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Acme Packet, Inc. (NASDAQ:APKT)

Q1 2010 Earnings Call Transcript

April 29, 2010 5:00 pm ET

Executives

Brian Norris – Director, IR

Andy Ory – President, CEO & Cofounder

Peter Minihane – CFO

Analysts

Paul Silverstein – Credit Suisse

Brian Modoff – Deutsche Bank

Simona Jankowski – Goldman Sachs & Company

John Marchetti – Cowen & Company

Catharine Trebnick – Avian Securities

Sanjiv Wadhwani – Stifel Nicolaus

Jeff Kvaal – Barclays

Operator

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

(Operator instructions) I would now like to turn the conference over to our host Mr. Brian Norris, Director of Investor Relations for Acme Packet, please go ahead.

Brian Norris

Thank you. Good afternoon, everyone. Welcome to our 15th quarterly conference call. I am Brian Norris, Director of Investor Relations; and I am joined by Andy Ory, our President and Chief Executive Officer; and Peter Minihane, our Chief Financial Officer and Treasurer.

The format for call is as follows. Andy will begin with a high level overview of our first quarter highlights. Peter will then follow with a detailed financial review and a discussion of our updated outlook for 2010. Andy will then provide an update on the key growth drivers for 2010, and the opportunity we see beyond our traditional session border controller market. We will then open the call up for Q&A.

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

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

Our non-GAAP results for three-month period ended December 31, 2009, and March 31, 2010, also excludes amortization of intangible assets related to the company’s acquisition of Covergence.

Finally our non-GAAP results for the three-month period ended December 31, 2009, also excluded the gain related to the Covergence acquisition.

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

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

A discussion of these risks and uncertainties is contained in our recent filings with the SEC, including those factors discussed under the caption risk factors in such filings. Investors should not place undue reliance on these statements, which are current only as of the day they are made and we disclaim any obligation to update them.

Before I turn the call over to Andy, let me briefly bring to your attention that we will be in New York on May 26 for the Barclays Capital Global Communications Media & Technology Conference, and then again on June 2 for the Cowen and Company 2010 Technology, Media and Telecom Conference.

One last calendaring item, please make plans to join us at 5 p.m. Eastern daylight savings time on Thursday, July 29, for our second quarter earnings results conference call. For more details on our IR Outreach plan for the second quarter, please feel free to contact me at 781-328-4790.

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

Andy Ory

Thank you, Brian, and good afternoon, everyone. We are pleased to be reporting the best quarter in the company's history. Our results were highlighted by record revenue, gross profit, operating margins and earnings.

Total revenue increased to a record $51.1 million in the first quarter, an increase of 24% compared to the fourth quarter of 2009. Operating margin expanded to 33%, up from 24% in the fourth quarter. This is the best evidence yet of the leverage in our business model.

We reported non-GAAP EPS of $0.16, up 45% sequentially and $0.06 ahead of First Call consensus. Beyond the financial highlights, we added 58 new customers in the first quarter, including 38 new service provider customers, and 20 new enterprise or government customers. We also shipped our 10,000th system during the first quarter, and our customer count surpassed 1000.

We are pleased to report a positive start to 2010. The growth drivers of our business are very strong, and the business continues to perform well. Our execution in the first quarter was driven by several factors. First, we continue to see growing momentum in all areas of the business. Second, we benefited from the very strong customer activity, which began to accelerate for us in the second half of 2009. Finally, we continued to see overall market growth as more and more enterprises, service providers, contact centers and government agencies embrace session oriented IP-based communications.

We are in the middle of a massive disruption, which is changing the way the world communicates. Service providers, enterprises and contact centers throughout the world are replacing their legacy circuit switch networks with next generation packet based networks based on IP. These IP networks require a unified service delivery architecture based on an expanding definition of session border control. Session border control is much more than session border controllers, the product category for which we have long been known. Rather it is a service delivery architecture that encompasses several other product categories that control voice, video and data sessions not only at IP network quarters, but also across IP networks to these borders.

Other product categories in Acme’s current portfolio include session routing proxy, multiservice security gateways, and session-aware load balancers. All of these product categories will be important elements of a unified architecture for delivering services. While our focus has traditionally been in the session border controller market, a market which is expected to reach $700 million by 2014. Our focus over the next five years is much broader.

You will see and hear much more from Acme Packet in these other emerging product categories. Based on the research we completed in conjunction with our five-year strategic planning process, we now believe that the market for our solutions may exceed $2 billion annually by 2014. This is over three times larger than the opportunity for session border controllers alone.

Our customers deploy our products as the foundation for a service delivery architecture, which enables them to deliver next-generation interactive communication services with the same quality assurance and security as they historically have offered over their legacy telephone networks. Our products are found at the borders between IP communication networks, and serve to unify the separate and ever increasing number of IP communication service islands.

