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Aruba Networks, Inc. (NASDAQ:ARUN)

F3Q10 Earnings Call

May 19, 2010 5:00 pm ET

Executives

Jill Isenstadt – The Blueshirt Group.

Dominic P. Orr – Chairman of the Board, President & Chief Executive Officer

Steffan Tomlinson – Chief Financial Officer

Keerti Melkote – Chief Technology Officer & Director

Hitesh Sheth – Chief Operating Officer

Analysts

Min Park – Goldman Sachs

Ryan Hutchinson – Lazard Capital Markets

Tim Long – Bank of Montreal

Mark Sue – RBC Capital Markets

Sanjiv Wadhwani – Stifel Nicolaus & Company

Erik Suppiger – Signal Hill Group, LLC.

Greg Mesniaeff – Needham & Company

[Stephen Patel] – Broadpoint AmTech

Joanne Makris – Mazuho Securities

Rohit Chopra – Wedbush Morgan Securities, Inc.

Lynn Um – Barclays Capital

[Asway DeWong – Segalman Investments]

Operator

Welcome to the Aruba Networks third quarter 2010 earnings call. During today’s presentation all parties will be in a listen only mode. Following the presentation the conference will be opened for questions. (Operator Instructions) This conference is being recorded today, Wednesday May 19, 2010. At this time I’d like to turn the conference over to Jill Isenstadt, investor relations.

Jill Isenstadt

Thank you for joining us on today’s conference call to discuss Aruba Networks fiscal third quarter 2010 results. This call is also being broadcast live over the web and can be accessed in the investor relations section of the Aruba Networks website at www.ArubaNetworks.com. With me on today’s call are Dominic Orr, Aruba’s President and Chief Executive Officer; Steffan Tomlinson, Chief Financial Officer; Keerti Melkote, Aruba’s Co-Founder and Chief Technology Officer; and Hitesh Sheth, Aruba’s Chief Operating Officer.

After the market closed today, Aruba Networks issued a press release announcing results for its fiscal third quarter ended April 30, 2010. If you would like a copy of the release you can access it online at the company’s website or you can call the Blueshirt Group at 415-217-7722 and we will fax or email you a copy.

We’d like to remind you that during the course of this conference call Aruba Network’s management may make forward-looking statements including statements regarding our financial guidance for the fourth quarter of fiscal 2010, the company’s belief that it will continue to gain market share and derive significant traction from its 802.11n products including but not limited to its spectrum analysis module, the timing, expectations, financial plans, intentions, strategies related to our proposed acquisition of Azalea Networks, our expectations relating to our partnership with Alcatel-Lucent Shanghai Bell including our ability to further strengthen our position in the Chinese markets and statements as to the company’s future economic performance, pipelines, financial conditions or results of operations.

These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control that could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today and you should not rely on them as representing our views in the future and we undertake no obligation to update these statements after this call.

Also please note that Aruba’s application of US generally accepted accounting principles or US GAAP requires disclose that the availability of new products, planned features and upgrades discussed during this call are subject to change or cancellation. For a more detailed description of these risks and uncertainties that may affect our results please refer to the risks and uncertainties described under the caption risk factors and managements’ discussion of analysis of financial conditions and results of operations in our quarterly report on Form 10Q filed with the SEC on March 3, 2010 as well as our earnings release posted a few minutes ago on our website.

Copies of these documents may be obtained from the SEC or by visiting the investor relations section of our website. Also, please note that certain financial measures that we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges including stock-based expenses and related payroll taxes, amortization of expense of acquired intangible assets, restructuring expenses and litigation settlement expense. We have provided reconciliation of these non-GAAP measures to GAAP financial measures in the investor relations section of our website located at www.ArubaNetworks.com and in our earnings press release.

Now, I’d like to introduce Dominic Orr, President and Chief Executive Officer of Aruba Networks.

Dominic P. Orr

Thank you for taking the time to attend our fiscal third quarter 2010 conference call. I am pleased to announce another record quarter for Aruba with clear progress on a number of important fronts. Revenues are growing and our pipeline is robust, new initiatives are gaining traction and we continue to expand the market for our products. We’re benefitting from mobility becoming an increasingly critical driver for enterprise productivity and we are helping to shape this trend with innovative solutions that solve today’s IT problem and better utilize scarce IT budget dollars.

During the quarter revenues grew 51% year-over-year and 10% sequentially to a record $69 million. Based on our strong growth rate versus those of our competitors, we believe we are continuing to gain share in our market. Demand was strong across our core verticals and across all three of our major geographies. Additionally, we saw solid growth in enterprise. The rate of pilots at larger brand name customers has clearly increased over the last six months, a trend that is enhanced by our increasing ability to access high level decision makers at these global 2000 companies and organizations.

Contributing to our growing mind share is our right sizing initiative which continues to gain traction. We are seeing more cases where customers are shifting budgets away from wired LANs to fund wireless projects. In the past, this customer would have done a complete refresh of the wired networks but today they are instead using these dollars to accelerate the deployment of our wireless LAN solutions and as a result saving both op ex and cap ex dollars.

For the second quarter in a row we added over 700 customers. In fact, customer acquisition in Q3 was even stronger than our record Q2 raising our total to over 10,000 cumulative customers. These new customers included one of the largest shipping companies in the world, a branch of the Brazilian government, a leading health services provider in Australia, a national dining chain in the United States, a domestic operator of retail gasoline convenience stores and many healthcare, education and government institutions worldwide.

