management and foreign exchange strategies.

Total headcount at the end of the third quarter of 2006 was 3,679 basically flat compared to the 3,675 reported at the end of Q2 2006. DSOs for Q3 2006 were 42 days, consistent with Q2 2006 and within our target range. The Company's GAAP tax rate for the quarter was 38%. The Company's third quarter 2006 non-GAAP tax rate was 27% compared to 25% in Q3 2005. Deferred revenue was $836 million at the end of Q3 2006, another all-time high for McAfee.

Year over year, deferred revenue grew by 27%. Short-term deferred grew by $29 million to end the quarter at $656 million, and long-term deferred decreased by $1 million to end the quarter at $180 million. We ended the third quarter with cash, cash equivalents and investments of $1.234 billion, a net increase of $81 million compared to the second quarter balance of $1.154 billion. During the quarter we generated approximately $79 million in cash from operations on a GAAP basis.

McAfee intends to invest its cash in R&D, small to mid-size strategic acquisitions and for the repurchase of its shares. The company is currently precluded from repurchasing shares due to its ongoing stock option review and the pending restatement. Upon completion of the review and the filing of all amended historical financial statements and outstanding quarterly reports, the Company may be in a position to resume its share repurchase program. McAfee has $246 million in repurchase authorization available until October 25, 2007.

Acquisitions. In the month of October 2006, McAfee announced the acquisition of Citadel Security software and Onigma, Citadel Security will provide McAfee customers with solutions and security policy compliance and vulnerability remediation; while Onigma will provide data loss prevention technology. McAfee has agreed to acquire substantially all of Citadel assets. The transaction is expected to close in the fourth quarter of 2006 subject to customary closing conditions including Citadel stockholder approval and expiration of the HartScottRodino waiting period. Our acquisition of Onigma closed on October 12, 2006. On a GAAP and non-GAAP operating basis, both acquisitions are expected to be slightly dilutive in 2006. McAfee will funds these acquisitions with their existing cash balances.

Guidance. Starting with the fourth quarter 2006 earnings call to be held in Q1 of 2007, we will only be providing guidance for the following financial line item. Revenue, GAAP and non-GAAP operating margins, GAAP and non-GAAP tax rates and GAAP and non-GAAP EPS.

I would now like to provide you with our fourth quarter 2006 guidance. The following updated guidance replaces and supersedes any previous guidance with respect to future periods and is valid as of today only. I would like to remind listeners that guidance is based upon managements current expectations then actual results may vary, perhaps materially, from those results anticipated in this guidance. Consistent with our preliminary results this guidance excludes any impact from any non-cash charges that could result from our internal review of stock option grant practices. Please see the footnotes in our press release for further details.

For the fourth quarter of 2006 we expect net revenue between $275 million and $295 million. We expect fourth quarter GAAP net income between $0.16 and $0.20 per share and non-GAAP net income between $0.31 and $0.35 per share on a diluted basis. We expect stock compensation charges for the quarter to range between $0.06 to $0.10 per share. Our GAAP operating income margin is expected to be 12% to 14% and our non-GAAP operating income margin is expected to be 20% to 23%. We expect our share count to range between 162 million and 164 million diluted shares in the fourth quarter. We assumed a GAAP tax rate of 30% and a non-GAAP tax rate of 27% for the fourth quarter of 2006.

On a GAAP and non-GAAP basis for the fourth quarter of 2006, we are expecting the following in terms of operating expenses: GAAP G&A expenses to range from 13% to 15% of revenue, and non-GAAP G&A expenses to range from 11% to 13% of revenue. GAAP R&D expenses to range from 18% to 20% of revenue, and non-GAAP R&D expenses to range from 17% to 19% of revenue. GAAP sales and marketing expenses to range from 33% to 35% of revenue, and non-GAAP sales and marketing expenses to range from 31% to 33% of revenue.

I will now turn the call back over to Dale to conclude.

Dale Fuller

Thank you, Eric. McAfee's strategy is all about protecting the important assets of our customers. From the enterprise of one to the enterprise of thousands, McAfee is proven. We don't just talk about security. Security is in our DNA. Over the last year we've heard from our customers that security is a very complex issue and that point products alone are not enough for adequate protection. Today's environments require a comprehensive, integrated and easy to manage approach to security risk management.