The proliferation of these network islands is fueling what we believe will become a multi-billion-dollar market for our solutions globally over the next several years. As the clear market leader, we are well positioned to benefit from the proliferation in the number of IP communications network islands. This proliferation continues to reflect itself in our improved financial results. Our business has performed very well for the last 18 months. Last year we reported revenue growth of 22%, and we are reporting revenue growth of 24% for the first quarter of 2010 compared to the fourth quarter of 2009. Based on the overall strength of the business and the growth drivers we are seeing in our key markets, we are raising our outlook for 2010. We're updating our earlier outlook, which called for 30% revenue and earnings growth in 2010.

We now expect revenue to grow by approximately 45% to a range of $204 million to $208 million. We now expect non-GAAP EPS to grow by approximately 90% to $0.65 to $0.70 per share. We believe we can deliver on this upwardly revised business plan, while also properly positioning the company for 2011 and beyond. For a closer look at the numbers and our outlook, let me turn the call over to Peter.

Peter Minihane

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

Finally please note that all earnings per share results amounts are on a fully diluted basis. With that, I’ll begin with a brief overview of our first quarter 2010 results. Total revenue was $51.1 million, an increase of 24% sequentially. Product revenue was $42.1 million, an increase of 31% sequentially primarily due to an increase in average selling prices, and continued growth in unit sales from our Net-Net 4500 platform.

Maintenance, support and service revenue was $9 million, which was relatively flat sequentially.

One direct customer accounted for 10% or more of revenue and that customer was Verizon Wireless at 14%. The distribution of revenue was 50% direct and 50% indirect. The greater than normal contribution from our direct channel was due to the increase in the revenues from Verizon Wireless. No channel partner accounted for 10% or more of our revenue in the first quarter.

Geographically, 57% of our revenues came from the United States and Canada, and 43% came from our international customers. We saw strong sequential revenue growth throughout North America, EMEA, and Asia-Pacific.

Gross margin was 82% consistent with prior quarters. Although we continue to enjoy gross margin in excess of 80%, we continue to model longer term gross margins in the upper 70s. Product gross margin was 83%, which as I mentioned earlier continued to reflect adoption of our higher capacity, software-rich products including the Net-Net 4500.

Service gross margin was 77%, which reflected the fulfillment of maintenance obligations, as well as headcount investment we have made over the last six months to support our rapidly growing customer base. We expect service gross margins to be approximately 80% for the remainder of 2010. Total operating expenses were $25.2 million, an increase of 6% sequentially, primarily due to an increase in compensation, employee benefits and occupancy costs.

Operating margin expanded to 33% compared to 24% in the fourth quarter of 2009. The primary driver to the expanded operating margins were higher than planned revenue, higher than planned gross margins, and lower than anticipated operating expenses. Our effective non-GAAP tax rate was approximately 36%.

Net income on a non-GAAP basis was $10.7 million compared to $6.8 million in the fourth quarter of 2009 reflecting an increase of 57% sequentially. Earnings per share on a non-GAAP basis was $0.16 compared to $0.11 in the fourth quarter of 2009 reflecting an increase of 45% sequentially.

Net income on a GAAP basis was $8.3 million or $0.13 per share compared to fourth quarter of 2009 when we reported net income on a GAAP basis of $9.1 million or $0.14 per share, which reflected a one-time gain of $4.3 million or approximately $0.06 per share related to the Covergence acquisition.

Non-GAAP net income differed from GAAP net income in the first quarter of 2010 as it excluded stock-based compensation expense and amortization of acquired intangible assets all net of tax of $2.3 million or approximately $0.03 per share. Non-GAAP net income differed from GAAP net income in the fourth quarter of 2009 as it excluded a gain of $4.3 million or approximately $0.06 per share related to the Covergence acquisition. It also excluded stock-based compensation expense, and amortization of acquired intangible assets, all net of tax of $2 million or approximately $0.03 per share.

We ended the first quarter with 474 employees compared to 450 at the end of the fourth quarter.

Moving to the balance sheet, we ended the first quarter with record cash, cash equivalents and investments of approximately $188.6 million compared to $175 million at the end of the fourth quarter of 2009. We generated $8 million in cash from operations during the first quarter. Cash flow provided by financing activities was approximately $8.8 million, primarily due to proceeds from stock option exercise.

Total capital expenditure in the first quarter was $2.8 million. We expect to spend an additional $5 million to $6 million in capital expenditures in 2010, which as I mentioned last quarter excludes any investments related to the relocation and expansion of our corporate headquarters in July.

Accounts receivable net was $29.5 million at March 31, 2010 compared to $25.6 million at December 31, 2009, primarily due to sequential increase in revenues in the first quarter.

DSOs decreased to 52 days at March 31, 2010 compared to 56 days at December 31, 2009. Due to standard contractual arrangements, our targeted DSO range continues to be between 60 and 70 days. Finished goods at customers at March 31, 2010 was $2.3 million compared to $3.4 million at December 31, 2009. This decrease was primarily due to time based acceptances of previously deferred product sales.