One key factor driving the growth of new customers has been the [inaudible] of 802.11n. 11n represented 58% of all our access point shipments in the third quarter up from 48% in Q2. Almost all new customer roll outs are using 11n which further enhances are value proposition. To keep driving both new customer growth and revenues from existing customers we continue to invest in our core product offering. In Q3 we announced our new spectrum analysis module, a software based RF spectrum analyzer. The proliferation of wireless devices is making networks increasingly susceptible to interference in both campus and multi site deployments.

Aruba’s new spectrum analyzer can identify this interference or dirty air and isolate RF problems in real time. Our solution is a software upgrade with no new hardware required. The only competing product is from our largest competitor and it requires a complete refresh of access points, even newly installed 11n access points to provide comparable coverage and performance. We also continue to invest in our virtual branch networking solution which leverages our user centric architecture. VBN continued to show strong progress in Q3. Customers are using our VBN solution in a variety of ways to meet their remote networking needs at lower costs.

For example, the hospital system in Michigan has deployed Aruba’s VBN solution in remote clinics. This enables the clinics to access the hospital’s electronic record system improving quality of care while observing HIPAA compliance. During the quarter we introduced our VBN 2.0 solution which migrates business critical IT services to the cloud making them affordable for small branches and home offices. Two key features of this solution are the application acceleration service and the content security service. The application acceleration service accelerates share point and web applications up to 20 times. The service leverages a cloud base cache mechanism that securely replicates data at the closest point to the remote location thereby improving performance significantly for the multitude of teleworkers and small branches accessing content in the data center.

The content security service delivers comprehensive unified front management solutions to the remote location. The on demand nature of both services which do not require new hardware investments give IT managers complete flexibility on service deployment. While we believe VBN is clearly an incremental market opportunity for our products we are also very pleased about the frequency with which we are initiating pilots incorporating VBN as an integrated package with our overall solution.

We are also expanding our incremental market opportunities through our proposed acquisition of Azalea Networks. Azalea has established itself as a leader in mesh networks for the industrial enterprise and is the number one market share leader in China. Azalea’s portfolio compliments Aruba’s enabling us to deliver comprehensive indoor/outdoor solutions to our enterprise customers. Mesh networks lower the cost of delivering real time voice, video and data in industrial enterprise applications.

Mesh traffic hops wireless from access point to access point without cabling. This lowers deployment costs but generally poses a technical challenge when sending delay sensitive information like video over multiple hubs. Though others have tried to address this challenge by repurposing mesh solutions designed for low speed data applications. Azalea started with a clean slate and developed a purpose filled solution without compromising fidelity, security or performance. We believe Azalea’s technology is best in class and most cost effective to deploy per square mile than any other mesh solutions on the market.

Here are some real live examples of how customers have used their technology. Azalea is currently deployed in what we believe to be the largest industrial broadband network in China at the [Daqing] Oil Field. The deployment currently covers 50 square miles and is being expanded to over 100 square miles. This is a multi service long haul network enabling transmission of remote well information, video surveillance, voice communications and mobile data access.

Azalea’s technologies is also used to enable wireless management of smart grids such as China’s power grids for automated meter reading and load control. Using the utility owned Wi-Fi network for distribution automation eliminates recurring data charges and gives the utility end-to-end control of its most important revenue source. Acquiring Azalea is more than just entering the mesh market, Azalea’s team is world class and with this acquisition we will immediately have a strong R&D and operations team on the ground in Beijing China.

We plan to expand on this talented group to support further R&D efforts in mesh and other products for the local and global markets enabling us to better leverage our R&D dollars. Additionally, Azalea should be viewed as part of a broader Aruba network in China which is one of the most important and fastest growing markets in the world for products like ours. Azalea has excellent relationships and an active sales effort with many of the leading service providers in China. To complement their efforts, last week we also announced the go to market partnership with Alcatel-Lucent Shanghai Bell, one of the top three networking vendors in China. This will further strengthen our position with the Chinese service providers which in turn serve as a primary channel for accessing China’s largest enterprises.

To better coordinate our work in China and the rest of the region, we recently appointed a new Vice President of Asia Pacific and Japan, Gary Jackson. Gary was formerly the Vice President of Asia Pacific at Force10 Networks and prior to that held similar positions at EMC and CISCO. We’re very excited to have Gary on board and look forward to continuing our progress on this front.

In summary, we had a very strong quarter which was notable for its momentum across multiple geographies, across multiple verticals and across multiple initiatives. We are very excited about the traction we are getting at the highest level of some of the world’s leading organizations and encouraged by how this traction is translating to pipeline, pilots and revenue. We believe our technical advantages over all of our competitors have never been stronger and expect to continue to gain market share. I am pleased with our execution in the third quarter as we continue to drive significant operating leverage while also investing further in our future.

A little later on the call I would be happy to answer any questions you may have and we will now turn it over to Steffan to go over the financials in more detail.

Steffan Tomlinson

In Q3 2010 total revenue of $69 million increased 10.1% sequentially and 50.5% year-over-year. Product revenue of $56.6 million increased 8.7% sequentially and 58.1% year-over-year. Professional services and support revenue of $12.2 million increased 17.4% sequentially and 25.9% year-over-year. In Q3 approximately 95% of our revenue came from in direct channels while 5% was direct. As a reminder, our indirect channels represent sales through our strategic OEM partners, VARs and distributors.

