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Blue Coat Systems (NASDAQ:BCSI)

F4Q10 (Qtr End 04/30/2010) Earnings Call

May 27, 2010 5:00 pm ET

Executives

Jane Underwood - Senior Director for investor relations

Brian NeSmith - Chief Executive Officer, President, Executive Director and Member of Stock Option Committee

Gordon Brooks - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Analysts

Scott Zeller - Needham & Company, LLC

Alex Henderson - Citigroup

Andrew Nowinski - Piper Jaffray

Kevin Shea - MKM Partners

Anthony Carbone - Auriga USA LLC

Jess Lubert - Wells Fargo Securities, LLC

Erik Suppiger - Signal Hill

Edward Parker

Daniel Ives - FBR Capital Markets & Co.

Tal Liani - BofA Merrill Lynch

Jonathan Ruykhaver - ThinkEquity LLC

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Blue Coat Systems Fourth Quarter Results Conference call. [Operator Instructions] I would now like to turn the conference over to our host, Jane Underwood. Please go ahead.

Jane Underwood

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

Before I turn the call over to Gordy, let me remind you that during the course of this call, we will make forward-looking statements about Blue Coat Systems, Inc. These statements regarding expectations concerning market growth and business opportunities, including levels of IT spending, expectations regarding future revenues, expenses, margins, profits, tax rates and other financial metrics, plans to develop and offer new products and services and enter new markets, success of our business strategy, acquisitions, restructuring and changes in our business model and operations, and other matters impacting Blue Coat's financial outlook and future business.

All statements, other than statements of historical facts, are statements that could be deemed forward-looking statements, including statements of expectations or beliefs and any statements of assumptions underlying any of the foregoing. Risks, uncertainties and assumptions include the risks that are described from time to time in the reports filed by Blue Coat with the Securities and Exchange Commission, including but not limited to, the risks described in Blue Coat's annual report on Form 10-K for the year ended April 30, 2009, and quarterly report on Form 10-Q for the quarter ended January 31, 2010.

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

Gordon Brooks

Thank you, Jane. Good afternoon. Today, we are pleased to announce company record net revenue of $133 million for fiscal Q4, an increase of 4% sequentially and an increase of 17% compared with the same quarter a year ago. Net revenue for the fiscal year ended April 30, 2010, was $496 million, an increase of 12% compared with net revenue of $445 million for fiscal year ended April 30, 2009.

Product revenue for fiscal Q4 was $88 million, an increase of 4% sequentially and an increase of 18% compared with the same quarter a year ago. This includes PacketShaper product revenue of $16 million and Blue Coat WebFilter product revenue of $6 million.

Product revenue for fiscal year 2010 was $322 million, an increase of 5% over fiscal year 2009. Service revenue, which is primarily composed of revenue related to support and maintenance, was $45 million, an increase of 4% sequentially and an increase of 14% compared with the same quarter a year ago. This includes PacketShaper Service revenue of $10 million and Blue Coat WebFilter Service revenue of $3 million. Service revenue for fiscal year 2010 was $174 million, an increase of 25% over fiscal year 2009.

On a geographic basis in Q4, net revenue in the Americas was $58.3 million and represented 44% of total revenue. Net revenue in EMEA was $47.9 million and represented 36% of total revenue, and net revenue in Asia-Pac was $26.3 million and represented 20% of total revenue.

Net revenue in EMEA declined 5% sequentially, and product revenue declined 9%. This trend was not in line with our expected performance in EMEA. We believe that the softness we experienced in EMEA was due to recent uncertainty of E.U. economic environment. We saw sequential product revenue declines in the majority of the countries in Europe.

In Q4, we had four deals in the quarter whose total value is greater than $1 million. All of which were in North America. On a non-GAAP basis, gross margin increased to 78.7% in Q4 compared with 76.3% in the previous quarter due to an improvement on our product margin. This improvement was primarily driven by product mix as our new ProxySG 9000, which replaces the 8100 appliance to the higher gross margin. Non-GAAP operating expenses increased to $76.8 million in Q4 from $71.7 million in the previous quarter, and increased from $73.2 million in the same period a year ago.

Total employee headcount was 1,261 as of April 30 as compared with 1,356 as of January 31. Approximately 90 employees affected by our restructuring program and on the transition plan ended employment during the quarter. In Q1, we have less than five employees remaining on transition.