Inventory at March 31, 2010 was $5.2 million compared to $4.4 million at December 31, 2009. Although we had a $1.2 million increase in inventories, our inventory turns at March 31, 2010 remain strong at approximately 6 turns, reflecting the continued hard work of our manufacturing team.

Finally, deferred revenue was $33.4 million at March 31, 2010 roughly flat from December 31, 2009. This net amount includes $7.3 million decrease in deferred product revenue in the first quarter, offset by a $7.2 million increase in deferred service revenue.

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

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

During our call in February, we discussed our revised outlook for 2010, which called for revenue and earnings per share growth of approximately 30% over 2009. Since then we've had the benefit of completing another quarter highlighted by record revenues and earnings.

As Andy indicated in his remarks, the growth drivers for our business are strong and intact. We are raising our outlook for 2010 revenue growth to approximately 45%. We now expect revenue in 2010 to range between $204 million to $208 million, compared to our earlier outlook of between $182 million and $186 million.

We expect to report sequential revenue growth during each successive quarter of 2010. We expect operating margin to be in the low 30s for the balance of the year as we continue to invest in all areas of the company. We expect to end the year with approximately 560 employees.

We are raising our forecasted 2010 earnings per share growth rate to approximately 90%. We now expect non-GAAP EPS to range between $0.60 to $0.70 per share compared to our earlier outlook of between $0.44 to $0.47 per share. Our earnings projections assume a full year non-GAAP effective tax rate of approximately 37%.

If the Federal R&D tax credit is reinstated, we estimate that our effective tax rate will be approximately 33%.

Finally, we now expect our full year weighted average diluted shares outstanding to be approximately 67 million shares. To summarize, we had a very strong first-quarter highlighted by record revenues, gross profits, operating margin and earnings. The business continued to perform very well. During our next earnings release conference call in July 29, we will share with you the highlights from the second quarter of 2010.

With that, I will turn the call back over to Andy.

Andy Ory

Thank you Peter. I want to spend a few minutes putting some context around the confidence we have in our outlook, and share our vision on the future of session border control architecture. Among fixed line, cable, mobile and over the top service providers there are several highly visible demand drivers fuelling the opportunity for our solutions. We are seeing a growing number of tier 1 service providers cast their investments in expensive legacy gateways and soft switches.

We are seeing growing demand for our solutions on the access side of our service providers’ customers as more and more enterprises insist on IP connections from their service providers. We are seeing growing demand for IP v4 to IPv6 interworking solutions as the global pool of IPv4 addresses nears exhaustion.

We are seeing rapidly growing demand by service providers for compact high-performance solutions like our Net-Net 4500 platform. We are seeing mobile service providers deploy our solutions for both peering and core session routing. We see the next areas of growth within wireless to be in fixed mobile convergence with dual mode handsets in Femtocell and WiFi access points, session initiation protocol services over 3-G, GSMA Rich Communication Suite services, and 4-G LTE and WiMax interactive communication, and finally we are seeing over the top providers such as Skype using our products to offer attractive, alternative consumer and business services.

Beyond our core service provider market, we are capitalizing on the growing demand for our solutions within enterprises, contact centers and governments. The most significant growth drivers in this market is the connection to the service provider, which is often referred to as the SIP trunking border. Enterprise network architects are racing to embrace SIP trunking to reduce cost, and set the foundation for enabling end-to-end IP unified communication, presence based voice, video, messaging and collaboration.

Infonetics' research recently forecast that the number of IP trunks deployed will grow to more than 24 million worldwide by 2013. Each of these trunks will drive demand for SBC technology on both the enterprise premise and the service provider access edge. Beyond SIP trunking, we believe growth in the enterprise market will be fuelled by demand from enterprises for security, interoperability, datacenter disaster recovery and regulatory compliance.

This summer will mark the ten-year anniversary of the company, when my partner and co-founder, Pat MeLampy, started the business in 2000, we believed then as we believe now that the public switch telephone network has a delivery mechanism for real term communication will eventually be replaced by end-to-end IP networks. We were not sure when that would occur or what velocity it would occur at. But it appears now in 2010 that this market disruption has not only arrived, but that is accelerating.

Over the next five years, we see session border control as a service delivery architecture encompassing multiple order categories, which we estimate to be worth over $2 billion annually by 2014. Product categories within the session border control architectural model include, but are not limited to, session border controllers, session routing proxy, multiservice security gateway, and session-aware load balancers.

Session border controllers or SBC for which we have long been known control sessions at the IP network orders. We believe that the market for session border controllers among service providers, enterprises, government and contact centers will grow to over $700 million by 2014 with a compounded annual growth rate of approximately 29% CAGR.

Beyond session border controllers, we are seeing emerging product categories led by demand for session routing proxies, multiservice security gateways, and session-aware load balancers. Session routing proxies route SIP sessions to and from borders, both access and interconnect and directly compete with class 4 soft switches. They also serve as the breakout gateway control function in IMS networks.