Approximately 58% of our sales were generated in the US and 42% of our sales came from international theaters. Revenues increased sequentially across all theaters with particular strength in Asia Pacific and the United States and a solid quarter in EMEA. Total non-GAAP gross margins in Q3 were above our target range of 65% to 68% at 69.8%, an increase of 40 basis point s from the prior quarter.

Q3 non-GAAP product gross margin was 66.6%, down 40 basis points from the prior quarter but up 330 basis points year-over-year. Q3 non-GAAP services gross margin was 84.8% compared to 81.6% in the prior year quarter driven by robust service renewals. Moving on to operating expense, non-GAAP research and development expense was up approximately $0.9 million from the prior quarter but decreased as a percentage of revenue from 15.1% in Q1 to 15.0% in Q3. The increase in dollars spent was due to additional headcount and equipment.

Non-GAAP sales and marketing expenses increased $0.5 million from the prior quarter due to headcount and commissions related to incremental revenue. Sales and marketing decreased as a percentage of revenue from 36.4% in Q2 ’10 to 33.8% in Q3 ’10. Non-GAAP G&A expense increased by $1.1 million and was up from Q2 ’10 as a percentage of revenue at 8.6%. This increase was due to an increase in outside services related to M&A and legal expenses.

Headcount at the end of Q3 was 635, an increase of 37 from the prior quarter. In total, operating expenses were down from the prior quarter as a percentage of revenue at 57.4% of sales on a non-GAAP basis. Our non-GAAP tax rate was 1.0% in Q3 compared to 0.7% in Q2. We expect our tax rate in Q4 to be between 5% and 10%. Non-GAAP net income for the quarter was approximately $8.5 million or $0.08 per share. This compares to non-GAAP net income of $6.3 million or $0.06 per share in Q2 ’10 and non-GAAP net income of $1.0 million or $0.01 per share in Q3 ’09.

Due to the appreciation of Aruba’s stock throughout the quarter, Q3 ’10 weighted average shares outstanding were 106.5 million shares on a diluted basis. The GAAP net loss for the quarter was $5.3 million or $0.06 per share compared to a GAAP net loss of $4.4 million or $0.05 per share in Q2 ’10 and a GAAP net loss of $5.8 million or $0.07 per share in Q3 ’09. A reconciliation of GAAP and non-GAAP information can be found in the supplemental financial information document posted to the investor relations section of our website this afternoon.

Turning to the balance sheet, we finished April with cash and short term investments of $144.4 million, an increase of $15.3 million over the prior quarter. Cash flow from operations was $10.9 million. We ended Q3 with $31.7 million of accounts receivable down from the Q2 ’10 balance of $33.7 million. Days sales outstanding were 41 days, down seven days from Q2. We believe the quality of our receivables remains excellent.

Moving down the balance sheet, short term deferred revenue increased 60% year-over-year and declined 4.6 percentage points sequentially. Typically we see increases to deferred revenue in the fourth quarter. Inventory totaled $15.3 million at the end of Q3 up by $2.5 million from the end of Q2. Over the last couple of quarters we’ve been actively preparing for managing the supply of our 802.11n portfolio of products while supporting those customers who are completing roll outs of 802.11 abg related projects. Inventory turns were healthy at 5.4 which declined from 6.3 in Q2 but was an increase from the 4.0 in the same period a year ago.

Now, I’d like to discuss our proposed acquisition of Azalea which we announced last week in a press release. Under the terms of the agreement Aruba will issue consideration of up to $40.5 million composed of approximately $27 million in Aruba stock and up to $13.5 million in cash over two years. The acquisition has been approved by the board of directors of each company and is subject to standard closing conditions. With the acquisition, we’ll add approximately 108 employees. Even with the additional headcount the acquisition is expected to be neutral to accretive to results over the next 12 months. We expect this acquisition to close in the first quarter of Aruba’s 2011 fiscal year.

Let me now turn to our fourth quarter guidance. We had another record quarter in Q3. Our pipeline of business remains robust and the initiatives we implemented are showing traction. However, we do remain cautious given the overall macroeconomic uncertainty. Aruba has been able to grow revenues and profits in a tough economy and we are encouraged that IT spending has shown signs of recovery. Taking these factors in to account, we expect revenues in our fourth fiscal quarter of 2010 to increased 33% to 37% year-over-year in the range of $71 to $73 million. We expect non-GAAP EPS of approximately $0.09 per share using 110 million shares on a diluted basis.

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

Dominic P. Orr

Now, Steffan, Keerti and I will be happy to answer any questions you may have. Operator you can now open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Min Park – Goldman Sachs.

Min Park – Goldman Sachs

First off, I was wondering if you could give us a bit more detail on your bookings and pipeline either by region or verticals please?

Dominic P. Orr

For our booking, we never really discuss our bookings but I can tell you from the go to market momentum point of view as we mentioned in the script that we’re seeing increases of momentum in all theaters with particular strength in North America and Asia Pacific. For Europe, we are having broad based strength we feel good about particularly good about the Middle East and northern Europe, particularly the UK. From the verticals the significance is not only the traditional healthcare, education and government verticals that did well for us but we’re seeing pretty broad based general enterprises uptick, that is really getting to be a clear sign.