This environment requires that security be more than a single product that addresses just a single dimension of a multidimensional problem. The new environment demands security become a sophisticated process that helps individuals and organizations take a proactive approach to protecting computing assets in the home and in large businesses.

At McAfee, we are taking the process of security to the next level. For example, we are helping our customers deploy automated enforcement of IT security policies to ensure protection and compliance. Our new offerings are helping customers streamline their approach to security. For consumers, this means we are providing automated updates and upgrades. We are providing one-click fixes to most common security problems. We are giving greater visibility into the entire home network.

For corporate customers, this means we are enabling the automation of manual processes such as performing security audits, reducing risk and compliance reports and, of course, remediation. In short, as we help customers streamline their approach to security, we are helping them gain operational efficiencies, reducing costs and also reducing their risks.

We are offering integrated solutions. We are helping customers around the world to manage their security through McAfee Security Center and ePolicy Orchestrator. Our integrative approach allows home users to eliminate the confusion of managing the security process. It allows larger customers to leverage the investments they already made in point products through integration.

We did all of this with our Total Protection Solutions and we will do it all again with our Security Risk Management. The end result of our efforts to integrate our solutions is that customers are finding they can feel confident that what they purchase today will integrate with what they will need in the future.

Customers who have seen our strategy and our road map are enthusiastic and are committing to McAfee as a long-term security partner. They, along with the 100 million other customers, understand the distinction between McAfee's comprehensive and integrated security risk management strategy, and the approach of point product vendors and other less sophisticated competitors on the margins of our market.

Our new products, as well as our recent acquisitions that build out our security risk management strategy, all are serving to reinforce McAfee's leadership as the proven security partner of choice. As a result, we are well-positioned to capitalize on the IT security market, which according to one analyst, IDC, was $31 billion in 2005 and is expected to reach $63 billion by 2010.

McAfee had a solid quarter. We have accomplished a lot so far, but we can do better. Although I've only been here a few weeks, I'm still in the process of getting comfortable and settled in. I am confident in our Q4 expectations. I am, however, still reviewing our 2007 plans and I'm not ready to provide a complete 2007 view. So I will delay our discussion of guidance for next year.

Thank you for joining us today. We look forward to giving you future updates on our performance.

Kelsey Doherty

Before the operator polls for questions I would like to inform you that McAfee will be presenting at the Goldman Sachs conference in New York on November 7, the CSFB conference in Phoenix, Arizona on November 28, and the Lehman Brothers conference in San Francisco, California, on December 5.

Operator, you may now poll for questions. Please, in the interest of time, limit yourself to one question. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mr. Daniel Ives - Friedman Billings Ramsey.

Daniel Ives - Friedman, Billings, Ramsey

First on the consumer side, monster quarter, is it just, it all clicked? Maybe you can give us some more granular information, what happened there in the quarter? Just a follow up, geographically, just talk about any sort of geographical soft spots, maybe specifically if you could address Europe and specifically Germany? Thanks.

Eric Brown

First of all I'll start with the revenue by geo performance. Year over year we had strong double-digit performance in all the major geos excepting Japan. So in regards to EMEA specifically we had very good year-over-year performance so we are pleased to report that.

In regards to consumer, I think the summary there is the following: upside performance delivered by online plus partners. Obviously the McAfee strategy of partnering with ISPs to maximize distribution is working well. The profit margins in that business are very good. I would also note that we are first to market with the fall launch of the Falcon product suites. So we had some good initial results in the first several weeks of selling in the third quarter of 2006 as well.

So overall I would say that the performance, the message that I would leave here is one of balance, 14% year over year in total, 14% year over year growth in the corporate side of the business and 14% growth year over year revenue in terms of the consumer business as well. So very good balance for the McAfee portfolio.

Daniel Ives - Friedman, Billings, Ramsey

Thanks, guys.

Operator

Your next question comes from Sterling Auty - JP Morgan.

Sterling Auty - JP Morgan

I want to follow up on that consumer question. Looking at the sequential growth in consumer especially the online, it was an awful big jump. Was there a change in how much contra revenue was in the quarter? Or change in the number of services per subscriber or any other metrics?