We estimate that the session routing proxy market may grow to approximately $450 million by 2014 with a compounded annual growth rate of approximately 8%. Multiservice security gateways transport all services and applications, including voice, video and data across the un-trusted Internet to private service provider network borders via IP session.

We believe that the MSG or multiservice security gateway market may grow to approximately $675 million by 2014 with a compound annual growth rate of over 50%. Session-aware load balancers are used to dramatically scale session border controller deployment. We believe that this market may grow to over $40 million by 2014 with a compound annual growth rate of over 100%.

We believe that session border control will continue to evolve and eventually expand beyond these 4 product categories. Given our focus on innovation and our broad customer base, we are well positioned to addressing these evolving requirements. We are excited about the future. In 2010, our objectives are to profitably grow our market and technology leadership. To be successful, we plan to continue to satisfy the evolving border requirements of service providers, enterprises and contact centers, implement new technologies to enhance product performance and scalability, invest in quality and responsive support, facilitate and promote service interconnects among our customers, and leverage distribution partnerships to enhance market penetration.

Our business is well positioned for strong growth. For the balance of the year, we will be focused on executing this plan and expanding our addressable market opportunity. I want to thank all of our employees for their continued hard work and dedication to achieving our vision for the session border control market. Thank you for joining us this afternoon, and for your continued support of Acme Packet.

With that, let me turn the call back over to Brian.

Brian Norris

Thank you Andy. Christine, at this time we would like to open the call up for Q&A.

Question-and-Answer Session

Operator

(Operator instructions) Now we’ll first go to the line of Paul Silverstein with Credit Suisse.

Paul Silverstein - Credit Suisse

Hey, guys, a couple of housekeeping items that I might have missed, and then some real questions, if I may? First off, Peter, what was the share count you projected? And was that exiting the year or was that for the year?

Peter Minihane

It's for the remainder of the year. That is 67 million shares.

Paul Silverstein - Credit Suisse

67.

Brian Norris

Paul, did you have a follow-up question?

Paul Silverstein - Credit Suisse

Yes, yes. The number of employees, I've got a number, Paul, employees at the end of the year?

Peter Minihane

560 employees.

Paul Silverstein - Credit Suisse

560, all right. Did you tell us what enterprise was as a percentage of revenue?

Peter Minihane

You know, we didn't but, from a bookings point of view it was between 15% and 20%.

Paul Silverstein - Credit Suisse

And that is up from around 15 last quarter?

Peter Minihane

Yes, it is. Yes, I mean it is pretty clear that on the SIP trunking side, as well as some of the relationships we have with enterprise folks, we're seeing real growth in the enterprise market.

Paul Silverstein - Credit Suisse

All right. And, Andy, you didn't give us a book-to-bill, did you?

Andy Ory

No, we did not.

Paul Silverstein - Credit Suisse

Would it be fair to assume it's greater than one?

Andy Ory

Well, we really didn't give it. I think what I'd say is that we are happy with the way the company performs. We really felt that racing from 30% to 45% was responding directly to the demand in the market that we've seen in the back half of ‘09 and the first third of 2010, and you know, we feel pretty good about the 45% growth.

Paul Silverstein - Credit Suisse

That's fair enough. Frankly, it's probably a foolish question. Peter, on your ASPs and margins comment is that just you being conservative? You hit greater than 30, it's industry best, and you were projecting it at close to 30 by the end of the year, it looks like there's a ton of leverage. Is there any reason why it can't go higher? Again, is that just you being conservative or --

Peter Minihane

You know, Paul I think when we feel the rest of the year we had very strong revenue growth in Q1. We had strong gross margins and we were a little behind in operating expenses simply because we didn't hire as many people as we had budgeted. That will catch up during the course of the year. We won’t get fully caught up by June 30th, but by September 30th I suspect we will be virtually at 100%. There’ll be one or two stragglers coming in in Q4, but realistically Paul we try to get everybody in the budget through June 30th that's been now pushed out when the reality strikes that it is very difficult to hire that number of employees. So I think we are being conservative, however, I don't see it going above what we have enjoyed here in the first quarter.

Andy Ory

Right. And I also think Paul that as we move from a session border control or company making a single product to a session border control service delivery architecture that has a whole host of different elements throughout the network, we see a much larger market opportunity. And I think we would be remiss not to try and invest into it and so it is clearly leverage inherent in our business. I mean, you see it when our revenue was higher than expected, it just dropped to the bottom line, but you know, we're not after leverage as much as we are after growth because we are confident that leverage is there.

Paul Silverstein - Credit Suisse

And just two more quick ones, if I may? Andy, those new markets that you spoke about on the call and that you're speaking about now, I assume from a gross margin perspective, it's high software content that we're talking about, so there's no reason that there should be an adverse impact on gross margins?

Andy Ory

Correct.

Paul Silverstein - Credit Suisse

All right. And, finally, there's still no evidence that you've seen of Cisco, Juniper, or anybody else?

Andy Ory

No.

Paul Silverstein - Credit Suisse

From a competitive standpoint?