With regard to non-GAAP functional expenses, sales and marketing increased sequentially to $44.5 million or 34% of net revenue compared with $41.3 million and 32% in the prior quarter. The sequential increase in sales and marketing expense resulted from increased commission expense and related social taxes totaling approximately $2 million. This increase was a consequence of the additional revenue generated in the quarter and the year-end commission accelerators that are part of our annual sales commission plan.

R&D increased sequentially to $22 million or 17% of net revenue in Q4 compared to $20 million and 16% in the prior quarter. As we discussed in our Q3 conference call, approximately $1.5 million of the increase in R&D was driven by planned expenditures associated with the transition to our new India development center. Lastly, G&A was flat sequentially at $10 million or 8% of net revenue.

As a result of the increase in revenue and gross margin, our non-GAAP operating margin increased 90 basis points sequentially to 20.8% in Q4, net of our profit sharing plan. Payments under our profit sharing plan increased in Q4 to $2.9 million compared with $2.7 million in Q3. This amount is embedded in the functional expense lines for cost of service, marketing, R&D and G&A. Most of our sales personnel do not participate in our profit sharing plan as they receive incentive compensation under the company's sales comp plan.

On a non-GAAP basis, the company reported net income of $19 million or $0.40 per diluted share in Q4, compared with $17 million or $0.37 per diluted share in the previous quarter, and $8 million or $0.19 per diluted share in the same quarter in the prior fiscal year. For the fiscal year ended April 30, 2010, the company reported net income of $59 million or $1.29 per share compared with $36 million or $0.84 per diluted share in the prior fiscal year.

One item unique in the quarter, nonrecurring and favorably impacting our GAAP tax rate is related to our deferred tax assets. During Q4, we concluded it was more likely than not that we would have sufficient future taxable income, to use all of our deferred tax assets on our tax returns before they expire. Accordingly, we recognized a net benefit of $10.6 million through the release of our reserves against those tax assets, also known as the valuation allowance. This recognition is recorded as an increase in deferred tax assets on the balance sheet and related benefit in Q4 of GAAP tax rate. The GAAP per share benefit of this release was $0.22. This did not impact our non-GAAP tax rate of 30% in the period, which is a representation of our forecasted long-term rate based on our expected distribution of earnings.

Turning to the balance sheet. Cash, cash equivalents and restricted cash balances as of April 30 were $237 million, an increase of $49 million over the prior quarter. Operating cash flow in Q4 was $26 million, a sequential decrease of $16 million, but a significant increase over operating cash flow of $5 million in the same quarter in the prior fiscal year. Annual operating cash flow was $97 million compared with $58 million in the year prior, an increase of 68%.

CapEx was $2 million in the quarter. Accounts receivable increased 7% sequentially to $64 million, which resulted in a slight decline in DSO to 38 days in Q4 as compared with 39 days in Q3.

Total deferred revenue increased 10% sequentially to $154 million on April 30 from $141 million on January 31, an 18% year-over-year from $131 at April 30, 2009. Deferred revenue at April 30, 2010, was primarily composed of unamortized support and maintenance contracts. Deferred revenue in prior periods includes the sales value of distributor inventory until we fully change over to direct shipment in the second half of fiscal 2010. Excluding such distributor inventory, valued at $6 million from the April 2009 deferred revenue resulted in more fair comparison year-over-year, which was a 23% increase as of April 2010 compared with 2009.

Now turning to our restructuring program. In the quarter, we incurred approximately $3.5 million in GAAP restructuring charges. We are able to vacate our Latvia facility more quickly than we planned. And therefore, the cost that we expected to incur in Q1 FY '11 in connection with the closure of that facility were recognized in Q4. We currently expect a total cost of the restructuring program to be $13 million and the final $500,000 will be recognized in our first quarter of fiscal 2011.

As of April 30, we've completed the transition to our new product development model across four engineering sites. In addition, virtually all the remaining R&D transition expense, approximately $3 million per quarter in both Q3 and Q4 in our operating expenses, was recognized at the end of Q4. From a financial perspective, as of April 30, the restructuring program is, for all intents and purposes,

complete.