Min Park – Goldman Sachs

Could you just help us better understand some of the drivers for the sequential margin lift? How much of it came from mix versus volume, especially on the product side?

Steffan Tomlinson

Part of it is mix. When you look on a year-over-year basis we’re selling higher margin products. Sequentially product gross margins were down 40 basis points and part of that is customer mix and a little bit of channel mix.

Min Park – Goldman Sachs

Lastly, what’s the percentage of your revenue mix for 802.11, what percentage of that was revenues from your 802.11 products and how does that compare from last quarter?

Steffan Tomlinson

What we disclosed is the percentage of units that were shipped and 58% of our access point shipments this quarter were 802.11n compared to 48% from the prior quarter and its well ahead of our estimates originally where we thought we’d get to the 50 percentage point by mid 2010.

Operator

Your next question comes from Ryan Hutchinson – Lazard Capital Markets.

Ryan Hutchinson – Lazard Capital Markets

I have a couple of questions, first on the guidance for Steffan and then one for Dominic. On the guidance, you guys have grown 8% to 10% sequentially for the last three quarters but when you give the guidance you’re typically looking for a rate of somewhere between 3% and 5%. You’re now entering your fiscal fourth quarter which is your yearend obviously which typically should be seasonally stronger especially considering the education vertical starts to kick in and the lick. So, I’m just trying to understand the guidance a bit better and is it fair to assume that it sort of follows the historical pattern?

Steffan Tomlinson

For guidance, we put together guidance as we typically do we look at pipeline, we look at deals, we look at momentum, seasonality. The guidance that we put forth effectively is implying that we’re going to be continuing to gain market share over all the other players that are out there and growing faster than the market. It’s important to note that we’re coming off a very robust record fiscal Q3 and also the year ago quarter was also one of the strongest quarters we’ve had to date. So both the sequential and year-over-year comps are strong and the fact that we’re able to grow sequentially call it 3% to 6% is something that we feel very comfortable with.

Dominic P. Orr

While we continue to lead in the education market against the competitors, we also mentioned that we are getting traction in the general enterprises. So, you can assume that the seasonality will change slightly just because of that mix alone.

Ryan Hutchinson – Lazard Capital Markets

Then Dominic I don’t know for you or Keerti or both, just walk through maybe the differences between the MicroCell architecture versus Meru’s single cell architecture, your views there? Is single cell better for n, is it really better for voice? And, do you buy the argument that single cell results in 30% cap ex savings and a 50% op ex savings?

Dominic P. Orr

Let me just set the stage clear on a couple of facts without my personal opinion on architecture. Meru Networks and Aruba Networks were founded in the same year, 2002. In fact, Aruba a little bit later than Meru so technically we are the younger company so that is fact number one. Fact number two is during the last eight plus years when both companies have existed there are many architectures that exist to solve the customers problems on stabilizing the air and supporting clients in a dense environment so in and so on.

Now, philosophically I do not try to align to one architecture versus the other. I think our philosophy in Aruba is we will build what works for our customers, particularly the larger customers and let the customer vote, let the customer vote with their wallet. So let me point out the fact that in roughly the same period of time when Meru Networks and Aruba Networks have existed for the last eight years, the customers have clearly voted in terms of the revenue that goes to each of the companies. Public records state that inception to date I think Meru Networks has derived $165 million of revenue from their customers. In a similar period of time or slightly shorter, Aruba has derived $780 million from our customers. That is roughly a five to one ratio.

The customers have voted in a five to one ratio in favor of the Aruba architecture. From our forecasts and quarter-to-quarter record, we have demonstrated that we will continue to gain market share relative to our competition and that would include Meru. I’d like to kind of in the spirit just to put things in perspective in the spirit of the NBA playoff season, I just want to say this is not a wireless LAN game, it is a basketball game, team Aruba and team Meru have played the game and team Aruba scored 91 and team Meru scored 19.

Now, I have to confess, when I get up in the morning there are more mornings than not I think about how to grow that 91 points and blow that out and then mornings I wake up and try and figure out how did the other team score the 19. I think that is what our investors want us to do as well.

Operator

Your next question comes from Tim Long – Bank of Montreal.

Tim Long – Bank of Montreal

I’ll follow up that basketball analogy here, I’ve got one for you Dominic and one for Steffan. Dominic you’ve mentioned on the call starting to get some pilots with some larger more household type of named customers. Could you dig in to that a little bit more, talk to us about what type of verticals they’re in, what you would expect for timing or scale of some of these and also are there costs associated with that, with developing the business with some of these customers? Then Steffan, if you could just talk a little bit, I’m just curious you saw a nice little spike in both revenues and gross margins on the services line, was there anything specific in there in the quarter and how sustainable do you think that the gross margin is for that business?

Dominic P. Orr

The adaptation of our technology for the larger brand name customers actually is across multiple, multiple industries I think ranging from retail to packaged goods to energy and high technology. I think one of the driving factors is with our released 5.0 Aruba OS we basically flattened the network by combining campus wireless LAN access and remote branch and teleworker access in to a single unified administration and access method on the single controller across a single operating environment and manage under the airwave of a single system.

I think that is probably singularly the biggest movement to win over some of this network, next generation edge architecture for some of these larger customers who has a genuine economic need to put workers in outer office environment or teleworking environment or decentralizing some or the more expensive property in to the more distributed smaller properties in a more cost effective neighborhood.