Andy Ory

No, I mean, what happens is you know, as we start opening up -- as we start putting historic markets that weren’t in the session border control architecture into a session border control framework, we are going to run into other folks. You know, one example is the whole class IV market. There really is a pretty robust class IV market out there. Now, we believe that it is going to move to you know, basically all IP, where you’re going to have session border controllers and session router proxies but, you know, there is a cap and grow that has to happen for that migration to occur. So we won’t run into folks into these markets that already exists. But no, we're not seeing the competitive disposition change much in any of our core markets.

Paul Silverstein - Credit Suisse

All right. Thank you very much. I'll pass it on.

Andy Ory

Sure.

Peter Minihane

Thanks Paul.

Operator

Thank you. We’ll next move to the line of Brian Modoff with Deutsche Bank.

Brian Modoff - Deutsche Bank

Yes, hi, guys. A couple of questions, one on Verizon as a 10% customer, any other carriers close to that? And you can recall a few years ago when we had Sprint kind of climb up into that kind of category and then they faded. What do you think is different about it this time? And can you talk on an international basis, too, about some large operators, perhaps internationally?

Andy Ory

Sure. You know, what's interesting is that, you know, Verizon Wireless is using our technology in a number of projects, which is consistent with our large service provider customers, and they're using it as part of the broader, session border control architecture for service deliveries, for interconnect routing and things like that, it falls under that umbrella. We would expect to see this trend continue across our entire carrier customer base.

Brian Modoff - Deutsche Bank

Now is this -- yes, this is kind of an acknowledgement by the carriers that maybe a centralized IMS architecture isn't going to be the way they're going to end up deploying this?

Andy Ory

Well, you know, I mean, you know, we've been big supporters of IMS as well, particularly an European phenomenon, not exclusively but to a large extent, and we do think that the larger carriers will deploy IMS. We announced something called an SMX and this is a smaller form factor IMS product that works for the folks that would be of medium size operators globally, and we've seen an awful lot of interest in that.

So we think that dealing with the IMS requirements, form factors and functions are necessary, but the expense needs to change a little bit and we think we can help both the large network equipment vendors as well as the carriers realize those expense changes.

Brian Modoff - Deutsche Bank

And then, finally, on the MSG product, can you -- is it a different, perhaps a different customer base you're seeing there? Is there another set of customers buying that? And is this a new area for you in terms of a sales channel?

Andy Ory

Well, think of it as fixed mobile convergence, and you know, we’re really seeing this pickup on the mobile side and, you know, we think this is -- this category segment is just going to continue to pick up. It is going to be more last mile choices. There is going to be more people that want to leverage broadband connectivity to reach, you know, the walled gardens of the carriers’ network to offer these kinds of services.

Brian Modoff - Deutsche Bank

So like a Femto [ph] would be a good --

Andy Ory

That would be -- exactly. Femtocell, picocell things like that.

Brian Modoff - Deutsche Bank

Okay, all right. Thank you very much, guys.

Andy Ory

And WiFi access point could be another.

Brian Norris

Thank you Brian.

Operator

Thank you. We’ll move to the line of Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs & Company

Hi, thank you so much. Just wanted to ask you, first, in terms of your guidance it seems to imply low single-digit sequential growth in each of the next three quarters, but in the last three quarters you've had pretty solid double-digit growth. Are you being conservative or do you actually see a slow-down for some reason in the market?

Andy Ory

No, you know, really if you look at it from a year-over-year, the $141 million that we did in 2009, we're now looking at $204 million to $208 million in 2010. We think that's indicative of a broad-based global multi-market opportunity where, you know, the business really is growing by 45% plus and we really feel that way. You know, we are cognizant that this is only the end of the first quarter and you know, we want to make sure that we stay focused on execution and investments in 2011 and 2012.

Simona Jankowski - Goldman Sachs & Company

And then in terms of your direct and indirect mix, it looks like pretty much all of the growth came out of the direct business, and indirect looks like it was maybe down about 5% on my math. I mean is that a function of kind of pulling some of your customers who previously were going through the channel to now service them directly or is there another dynamic there?

Andy Ory

No, no. In fact, you know, what Peter referenced in his remarks is that the principal difference in our direct, indirect mix this quarter from last quarter was one large direct customer that was greater than 10%, and that was Verizon Wireless at 14%. If you correct for that I think you'll see that Acme Packet is very focused on engaging channels. In fact, I would say that our partner activity continues to increase significantly, and it really is the only way a company like us could take advantage of a global opportunity that's emerging so quickly. So no, please don't read into the fact that we're looking to shift from indirect to direct, because that would not be accurate.

Simona Jankowski - Goldman Sachs & Company

So the decline in the indirect business was just kind of seasonality or lumpiness, or what would you attribute it to?

Andy Ory

Probably just a measurement of one quarter. I think when you look at it over the course of the year you shouldn't see much of a change.

Peter Minihane

Yes.