In closing, I'm very pleased with the financial results for fiscal year 2010 and, in particular, the dramatic improvements we've seen in the areas of operating profit and cash flow from operations. The first seven months of my tenure as CFO, we've undertook some very ambitious initiatives. We successfully executed on our restructuring program, which appropriately reduced our cost structure while focusing on improving our global operations and efficiency of our infrastructure. I'm also extremely pleased with how well we executed or removing stock rotation rights with our distributors. This initiative has provided us with greater visibility into the timing of our customers' transactions and has reduced cost for both Blue Coat and its partners for providing local shipping.

The other notable area of focus has been our BluePlanet environmental initiative. This program has allowed us to become a smarter, leaner and greener company, while positively impacting the bottom line. Overall, Blue Coat is entering its new fiscal year with very strong operating model, and I'm encouraged by the opportunity that we see for the company.

Turning to our guidance for fiscal Q1. We currently anticipate net revenue in the range of $121 million to $126 million. Within this range, we expect Service revenue to be between $46 million and $48 million. On a GAAP basis, we expect earnings per share to be in the range of $0.21 to $0.26, including the remaining $500,000 of expense related to the final elements of our restructuring program. In addition, we expect approximately $500,000 of expense in other income and expense, or OIE, a fully diluted share count of approximately 48 million shares, and a tax rate of 36%.

On a non-GAAP basis, we expect gross margin to be between 77% and 79% and operating margin to be between 20% and 22% net of profit sharing. We expect earnings per share to be in the range of $0.35 to $0.40 per fully diluted share, and a tax rate of 30%. This guidance is based on foreign currency rates effective as of this announcement, and any material changes to those rates could impact these projections.

We had expected flat to slightly down seasonality in Product revenue from Q4 to Q1 due to the start of our new fiscal year and our annual sales compensation plan cycle. However, we are being cautious given developments in EMEA and their potential impact on our region is, historically, provide 35% to 40% of the company's revenue. We did see an impact on our business in April, and we currently have no evidence that conditions will improve in the near term. These developments when combined with the expected seasonality have affected our revenue guidance.

However, as evidenced by our profit guidance, we intend to continue to execute within the operating model we have established. Within the constraint of that operating model, we're investing for continued future growth, which Brian will discuss in a moment.

Now let me turn this call over to Brian.

Brian NeSmith

Thanks, Gordy. I'm going to use my portion of today's call to touch on a few highlights, both fourth quarter and for fiscal 2010, followed by providing my view of our growth opportunities and some color on our Q1 guidance.

Q4 was another good quarter for Blue Coat. We achieved 17% year-over-year revenue growth, while improving gross profit, operating profit and cash flow. During the quarter, we released the CacheFlow 5000, a carrier-focused, bandwidth-savings appliance, which is targeted initially at service providers and regions of the world were bandwidth is expensive. We also launched our ProxySG virtual appliances, which are similar to our MACH5 appliances, but run on industry-standard servers running VMware. Customers can consolidate the ProxySG virtual Appliance with other relevant applications to reduce cost and better utilize their existing IT infrastructure.

Demand in Asia and the Americas was solid in Q4. However, our performance in EMEA was weaker than we had expected, which we believe is related to the current economic uncertainty in Europe. The weakness in Europe was offsetting Q4 by a number of larger deals in North America. In Q4, we saw a continued increase in the number of partners cross-selling ProxySG and PacketShaper appliances. Cross-selling grew by 15% sequentially with every region experiencing a quarter-over-quarter increase.

Overall, fiscal 2010 was a strong year for Blue Coat. Despite a difficult start from macroeconomic headwinds, we achieved 12% revenue growth. We invested conservatively and adjusted our business to improve our gross margin, operating profit and cash flow. In particular, I am very pleased with this 61% increase in non-GAAP operating profit that we delivered for the year.

As Gordy highlighted in his comments, we are being cautious in this environment and are generally being conservative with new investments so that we can maintain a healthy set of operating metrics. We are investing for future growth, and I'm excited about the opportunities we see in fiscal 2011.

Our strategic product focus is riding the tailwind of several industry trends, including severe malware threats, growth of Web 2.0 content, the proliferation of video and ever-increasing regulatory and statutory compliance requirements. We continue to offer unique value for both the Internet connection and on the Internet infrastructure of large organizations. Whether these organizations are trying to make their network faster or trying to make their network safer, or trying to ensure that their network compliance with applicable laws to Blue Coat Application Delivery Network is positioned well to assist.