Tim Long – Bank of Montreal

Dominic anything on timing or how big some of these customers could be?

Dominic P. Orr

I think some of these customers are big but the timing is once we move from the verticals to the general enterprise, particularly those large enterprises, they go through a corporate [inaudible] pilot, standardization certification and then rollout and commensurate with all the other big enterprise projects that you are probably very familiar with. This is at least a multi quarter kind of activity. Of course, it also means that it would consumer some more engineering services from our partners as well as some Aruba resources. That will be a trend.

Tim Long – Bank of Montreal

Steffan on the services?

Steffan Tomlinson

The services business grew very nicely both sequentially and year-over-year. The margins actually improved by over 300 basis points sequentially and part of that was driven by the fact that the infrastructure costs for this core organization are relatively fixed and we had robust support renewals that had come in in the quarter, some of which had a past due element to it. Going forward, we anticipate both products and services lines of revenue to grow. We don’t give exact guidance on the split but we anticipate both of them to grow.

On the gross margin sustainability of the service business at these levels, I would say it’s probably more prudent to be in the low 80% range as opposed to the mid 80% and hopefully that answers your question.

Operator

Your next question comes from Mark Sue – RBC Capital Markets.

Mark Sue – RBC Capital Markets

Steffan the $4 million in revenue upside and I think it only translated in to an incremental $0.01 in EPS, most of which came from a lower tax rate versus your guidance of 5% to 10%, how should we think about the rate of operating margin improvements? Also, as you dive deeper in to Asia will that require additional investments as well? And, when we might see a bigger jump in operating margins overall?

Steffan Tomlinson

Well, we’re very pleased with our operating margin performance not only this quarter but the prior quarter as well. If you just rewind the tape for a moment, back in our fiscal Q1 our non-GAAP operating margin was 7.6%, fiscal Q2 was 10.1% and fiscal Q3 it’s 12.4% so we’re showing very healthy sequential growth on operating margin mainly driven by the revenue growth. Our long term model as we’ve highlighted is 19% to 20% operating margin and we will continue to make investments that we feel are prudent to drive the revenue growth but also wanting to show some sequential operating margin improvement. So I think there is a good base line that we have here at 12.4% and we’ll look at it prudently in terms of getting to our longer term model.

Mark Sue – RBC Capital Markets

I guess that means you’re going to spend more in absolute dollars in the near term?

Steffan Tomlinson

In the near term our op ex on an aggregate basis has been increasing but we’ve actually been able to get leverage every quarter for the past several quarters. We will continue to make investments and we’ve been consistent with that message even at the outset of this fiscal year.

Mark Sue – RBC Capital Markets

Steffan, on your tax rate I think you have about $84 million in federal NOLs, is there a limit that you can use in a given year? And, when do we get to kind of a normalized tax rate?

Steffan Tomlinson

The current federal NOL level is $88 million and what we look at as far as a normalized tax rate we’re going through an IP cost sharing analysis in the next couple of quarters. We’ll have a better read on what the longer term effective tax rate will be if we do implement an IP cost sharing relationship we will have a lower effective tax rate than what the norm is. The limits and the timing of how much we can actually realize of the NOLs will be dependent upon our earnings power. So over the next couple of years we feel like, at least the next 18 to 24 months we won’t be a federal tax payer.

Mark Sue – RBC Capital Markets

So should we assume your typical 5% to 10% or less than that for the 18 months?

Steffan Tomlinson

Well, we only give guidance one quarter out so I would stay stick to the 5% to 10% on a non-GAAP basis and then if we have any updates we’ll talk about that on future calls.

Mark Sue – RBC Capital Markets

Lastly, Steffan the mix was better with 802.11 [inaudible] margins, you would think that would actually improve but it didn’t. Was that just because of the mix of access points within 802.11n?

Steffan Tomlinson

When you look at the product gross margin which was down very slightly on a sequential basis, part of that is not necessarily just product mix, there’s also customer mix and industry mix in that. We’ve been fairly transparent on prior calls regarding there are certain industries that have lower margin mix than other industries and I think you’re seeing some of that in this quarter. But, we feel very good about the 66.6% for product gross margins, we’re very happy with that performance.

Mark Sue – RBC Capital Markets

Can you just lastly remind us which industry has the lowest gross margins?

Steffan Tomlinson

I decline to comment on that one.

Operator

Your next question comes from Sanjiv Wadhwani – Stifel Nicolaus & Company.

Sanjiv Wadhwani – Stifel Nicolaus & Company

Steffan could you just talk about European exposure? I know you gave international revenues but any granularity on European exposure? And, are you seeing any difference in the demand outlook there over the last couple of weeks?

Steffan Tomlinson

For the last quarter that we just reported Europe was strong, in fact almost all parts of Europe were hitting on all cylinders. I’d say central Europe was maybe a weaker part but all the other regions within Europe have been very strong. The last couple of weeks have definitely put in a little uncertainty in to the mix but the pipeline, the forecasts, the direct feedback we’re getting from our sales leadership is very strong and we anticipate having a strong Q4 in Europe. But also, let me turn it over to Dominic.

Dominic P. Orr

We all read the same newspaper and wireline so I guess we will all cautiously watch the European situation at a macro level but barring that like Steffan said, we’re very optimistic about our business.