Simona Jankowski - Goldman Sachs & Company

Okay, and then just the reference on Verizon Wireless, can you give us a sense of how big they were for you guys last quarter? And also if this is a kind of one quarter, multi-quarter, multiyear kind of engagement?

Andy Ory

Yes, no. We've been working with Verizon Wireless for quite some time. In fact, there was a press release we did with them on another project, probably almost a year ago and no, we would expect to be working with Verizon Wireless for quite some time. As far as the size, you know, in this particular case we recognized 14% of our sales, and so I guess you could do the math. I actually haven't done the math.

Peter Minihane

Well, it's approximately $7.4 million.

Andy Ory

Right, okay.

Peter Minihane

And the prior quarter was probably about approximately $1 million.

Simona Jankowski - Goldman Sachs & Company

Okay, got it. That's very helpful. And then just last question, in terms of, Andy, the new categories, you kind of outlined with the session routing proxies and the multiservice security gateways and load balancers, can you just comment on are these products you are selling today? And, if so, what percent of your revenues are attributable to them? And then, also, if you can just give us a sense of, you know, how does your position in SBCs help you with those new categories? Is the R&D shared or does your position at your customers facilitate your entry? If you can just give us a little more color on that side?

Andy Ory

Sure, we are selling all these products today. In fact, what's happening is that as we deploy session border controllers to solve the first problem, the way to think about it is that just this problem is being solved from the center outwards, and so the first thing that needs to happen is to deal with the interconnect of two different IP networks, and then as you start to see that there are more IP networks that there is more interconnect, that there is more routing choices that there has to be more management of all of these things that mobile starts to get integrated into wireline.

There is emerging requirements for these other product categories to provide end-to-end session oriented architecture for service delivery, and so it's really been an unraveling of us just addressing these problems and listening to our customers. People look to us to solve their problem, not to provide a session border controller but to help them understand about a session oriented architecture for service delivery. And as we come in and talk with them about those technologies it's very strategic for them to see that we have each and every one of these product categories.

You know, as you notice the session-aware load balancer, we talked about growing maybe to $40 million over the next three or four years and you might say, well that doesn't seem all that significant. That's a pretty small category, but it's actually a very strategic category, because what we're finding is that as people scale hundreds of session border controllers geographically in separate places across their active infrastructure, their manageability, their redundancy, their load balancing, they aren't able to affect, and so we’ve developed technology that allow them to safely manage and move those sessions across all those different connections behind a single IP address to scale seamlessly, manageably, and with resilience, and so what happens is where is the value.

Well, the value isn't in the session where a load balancer nor the session border controller, it is in the marriage of those two technologies and our ability to provide the solution. As far as the shared R&D, this is something that is happening, our engineering organization is not separated necessary along product lines. This architecture really touches all of our elements.

Simona Jankowski - Goldman Sachs & Company

And what percent of this, of your business is these products right now?

Andy Ory

The percent of these products, less than 10% if you were to break them out.

Simona Jankowski - Goldman Sachs & Company

Okay. Thank you so much.

Andy Ory

Sure.

Brian Norris

Thanks a lot.

Operator

Thank you. We’ll move to the line of John Marchetti with Cowen & Company.

John Marchetti - Cowen & Company

Thanks very much. Hi, guys. You mentioned obviously a little bit more investment in things like that as we're moving through the next couple of quarters, you know, partially in hiring and partially I'm guessing in support of some of these things that you're calling out here today. You know, with the 90 or so heads that you still have to add, do you see those primarily in sales and marketing? Do you think of those you know, sort of a little bit more balanced between that and R&D? And then just from an R&D line or even a sales and marketing line should we really think about any increases in OpEx really being tied to those heads or is there also you know, a lot of development work that still needs to be done over the next couple of quarters in support of some of these new products?

Andy Ory

I mean, I guess Peter, do you want me to start or…

Peter Minihane

You do it.

Andy Ory

Well, I mean, first of all you know, we had a plan. We entered the year with 450 people and our plan was to add 108 and when Peter says, 550, I guess he stuck two more in there.

Peter Minihane

Yes. Approximately 560.

Andy Ory

Approximately 560, and you know, we've hired about 25 or a quarter of those folks in the first quarter and you know, I think our goal would be to hire a little bit more in the first quarter, but we're going to make that up in the second quarter. The salespeople tend to come online first, because we just need them at the beginning of the year to sign up for quotas, to get trained, to get involved in our go to market strategy.

R&D is going to be hired throughout the whole year, and my guess is a large portion of the R&D hiring is yet to occur, and Peter can talk about that. As far as the amount of R&D to, you know, develop these products, these products are developed and deployed. The R&D or the engineering is to help us evolve all of these products and the architecture to deal with the rapidly emerging requirements that people continue to shift to a session oriented end-to-end IP architecture. And, you know, I think we can keep R&D or engineering in control. We don't see any large OpEx changes as a result of that.