Eric Brown

The net adds of subscribers for the quarter was approximately 1.7 million. This is fairly consistent with what we've seen on the last couple of quarters. We also enjoyed for the quarter very solid placement default and recommended placement with Dell. So we are starting to see the uptake, the bookings and hence the net add from that portion of the business as well. So that would be some of the key contributors to the performance there on the consumer side of the business.

Operator

Next question comes from Sarah Friar - Goldman Sachs.

Sarah Friar - Goldman Sachs

Good afternoon, guys, great quarter. Just two quick questions for you. Firstly on the enterprise side, actually great strength there, too. Can you give us a sense for how many customers have already done the upgrade to TPS? Are we still on the first 10% type range?

I think the question that everyone is still wondering about is, how much is the board still exploring other alternatives as well as obviously looking to replace a new CEO? Can you give us any update on that front too?

Eric Brown

This is Eric I will answer the first half of the question there. If you could just clarify a bit and repeat it.

Sarah Friar - Goldman Sachs

Sure, so just on the enterprise side ,because you really did see very nice strength there on the large enterprise. Can you give a sense for how far penetrated TPS is, have your first 10% of customer done that upgrade, are we in the first 20%, can you give a sense for how much tailwind is still in that upgrade?

Eric Brown

TPS, it was only launched about five months ago and so as with any major enterprise and SMB technology launch that is early stage. It's fair to characterize this as still very early stage. What we are finding is that the TPS messaging, single agent, single management is resonating very, very well. When we benchmarked TPS against other offerings what we finds and what we hear back from customers is one agent, one console is replacing as many as three or four agents and three or four management consoles to get comparable protection. I would say that our initial role and messaging has been focused more toward the larger end of the enterprise but the message is now diffusing more towards the small and medium side of the business.

Dale Fuller

And early in results from our customer base now, and again were just starting to see the ramp up and we are seeing good traction, is that it's very positively received. So we think we are on to something very strong here and we hope that we continue to see that as the wave starts to grow.

The CEO search process, so the board which I happen to be a member of, we are in the process right now. We have now settled on a search firm yet but we are in investigation with the different search firms to settle on them and we are actively pursuing a CEO to replace myself as the interim CEO and president.

Operator

Next question comes from Philip Winslow - Credit Suisse.

Philip Winslow - Credit Suisse

Hi, guys, just had a quick question on the small and mid-size business portion of the business. I was wondering what trends you are seeing there and also a it's been a bit of a laggard over the past couple of years. What initiatives do you have in place to try to turn that around?

Eric Brown

I think that we are not satisfied with a 5% reduction year over year in SMB. It clearly is the one area where we need to spend time. We believe we now have with TPS the correct product offering for SMB. I don't think we are as of this stage seeing the full effects of TPS in the SMB segment. As I noted the initial roll-out was more focused in terms of messaging, training, et cetera, towards larger enterprise so a diffusion of this messaging needs to occur as well.

I think that with what we've done here is we've added to the team Roger King an executive who for many, many years operated very successful in the software spectrum, a reseller of enterprise technologies including security technologies such as McAfee and others. We believe that his insight will give us good views, new views on ways to improve our SMB and channel performance.

Operator

Our next question comes from Gregg Moskowitz - Susquehanna Financial.

Gregg Moskowitz - Susquehanna Financial

Thanks, I was wondering if you could talk about, I know it is early and it was a soft launch with Falcon suites but are there any suites in particular that you are seeing most success with out of the gate?

Secondly on the enterprise side, you have four different technologies that were acquired in the risk management area if you include Foundstone. How do you plan to integrate those and more specifically when do you expect that all to be a fully imbedded part?

Eric Brown

In answer to first half of your question, early results -- and I emphasize early since we only recently launched Falcon -- of the four suites, the MIS Suite appears to be the leading seller out of the gate. In regards to the recent acquisitions, specifically Citadel, again, the deal hasn't technically closed yet, so that's the first caveat. We do expect that to occur towards the ends of the fourth quarter.

However, the best way to characterize it is already pre-integrated. A company that was designed with integration, with McAfee products already and so there is no road map to integration issue there. It is integrated out of the box. We expect to be making further changes but we are well ahead of the curve as far as that is concerned.