Sanjiv Wadhwani – Stifel Nicolaus & Company

Any color on how large Europe is Steffan? Any sort of direction?

Steffan Tomlinson

Europe as part of the total, it fluctuations on a quarter-by-quarter basis but it’s usually between 20% and 30% of our business.

Sanjiv Wadhwani – Stifel Nicolaus & Company

Then just as a follow up on that, China is it safe to assume that it’s currently less than 5% of revenues?

Dominic P. Orr

I think it is safe, yes.

Operator

Your next question comes from Erik Suppiger – Signal Hill Group, LLC.

Erik Suppiger – Signal Hill Group, LLC.

First off, just on the G&A I thought that might come down in light of legal expense declining. Is there a reason that was up in the quarter?

Steffan Tomlinson

Part of it was due to legal expense related to the M&A transaction that we’ve been working on Azalea and so that was part of it. Then there is other legal expenses that we incur. I anticipate for next quarter the legal expenses to go down quarter-on-quarter.

Erik Suppiger – Signal Hill Group, LLC.

Any sense for how much? Was it more than $500,000 or can you ballpark what you had for Azalea?

Steffan Tomlinson

We don’t like to disclose that outside of extraordinary circumstances like we’ve done in the past but going forward we’re not going to quantify specifically a line item within the G&A organization.

Erik Suppiger – Signal Hill Group, LLC.

Linearity for the quarter can we assume it was normal in light of account receivables and what not?

Steffan Tomlinson

Correct.

Erik Suppiger – Signal Hill Group, LLC.

The service renewals you said were pretty strong in the quarter but deferred revenue was down sequentially. What was the dynamic there?

Steffan Tomlinson

Service renewal was strong and there were a couple of large companies that came do. The deferred revenue did come down slightly because there is a counter building dynamic that is going on where a number of our customers are co terming support renewals with the calendar year so there’s actually going to be a little bit of seasonality in our short term support deferred revenue. As our fiscal Q2 encompasses the months November, December and January, fiscal Q3 there’s a little bit of a lull in broader support renewals. So there’s a counter building balance there between some very large customers coming in and making a renewal and the broader population.

Erik Suppiger – Signal Hill Group, LLC.

Then lastly, in terms of the application acceleration and the security piece, is that just a normal down load in which case you don’t really have a good sense for the attach rate or is there any way you can engage what kind of attach rate you’re getting for those features?

Hitesh Sheth

These services have been introduced very recently and so as such we don’t have attach rates just yet.

Erik Suppiger – Signal Hill Group, LLC.

Will you be able to determine that going forward?

Hitesh Sheth

Going forward, as Dominic mentioned the nature and the way the services are deployed, they are provisioned from the cloud and they are pretty much on demand and as such it gets downloaded directly to the client from the cloud. It’s very hard to measure attach rate out the door. So we will not be able to disclose the attach rate on this.

Operator

Your next question comes from John Marchetti – Cowen & Company.

John Marchetti – Cowen & Company

Steffan, you mentioned the Azalea deal should be neutral or accretive? Can you talk a little bit about with the 108 folks coming on next fiscal year what sort of expenses you expect as you build out the broader China push? And maybe, any sort of sense of what Azalea is doing now in terms of revenue? I know you mentioned that they had number one share of the outdoor mesh networks in China.

Steffan Tomlinson

The 108 people that we are acquiring as part of the deal, I believe about 98 people are in China, about 10% are outside of China. We acquired Azalea for a number of reasons, one of which is being a world class R&D center within China and the attraction that they’ve had to date, they have over 140 customers. Last calendar year they did a little bit north of $5 million in sales. We’re not going to be breaking them out as a separate unit going forward but I will say that with our stated goal of having this business being neutral to accretive over the next 12 months it indicates that we feel comfortable that the op ex that we are inheriting will be more than offset by some of the contributions they’ll be bringing not only in the organic business but also the broader business when we put their products in to our channel.

John Marchetti – Cowen & Company

I guess above and beyond that then Steffan, how do you look at the expenses associated with sort of this broader push in to China? You obviously signed up with Alcatel-Lucent Shanghai Bell, things of that nature. How should we think about expenses next year in support of that broader push in to the china market?

Dominic P. Orr

Obviously the key focus here is industrial enterprise where traditionally we will have started from the more office related enterprises. The objective is to use this new portfolio, combine it with our existing portfolio to make it a complete portfolio available for the existing Aruba worldwide sales channel. So other than some market development effort we are not building a separate sales force or go to market activity so the leverage is going to come from what they have traditionally been go to market inside China, how does it get this new portfolio combined with our own, get it plucked in to the existing Aruba direct touch sales force and our enterprise system integrated and reseller partners.

Operator

Your next question comes from Greg Mesniaeff – Needham & Company.

Greg Mesniaeff – Needham & Company

That was a similar question I had in mind and if I can just drill a little bit deeper on the Azalea sales equation. How do you envision the channel strategy changing post the acquisition vis-à-vis is it going to be mostly a dedicated sales channel or is it going to be part of the in direct distribution network you have?