Our current growth opportunities are focused in four areas: One, providing a complete, secured Web Gateway solution for large enterprises; two, the CacheFlow 5000 for carriers; three, a new cloud-based security service targeted at the mid-market, but equally useful for branch and individual users and large enterprises; and finally, the fourth, expanding our focus into the broader WAN Optimization market.

We are the market leader in Secure Web Gateways for large enterprises. Our solutions offer better visibility of Web 2.0 content with more flexible and granular policy to control and govern these new applications. We also provide a comprehensive, layered defense and includes web application-level security that can help protect against malware attacks. With realtime updates from our WebPulse, collaborative cloud-based defense, we can block rapidly evolving web-based threats for our more than 62 million WebPulse users worldwide.

This quarter, we plan to introduce a new ProxyDLP Appliance for data loss prevention, which will provide us with another opportunity to up-sell into our large customer base. We see a great opportunity to upgrade our customers that have only a ProxySG with our ProxyAV, ProxyDLP and PacketShaper products, as well as assisting our customers in building more robust, high-availability Secure Web Gateway solutions. We are less than 15% penetrated with ProxyAV and also have low penetration with the other up-sell opportunities.

I'm excited about the CacheFlow 5000 and the opportunity we have with carriers. This unique bandwidth-savings appliance has a rapid ROI and helps service providers cope with the explosive traffic growth driven by video, rich web content and increasing number of high-bandwidth users on the public Internet. We resurrected the CacheFlow name in order to leverage the great brand recognition we earlier achieved in the carrier market. I'm very pleased to say that CacheFlow is back.

We've received an enthusiastic response for the CacheFlow 5000. In Q4, we had wins at Telecom New Zealand and at STC in Saudi Arabia and Kuwait. While we view the CacheFlow 5000 as more of a midterm opportunity, we are off to a great start. I'm looking forward to updating you as this product gains traction in the market.

We see a great opportunity to extend our technology capability beyond appliances and into cloud services. Cloud services market presents a large, generally untapped opportunity in particular for the mid-market. We remain on schedule to release our new cloud-based Secure Web Gateway offering in the second half of calendar 2010. This new solution will provide expanded security functionality and leverage the software-as-a-service or a SaaS business model. This business model is based on selling subscription services as opposed to products. Ultimately, we think that there will be multiple cloud services targeted at large enterprises, the mid-market and small and medium business.

We are building this service on our current assets using our ProxySG and PacketShaper as a technology base. We also heavily leverage our Reporter product. As a result, we believe that our cloud service will be richer in features and more compressive in capability than any security cloud service in the market today. We also intend to take advantage of our extensive caching and WAN Optimization functionality to reduce our bandwidth cost for this service, which should give us a cost advantage over our competitors. Blue Coat is also uniquely positioned to deliver hybrid solutions combining our appliances and cloud services and giving customers alternative ways of using our products.

In the WAN Optimization market, we have been successful on building a very strong business in the areas of video, web content and application acceleration. Our sales and marketing efforts are focused on these areas to date as these where we provide unique product differentiation. We have made great progress on making our product more competitive in the Storage and Email Acceleration segments of the market. Customer reactions to these enhancements have been quite positive and is a good indicator that we can be successful in further penetrating these market segments. We believe this represents a strong opportunity for us to grow our business.

In Q1, we will begin investing in targeted demand generation, as well as evaluation programs to accelerate our competitive position in the overall WAN Optimization market. I've also charged our sales organization to apply greater focus on our competitors' wheelhouse and to actively pursue Storage and Email Acceleration deals.

I'm also extremely pleased with the positive reception from both partners and server vendors to our new ProxySG virtual Appliance. Notably, the ProxySG virtual appliances have gone through extensive testing and validation at Dell for deployment on its PowerEdge servers. We continue to believe that virtualization will be a game-changing technology that will help both large enterprise and mid-market customers contain costs and boost efficiencies.

Turning to our Q1 guidance. In the first quarter, we are expecting seasonal softness related to our fiscal year end. We also believe the weakness that we experienced in EMEA during Q4 will continue into the first quarter.

In Europe, we are fighting economic conditions, are evolving rapidly, making us cautious about projecting business in this geography. As our EMEA sales typically constitute 35% to 40% of our total revenue, the current uncertainty in Europe could meaningfully impact our revenue, and we have adjusted our guidance accordingly. In Q1, we are expecting stable demand in both North America and Asia-Pacific.