Operator

Next question comes from Rob Owens - Pacific Crest.

Rob Owens - Pacific Crest

Good afternoon. I was looking for more color on TPS and especially some of your wins. Are you seeing competitive displacements at this point or are you effectively seeing these wins within your existing customer base?

Eric Brown

I would say initially again the strategy here with TPS has been, roll it out to the installed base and use it as an upsell/cross-sell opportunity in connection with maintenance renewals. Then further within that strategy to focus more with, again higher end enterprise messaging initially, and then filtering it down.

We are not looking out of the gate to go full bore against competitive displacements. The easy traction, the easy money is in the upgrade and the upsell process. We are seeing very good results five months into the TPS sales cycle as far as that is concerned.

Operator

Next question comes from Walter Pritchard - Cowen.

Walter Pritchard - Cowen

Can you provide us any detail in terms of next quarter how much revenue you are expecting to roll off the balance sheet? Also it looks like just related, the term length or the long-term/short-term stabilized after last year having come up quite a bit, more long-term, can you help us out with what the driver of that stabilization has been in the deferred?

Eric Brown

Yes, the first part of the question I will not respond to but I will simply make the observation that in Q1, Q2 and Q3 of this year the amount of deferred off the balance sheet each quarter has been relatively stable.

With regards to the second portion of your question in terms of the term, the contract length, again what we've been seeing in terms of our sequential deferred revenue growth certainly through the first three quarters of this year, is a steady compounding with the bulk of the incremental adds to deferred revenue going into the short-term deferred category and very little actually incrementally going into long-term.

So what that suggests is that we are not pulling forward maintenance renewals but rather just compounding the overall deferred revenue base. So this is one of the things that we watch for and actively manage as we go through deal configurations and processes.

Operator

Thank you. Our next question comes from Todd Raker - Deutsche Bank.

Brian Thackery - Deutsche Bank

From a macro perspective, can you talk about what's in your expectations for the fourth quarter with regards to any potential push out in consumer spending on the PC cycle that will now launch into Q1?

Eric Brown

We have no specific exceptions in terms of push out effects. Our understanding is that most of the PC OEMs are offering free upgrade programs and so that opportunity should not, in and of itself, forestall or modify significantly any unit purchase behavior. So we are expecting business as usual on the consumer side of the business for the fourth quarter in that regard.

Dale Fuller

But it's fair to say we are watching it very carefully and we have plans in place that if we start seeing a fall off because consumers are pushing off their purchases we are going to make the adjustments necessary.

Operator

Next question comes from Heather Bellini - UBS.

Heather Bellini - UBS

I was actually wondering if you could give us an idea of the AOL contract. There is talk in the market the contract is up for renewal in November, and I was just wondering if you could clarify that and also give us an idea of what percentage of revenue that would represent? Thank you.

Eric Brown

Again, Heather, this is Eric. We don't specifically call out revenue contributions from AOL or other partner contracts. We are precluding from doing so by confidentiality provisions.

In regard to the current status of our relationship with AOL we continued to do business with AOL. They are a very, very good partner. We are actively engaged on a daily basis in regard to extensions and modifications of the agreement to further enhance their strategy. Beyond that, however, we are not in a position to provide any specific details.

Operator

Next question comes from Brian Pitz - Morgan Stanley.

Brian Pitz - Morgan Stanley

Good afternoon, I was wondering if you could provide a little bit of color into guidance. One question I had was, does that include acquired revenues such as from Citadel?

The second question I had was maybe a little bit of color behind large deals, number of deals over whatever categories you would to break them out by -- 100,000/300,000/1 million preferably?

Eric Brown

Okay, in regards to your question about what's factored into the Q4 guidance, the expected contribution of Citadel is negligible. And again, the deal hasn't closed. There are a couple of customary closing conditions and so Citadel is not a factor in regards to the Q4 guidance.

Dale Fuller

In Q3 we closed 264 deals over $100,000; 29 deals over $500,000; and five deals over $1 million.

Operator

Next question comes from Chris Hovis - Morgan Keegan.