Dominic P. Orr

We do not change our direct touch and direct fulfillment system integration partner strategy to go to market. It is just that inside China we’re going to use Alcatel-Lucent Shanghai Bell to go through their service partner end channels to provide managed services to the enterprises. Our target market is still the enterprises. Outside of China we are going to address to go to market via the part of our channels that address industrial enterprises and that we have already quite a number of these partners. So perhaps we’ll pick up some new partners for this industrial applications but we feel pretty adequate at this moment with the use of the majority of existing channel partners and our own sales force to promote this new not only Azalea product but the combined Aruba Azalea product line.

Greg Mesniaeff – Needham & Company

How would you characterize the margin profile of this industrial vertical vis-à-vis your other major verticals?

Dominic P. Orr

I think if you look in to our products there are access points and there is the management platform and the controllers with the mobility applications. Our network management platform and mobility applications primarily do not change. What we are adding now considering that we use to provide four to five bar signals within the space, now we can expand this four or five bar signals to large oil fields, large transportation hubs and so on with the particular design to support multimedia in a very light latency and highly secure manner.

Hitesh Sheth

Just to add one point here, the Azalea products fundamentally do not change the margin mix of our product lines.

Greg Mesniaeff – Needham & Company

Just one quick final follow up, could you give us a quick update on your relationship with Symbol/Motorola post the litigation settlement?

Dominic P. Orr

Obviously they had a competing wireless infrastructure business and they have a mobile handset business which some of our common customers deploy both our infrastructure and their handset and in those situations we will support and make sure that it is interoperable in our customer environment. I think our relationship has not extended beyond that.

Operator

Your next question comes from [Stephen Patel] – Broadpoint AmTech.

[Stephen Patel] – Broadpoint AmTech

Can you talk about how much of your revenue mix and growth in recent quarters have been from smaller deployments that are say under 100 access points versus large deals that are more on the order of 1,000 access points? Then, can you talk about any changes or trends you’re seeing in the competitive dynamic in both the smaller and larger deals?

Dominic P. Orr

We never really disclose that, segment our market that way publically. But, what I can tell you is when we win, we win because of resiliency in the air, quality of service in the air, manageability, scalability and security, end-to-end security and our exceptional presale and post sale services. All those tend to point towards the larger campuses and the larger distributor network for enterprises. So I think you can assume that continues to be the case.

The competitive landscape we have not seen change much. I think that when times are tough everybody tends to be more competitive including the larger vendor. But, on the other hand because we sell on the value of end-to-end system level value as well as total cost of ownership so is evidenced in our ability to be able to preserve gross margin we have not been under competitive pressure from a pricing perspective. We were expecting that HP 3Com merger to change somewhat the scene but so far that has not happened yet. We continue to see HP primarily in the K12 and a little bit of the hospitality market and that’s it.

Hitesh Sheth

One initial point I’d make on the competitive landscape is that while I’m sure you’re asking the question in the context of the wireless LAN business, the one point that is worth reinforcing here is that even as IT spend recovers what we are finding here is that the IT managers are still spending their dollars very, very carefully and as a result we do end up competing in almost an indirect way but we end up competing with wired infrastructure providers. We continue to win business away from wired infrastructure providers in the marketplace.

[Stephen Patel] – Broadpoint AmTech

If I could follow up about your VBN products, can you talk about the initial feedback you’ve had on the VBN 2.0 offering and how you think that revenue trajectory might compare to what you’d experienced with the first generation of VBN products.

Dominic P. Orr

As we disclosed earlier, we are very pleased with the traction we are seeing with VBN in the marketplace. The early reception from our customers on the new services that we are offering now as part of VBN 2.0 has been very, very good. The whole premise behind VBN which is really simplifying remote net deployment of remote locations and dramatically reducing both cap ex and op ex has resonated from day one. Now, what we’ve done is VBN 2.0 is enabled the delivery of services that traditionally customers have had to pay for with incremental equipment at the remote location site and now what we can do is it allows them to use our platform and deliver the services from the cloud and really do this in a much simpler and more cost effective management than done previously.

Operator

Your next question comes from Joanne Makris – Mazuho Securities.

Joanne Makris – Mazuho Securities

Just following up a little bit on the competitive dynamic question, there has been quite a splash of late from some of the more traditional security players moving in to wireless LAN obviously from the security angle and with the hope of leveraging a pretty large install base from the middle market customers. I’m wondering if you are seeing any of that yet in the marketplace? Obviously the product launches are fairly new. Secondly, could there be some enhancements or changes to your security offerings or potential partnerships there and how you view the demand for security as driving some of the business in the near term?

Dominic P. Orr

Do you have any specific vendors in mind?

Joanne Makris – Mazuho Securities

Sure, like for example [Fordanet] recently moved in to the space with a wireless LAN product.

Dominic P. Orr

I think on the edge of the network if you think about how users connect the broad transition is migrating towards increasing the wireless access so it’s not that surprising to look at vendors that traditionally focused on other aspects of the value proposition migrating to adding wireless. But, our value proposition there as Hitesh talked about earlier is enabling the cloud based branch office. If you look at every other vendor out there in the marketplace they are basically looking at integrating more capabilities within a box so in other words it’s more of a branch office in a box strategy with wireless as another feature added while our fundamental approach is going to be cloud based delivery of services.

From a [inaudible] perspective that is going to be far better than upgrading your boxes all the time. So at the highest level we think we’re going to continue to be differentiated from that perspective. Having said that, we have not really seen or competed against any of these vendors because it’s fairly new in terms of product introductions in the marketplace.