In closing, I'm very encouraged about the growth opportunities in cross-selling, a more complete Secure Web Gateway solution, the potential of the CacheFlow 5000 with carriers, the coming introduction of cloud services that will extend our technology into the mid-market and our growth prospects in the broader WAN Optimization market. Blue Coat is well positioned competitively in each of these markets. From a bottom line perspective, we remain committed to driving further operating profitability and managing the organization efficiently, while appropriately investing for future innovation and growth.

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

Jane Underwood

Thank you, Brian. That concludes today's prepared remarks. Before opening the call to Q&A, I'd like to request that analysts, please only ask one question and, if necessary, only one follow-up question. If you have any additional questions, please return back into the pool in queue. Sandra, we'd now like to open up the call to answer questions.

Question-and-Answer Session

Operator

And the next question is from Anthony Carbone with Auriga.

Anthony Carbone - Auriga USA LLC

I guess, I'll start with the question, I'm sure it's going to be the theme of the line of questioning, and that is the guidance. And certainly, while I think we all understand the macro situation going on with Europe, a lot of the April quarter -- in fact, all of the April quarter companies that have recently reported have cited no material weakness in their EMEA business. So given your guidance, and if I look at the five-year seasonality of both America and Asia-Pacific, you're implying a Product revenue guidance of down 13% sequentially, and on EMEA, down 20% sequentially. So I guess if you could provide us a little bit more detail of what it is about your business? Or is there exchange rate risks? Are you more exposed to the PIGS, for a lack of better word? Is there something about your business that's different than say Network Appliance or HP, which just recently reported and suggested that they weren't seeing any weakness?

Gordon Brooks

This is Gordy. Let me talk a little bit about the trends that we saw in April that caused us concern as far as just what we had seen in pipeline, the way deals had gotten -- looks like a year ago, when deals were stuck in third parties, the type of closure rates that we were expecting, as well as the weakness that we saw across, as we said, almost every country in Europe. So those trends, I think, are what driving our overall concern as far as just from a specific standpoint of our business and the trends that we see and the transactions that we encountered in Europe. I think from a macro standpoint for the overall Product revenue, we have not seen a sequential decline in Product revenue. Last year, there was a small sequential rise in Product revenue from quarter-to-quarter going from Q4 to Q1. This year, we did expect a sequential decline, so there would have been -- or at least in my expectation, there would have been that anyway across the geographies. So I think that, again, this concern of ours in the circumstances in April added onto making that even more significant than we would normally have expected. I'll let Brian talk about, at least, if there are any circumstances regarding our businesses that might be different ultimately.

Brian NeSmith

Yes, I mean it's very difficult to contrast us to NetApp or to HP just in the great variety of businesses at there end and a very different area. One thing that we know as a matter, of course, is that in general, the average size of the customer in Europe is a bit smaller than it is in North America. I don't know whether that was a driver in it. We do know that when we look at the pipeline, we look at the expected forecast as we do the rollout from our field sales function. If they were seeing softness throughout Europe and given what we saw at the end of the quarter, especially in the last month is business that we expected to close. And even in Europe for our Q4, that didn't. And so we just as a result, adjusted our closure rates. And looking at the numbers, and then that equates to, obviously, seeing the numbers move down. I'm a little hard pressed to give you anything specific because I'm not sure I'm qualified to tell you how, what drives HP and NetApp's businesses as a contrast to ours. I just know that's what we see.

Anthony Carbone - Auriga USA LLC

Just as a follow-up, is there any of the weakness or at least in the top line related to foreign exchange? Or my understanding is you sell all your product in U.S. dollars?

Gordon Brooks

Yes, we do. We're a U.S. dollar functional currency, so we do not have foreign exchange risks from any currency-translation standpoint. There may be an element underlying things where because things are done in U.S. D [dollar], that as the U.S. dollar strengthened, our product become more expensive in Europe and potentially have discount pressure. so that could certainly be an underlying element, but it's not a foreign-currency translation element that you would see in companies that have local currency in euros or British pound sterling.

Operator

And the next question is from Tal Liani with Bank of America.