Peter Minihane

We do not, and if you then look at going from approximately 474 employees up to 560 employees for the remainder of the year, to your point we really have loaded and loaded in our budget that the sales organization would be front-end loaded that is the first three or four months of the year, and the rest of the organization will be scattered throughout the first seven or eight months of the year, and again John you have to go back that we really did start to invest heavily in people in the October, November and December timeframe in our maintenance support organization, because we found that we were having a situation because of our increased product revenue, we had a large installed base to support. So we actually took some 2010 headcounts and brought it forward 90 to 120 days for the latter part of 2009.

John Marchetti - Cowen & Company

And is that also reflected in what we saw in the service margin this quarter, Peter?

Peter Minihane

Yes, so if you take look at that now. I was just going to say that John that actually if you look at our service margins, they have gone down to the high 70s. We think they are going to go back to 80%. It is a combination of that headcount that went out and hired in October, November, December. We're on full-time effectively in Q1. In addition to that, just the overall maintenance costs related to supporting the installed base was probably a little higher than we had anticipated. And again I think that is just a reflection of wear and tear on a product, as opposed to if it was a dramatic increase in warranty costs, we would be worried about it. That is just not the case.

John Marchetti - Cowen & Company

Okay, and then just one quick follow-up. I know we've kind of beat this direct, indirect stuff to death here. But Alcatel-Lucent, and NSN as go-to-market partners, any changes there in this quarter, you know, other than the fact that obviously Verizon sort of changed the configuration of the numbers?

Peter Minihane

I think, I am sorry, go ahead.

Andy Ory

Let me, before the number, just a philosophical point again, we will work with anyone that will help us bring our session border control architecture and solution to the marketplace for service providers, enterprises, contact centers and government agencies. We will work with anyone, anyone that can add value that the customer wants to work with.

And what we are finding is more and more folks are credibly coming forward, saying that we're strategic and they represent a viable and valuable pathway to the end customer. We enjoy a very good relationship with our network equipment vendor partners. We have an awful lot of deployments, and continue doing an awful lot of business with Alcatel Lucent and Nokia Siemens networks, and Ericsson, and Intel [ph]. And we will continue to work with them. I think that this is a reflection of the overall market activity and the breath of channels that are actively engaged in addressing this market, and not on our relationship with anyone particular distributor.

Peter Minihane

If you take the two distributors in the prior quarter John, they were about 13% each, and they were very consistent during all of last year at both of those distributors. Again, they represent tens and tens of end-user accounts.

John Marchetti - Cowen & Company

Absolutely.

Peter Minihane

Opposed to just themselves. So we think -- no, we don't think, we have both of those in the 7% to just short of 10% range for the current Q1, and again I think it is reflective of the dramatic increase that we had going from the approximately $41 million to $51 million in the quarter.

John Marchetti - Cowen & Company

Okay. Thank you very much.

Andy Ory

Thank you John.

Peter Minihane

You are welcome.

Operator

And the next question comes from the line of Catharine Trebnick with Avian Securities.

Catharine Trebnick - Avian Securities

Well, congratulation on the quarter.

Andy Ory

Thank you Catharine.

Catharine Trebnick - Avian Securities

All right. My question has to do with product. So when I did my last round of checks, it looks like the SMB part of the market from the carriers is picking up in terms of SIP trunking. What do you have in the pipeline that would be lower cost offering and more software based solution for that?

Andy Ory

It is an excellent question Catharine. We look at our solution both from a strategic point of view as technology and distribution. When we acquired Covergence a year ago and I think they have performed very well, and we are delighted that after a course of one year it made so much sense to Acme and Covergence.

When we acquired them, they had a software only solution that we found very, very valuable. We have been investing in that and we have been investing in relationships

that will allow for a broad global go to market strategy for our software to be available to the SMB market and other folks in a software only way. Two different ways that I believe you will find Acme’s products in the future, one is a software that can be downloaded on to a general-purpose computer.

Another way is that our software will be put into other network elements and infrastructure in the enterprise, both of which will allow to expand our reach and decrease our cost of addressing that market, and provide opportunities for lower cost per session utilization. And we have been working hard on that. We don't really have anything to talk about today, but I do think that if we keep to our knitting, I think you will see that we will have the best in class solution for the SMB market over time.

Catharine Trebnick - Avian Securities

All right. And then the other question I have is on over-the-top services you have the relationship with Skype for the business. Google and some of these other guys are -- how do you think that might play in a carrier environment as they're racking up all their deals and trying to figure out what they're going to do on Voice over IP?

Andy Ory

Well, you know the world, if you were to look at the way we see the world in the future, there is two different architectures that will manifest themselves simultaneously, and they will have competitive value propositions in business models and applications. First of all, let me say we will all be IP, end-to-end IPs. Secondly, one of them will be federated.

They will be closed privately managed signal networks that will extend links to one another, and will look a lot like what we talk about from a session border control architecture when the TDM service provider network moves to IP and connect via SIP trunks to enterprises.