Operator

Your next question comes from Rohit Chopra – Wedbush Morgan Securities, Inc.

Rohit Chopra – Wedbush Morgan Securities, Inc.

With the new R&D facilities in China does that mean there’s an opportunity to shift some of your R&D costs that are in the US over there and maybe increase margins over the next few quarters as well?

Hitesh Sheth

What we’re trying to do here is to be very balanced in the way we incrementally add R&D capacity to our efforts there. This is less about shifting from US to overseas and it’s more about making sure that we stretch our dollars very effectively.

Dominic P. Orr

This is also not a cost equation as well as talent. China is producing a significant portion of the computer science degrees in the world for not participating in that market will be a disadvantage for us in the long term. I want to make sure that this whole three pronged strategy of India, China and Silicon Valley is really every bit as much capturing talent as well as having cost effective infrastructure.

Rohit Chopra – Wedbush Morgan Securities, Inc.

Hitesh maybe you can answer this because you talked a little bit about it before, is there any value to owning a switching portfolio and delivering a bundle to the end user?

Hitesh Sheth

Our goal is to deliver secure mobile access solutions for our customers and as such we are not trying to nor interested in directly participating in the switching business head on the way you describe it.

Rohit Chopra – Wedbush Morgan Securities, Inc.

But partnerships would be something you would consider?

Hitesh Sheth

We would be more than willing to partner with switching vendors in the market.

Rohit Chopra – Wedbush Morgan Securities, Inc.

Then Steffan maybe a couple of questions here, average deal size is that improving and are you seeing an uptick in any of the larger deals like the seven figure deals? Then, if you could just tell us whether Australia has actually wound down and maybe some 10% customers?

Steffan Tomlinson

Average deal sizes haven’t really changed that much. When we look at initial POs that come in from customers versus the balance of follow on orders, we’re still looking at POs that are in the $50,000 to $75,000 range. The lifetime value of customers however has gone up nicely and it continues to grow quarter-over-quarter. When we look at larger deals, the pipeline has never been larger for high six digit, low seven digit deals. The fact that we’ve broaden our product offering with VBN 2.0 we look at the things that we’ve done with network right sizing and other initiatives that we’ve put in place, the fact of the matter is we are getting up higher and higher on the priority list of corporate CIOs and CTOs. Relative to the Australian deal, that deal did contribute in the quarter but we had no 10% end customers in the quarter and we feel very good about the balanced growth that we had across both geographies and vertical mix.

Rohit Chopra – Wedbush Morgan Securities, Inc.

And Australia is it winding down, is it done?

Steffan Tomlinson

It’s winding down.

Operator

Your next question comes from Lynn Um – Barclays Capital.

Lynn Um – Barclays Capital

Most of my questions were asked but I think Steffan in your prepared remarks you made a comment about deferred revenues being up in 4Q, did I catch that correctly?

Steffan Tomlinson

You did. Typically we do have growth in deferred revenues in our fiscal Q4.

Lynn Um – Barclays Capital

In one of the questions afterwards you talked about some seasonality in 3Q in the support side, is that right?

Steffan Tomlinson

Correct.

Operator

Your last question comes from [Asway DeWong – Segalman Investments].

[Asway DeWong – Segalman Investments]

I was just wondering, I think you mentioned that you were a bit surprised that the mix was 58% .11n ahead of your expectations and I was actually thinking about it the other way. I would think why isn’t the mix more 100% or closer with .11n given that the standard is ratified? I mean who is still buying abg access points and why are they doing that? Is there a big price difference now between the two technologies still? How are you thinking about that?

Dominic P. Orr

Basically if you look at the revenue profile, every quarter we have significant repeat business from the install base. Particularly we view our larger corporation in the middle of a rollout of a project you are certified on certain models and while you are certifying the next model your current deployment continues to rollout so a lot of our projects, particularly the larger ones the customers are continuing to rollout and since they probably started the project last year with abg they will continue to rollout abg. As we mentioned in our prepared comments that close to 100%, you’re right, in the new rollout are 11n. It is just existing projects.

[Asway DeWong – Segalman Investments]

How much of a price difference is there now?

Dominic P. Orr

If you really look in to the whole system that you have to upgrade, power leads and that and you have to put in installation costs and you have to buy the controller and so on I would say an 11n project and abg project probably do not differ more than 10% to 15%. That’s the difference.

Operator

At this time I would like to turn the call back to management for any closing remarks.

Dominic P. Orr

Again we thank you for being on the call today. I’d like to take a moment to thank as usual our employees, our customers and our partners. We appreciate your support. We are very pleased with our Q3 results and as you have heard we are optimistic about our outlook for Q4. We remain very excited about our future opportunities ahead of us and we’ll do our best to execute on our market vision. Again, Aruba employees, Aruba partners, Aruba customers we want to thank you for helping us grow in this difficult environment. Thank you for listening and we look forward to updating you on our progress in the coming months. Thank you.

Operator

Ladies and gentlemen if you’d like to listen to a replay of today’s conference please dial 1-800-406-7325 or 303-590-3030 using the access code of 4295956. This does conclude the Aruba Networks third quarter 2010 earnings call. Thank you very much for your participation. You may now disconnect.

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Source: Aruba Networks, Inc. F3Q10 (Qtr End 03/30/10) Earnings Call Transcript
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