Chris Hovis - Morgan Keegan

Yes, nice quarter. Could you guys talk a little bit about what you saw driving the strength in IntruShield and as a follow up, talk about what you are seeing in terms of demands for the Web security gateway appliance?

Dale Fuller

It's clear that the market itself sees McAfee as a proven security vendor and that's why we are seeing the growth in our marketplace, both on the enterprise and the consumer.

Eric Brown

I would say also that we did indeed pioneer intrusion prevention with the IntruShield product line. We continue to enhance and expand it and I think we've become increasingly successful training our sales force and our partnership networks in terms of positioning IntruShield. It’s an indication that customers require and demand a defense in-depth both on the host PC and at the perimeter; IntruShield is extremely well suited for that.

Operator

Next question comes from Ed Maguire - Merrill Lynch.

Ed Maguire - Merrill Lynch

Yes, good afternoon. Eric, could you just expand a little bit on the details around the contra revenues in the retail? And also provide just a little color on whether you expect any changes in the sales organization now that Roger King is on board?

Eric Brown

I think in regards to the second half of the question it's premature to comment on that. Roger needs time to make his assessment of the team, the 2007 go to market plans, et cetera, so we will have to reserve comment on that for a later time.

In regard to the change in presentation of the retail bookings, up until now one component of our bookings has been reported net of contra, that being retail. So Q3 2006 is the first time that we've unified the reporting for bookings across all of our different subject segments, i.e., everything is shown gross of contra. And if you are looking at the attached tables what you will find is everything recast to appropriately gross up the retail bookings so it's consistent with the Q3 2006 presentation.

As you compare those numbers what you will find is that in a given quarter, say over the last four quarters, the amount of implicit contra revenue embedded in the retail segment would range from approximately $5 million to say, $8 million per quarter.

Operator

Next question, Rob Breza - RBC Capital Markets.

Matt for Rob Breza – RBC

Could you talk a little bit about your $79 million cash flow, the components, what worked for you, maybe what didn't as far as the contribution there? Thanks.

Eric Brown

Sure. Again, I would like to emphasize that the cash flow number there is a GAAP operating cash flow number of $79 million. So one of the things that you would need to consider to normalize the cash flow would be the expense items that we exclude from the financial statements, specifically the SEC and the compliance costs. A rough estimate of a normalized operating cash flow for the quarter, you would increase it by $5 million or $6 million versus the $79 million that we gave. So $85 million would be a rough proxy for normalized non-GAAP operating cash flow for the quarter, which is consistent with prior quarters.

Operator

Next question comes from Clay Border - Mansville Capital.

Clay Border - Mansville Capital

I was noticing on the Cox Cable tech support site that they stopped providing McAfee security products on October 2. Can you comment a little bit on your relationship with Cox? And the second question is your press release mentions a new agreement with EarthLink and I was wondering if you could expand on the nature of that relationship?

Eric Brown

I am not sure what you may have seen with respect to Cox but Cox is still a valid and an active partner with McAfee.

Operator

The last question comes from Israel Hernandez - Lehman Brothers.

Israel Hernandez - Lehman Brothers

Good afternoon and good quarter, guys. In the past McAfee has targeted 25% operating margins as its long-term objective. Is this still the plan, looking out over the next several quarters, or given some of the gross margins pressures that we are seeing, do you think that might be a bit aggressive?

Eric Brown

I think that, again, it's important to understand that for historical context the Company had to redesign the business and shed the non-core, non-security assets to improve the operating margins which we've done so successfully. Our current expectations with regards to operating margins for the fourth quarter reflect our view of the investments that we need to make, most specifically in the channel and also in the expansion of R&D and sustaining our leadership and security risk management. So we feel that is more important in terms of long-term value creation.

One of the things that we are still in the process of doing and this involves the review between myself, Dale and the senior team here, is the 2007 plan as we look to strike a correct balance in terms of investing for the future versus dropping net profits and cash flow to the operating margin line.

So we will have more to say about that when we comment on 2007.

Kelsey Doherty

All right. Thanks, Eric, and thank you everyone for joining us today. We look forward to reporting future progress at McAfee.

Operator

Thank you for joining today's conference call.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: McAfee Q3 2006 Earnings Call Transcript
This Transcript
All Transcripts