The other side of the world, where the over the tops exist is that this aggregation of the service island from the network connectivity, and it looks a lot like end-to-end connectivity with the middle being like a giant Internet. And it will be these end points connecting to each other and connecting to disparate service islands. And we also made technologies in our technical solutions and we used to address that market as well. Skype is an example of that, but there are many more. And what Google talked about is exactly something like that. And we're finding a lot of interest and a lot of potential value that will be realized in the over the top services.

So, we have several relationships with a number of over the top providers. We use Skype is an example, but we clearly think that market is going to continue to grow.

Catharine Trebnick - Avian Securities

All right. Thank you very much.

Andy Ory

Sure. Thank you Catharine.

Peter Minihane

Thanks Catharine.

Operator

Thank you. The next question comes from the line of Sanjiv Wadhwani with Stifel Nicolaus.

Sanjiv Wadhwani - Stifel Nicolaus

Thanks. Congrats again on a great quarter. A couple of questions, international revenues also increased very nicely. Can you talk about any specific geographies that are doing particularly well over there?

Andy Ory

Yes, we were really happy with the progress that we made throughout all of Europe. We think that the EMEA territory has been performing very, very well. The other one that surprised us last year was just significant growth, and continue to surprise us is the whole Asia-Pac area. I mean just really doing great. That was really the first market we entered a long, long time ago, our initial customers of 2003. And it is felt that there was a half decade lull, and it is really picking up across all the different geographies in the Asia-Pac. So I would definitely point to those two as standouts internationally.

Peter Minihane

But again, we have a fairly large piece, 25%, above 25% of our business is from EMEA.

Sanjiv Wadhwani - Stifel Nicolaus

Got it.

Peter Minihane

And they have been a solid workers for us here for the past five or six quarters.

Andy Ory

Yes.

Sanjiv Wadhwani - Stifel Nicolaus

And then last earnings call you guys mentioned that during 2010 one customer will come up with a 10% customer sometime during the year, but was that referring to Verizon Wireless, or is that somebody else out there also?

Andy Ory

No, no. It was referring to Verizon Wireless. I mean we do expect that we will continue to enjoy several large service provider customers buying an awful lot of gear. And you know it is quite possible that this happens with other customers over time. But there is no real imminent concern from our point of view of customer concentration.

Sanjiv Wadhwani - Stifel Nicolaus

No. Yes, yes, I just wanted to confirm, though, that was not somebody else that you guys were referring to.

Peter Minihane

While, we had looked down at the end of the fourth quarter as we prepared for our earnings call on February 2, and really thought we should give an indication because we did have indications that we would have a strong first half of the year from Verizon Wireless.

Sanjiv Wadhwani - Stifel Nicolaus

Got it. And then last question, just on that deferred product revenues, declining sequentially, just not a concern, but was that because of Verizon Wireless sort of revenues being recognized or was that a bunch of other customers in that?

Peter Minihane

It was Verizon Wireless along with another half a dozen or so customers. But again product goes in and out of the deferred revenue category, and it is time based and many of these things we have very little if any control over.

Sanjiv Wadhwani - Stifel Nicolaus

Got it. Perfect. Thanks so much.

Peter Minihane

Okay. You're welcome.

Brian Norris

Christina.

Operator

Yes.

Brian Norris

Do we have time for -- I think we have time for one more question.

Operator

Okay. The last question will be from the line of Jeff Kvaal with Barclays.

Jeff Kvaal - Barclays

Yes, thanks very much.

Andy Ory

Hi Jeff.

Jeff Kvaal - Barclays

I was wondering, gentlemen, If you wouldn't mind taking us through some of the gross margin variables you expect to see over the course of the next few quarters, and to what extent moving into some of these market adjacencies might affect that? Obviously, your long-term model is a little bit below where you are now, so what would it take to get back down there? Thanks.

Andy Ory

Sure. No, Jeff thank you for joining us. We consistently guide into the upper 70s, because we think long-term that is the right kind of model that Acme Packet ought to be looking at, an upper 70s gross margin and still breaking the 30% operating margin barrier. We really don't see an awful lot of change in our gross margin this quarter or next quarter.

In fact the product categories that I have talked about we have deployed, and they have very similar gross margin profiles. I think the biggest concern would have been if our go to market strategy in the SMB market and the medium enterprise market would have required hardware only, and that certainly could have been margin dilutive. But given the technologies we have developed for software and some of the relationships for pursuing in an OEM fashion, we really don't see any of these activities as being margin dilutive.

Jeff Kvaal - Barclays

Perfect. Thank you very much.

Peter Minihane

Thanks for joining us.

Andy Ory

Thank you. Well, I want to say thank you to everyone for joining us this evening. It was another very strong quarter with record financial results and an upwardly revised outlook for 2010. We see very exciting opportunity ahead for session border control solution. We look forward to seeing as many of you as possible during this outreach period, and updating you on our continuing progress during our next conference call. Thank you.

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Source: Acme Packet, Inc. Q1 2010 Earnings Call Transcript

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