Tal Liani - BofA Merrill Lynch

I want to ask a different angle. Last year, you grew 2.1% sequentially in July, which was a very difficult quarter. The year before, you had a little bit of Packeteer, but you grew 16%. If I remove Packeteer, you still grew very nicely. The year before, you grew 14.6%. The question is whether -- your explanations on Europe were very clear. Now when we look at the rest of the world, in your comments, you mentioned that you expect U.S. or the rest of the world to be stable. When you say stable, do you mean continued growth on a sequential basis? Or do you mean -- is there also an issue of slowing momentum in U.S. and the rest of the world or is it purely just Europe?

Gordon Brooks

I would say, Tal, that -- a couple things. Again, we've talked over -- at least, I've talked over the last three months or so about annual comp plans. It may sound like a very tactical element. But we have annual comp plans over last couple of years, and they do drive a certain amount of behavior, which is strength coming into Q4 and usually a step-down function going into Q1. So when we say stable going into the Americas and Asia-Pac in Q1, it actually means that we would expect seasonality in both of those areas, again, due to these trends. We did not see that last year from Q4 to Q1. We did have annual comp plans, but we had a significant change in the environment between those two periods that we believe had an impact to allow that to be seasonally up. We also had a significant amount of support revenue, seasonally up there as well. But I think that, again, we would have expected to be slightly down in those other two geographies, and that's what we're planning for. And again, I think that is a much more around the dynamics of that comp plan cycle.

Kevin Shea - MKM Partners

You mentioned in your comment you discussed a few -- you have lots of new initiatives for the next few quarters. One of them is the cloud services. Cloud requires to build up some infrastructure. Can you discuss what is required to be built? And is there a risk to margins because of that?

Brian NeSmith

There are a couple of things. One is, there is some infrastructure to be built in order to have prototypes up and running, any of the expenses within FY '11 related to what we think had to flow through the P&L. We have set up the operating model to be able to ignore that. Any build-out for the base level of service will be amortized over the time that customers is receiving service, and that's where we're receiving revenues against it. So we are also planning on that type of build-out in amortization of capital to match within the P&L. So in essence, we have planned the model, such that we could absorb the overall -- any type of build-out that we would need to do and within the growth of the operating margin percentage. So we thought through that for FY '11.

Operator

And the next question is from Andrew Nowinski with Piper Jaffray.

Andrew Nowinski - Piper Jaffray

So your product margins would suggest you're not seeing any kind of pricing pressure from the competition. Specifically, with regard to Europe, are you seeing that's just all the -- all competitive deals are simply put on hold or being pushed out? Or are you also expecting an increase in pricing pressure from your competition going forward in that region?

Brian NeSmith

I'd say, it's what I'd call the big D because everything is to lag. We saw delays in the cycle time from purchasing, delays in items. I don't think the loss rate changed. I don't expect going into Q1 or this fiscal year for the pricing or margin picture to change in a material way, especially as we look into Q1. We're forecasting margins to be consistent with what we saw in the previous quarter as well. We're not seeing a significant difference between margins in Europe as opposed to other parts of the world. So it's not a pricing or competitive dynamic that's driving the equation.

Andrew Nowinski - Piper Jaffray

Just a follow-up on -- with regard to your CacheFlow 5000, the virtual client, could you just talk about what kind of assumptions you're making with regard to contribution to the top line in the July quarter for most of your products?

Brian NeSmith

The virtual appliance will be nominal. I think it's hard to ever say -- it's not material. But even that, it seems below, not material. It's mainly customers evaluating and exploring it in trials. The CacheFlow appliance, we've already had some great wins. We're in a number of big competitive wins. I don't expect it to be material in Q1, but I do expect it to have an impact. So it's not a small amount of revenue, and it's starting to grow. Like a lot of new products when they're first introduced, they don't grow in a nice straight-line manner. So I expect it to kind of burst and move around a bit for the first few quarters. But I would hope, as we got toward the end of this year, that we definitely start to see that having a material impact on our overall revenue.

Operator

And the next question is from Jonathan Ruykhaver with ThinkEquity.

Jonathan Ruykhaver - ThinkEquity LLC

Brian, you've talked over the last couple of quarters about the change to realign sales, to better focus on large strategic customers and also the differentiation around ADN and the opportunity to cross-sell. Do you think that -- and maybe the execution on the sales side related to ADN isn't as strong you would hope. Maybe the messaging, if you look at the messaging around application visibility control on optimization, is that something that maybe isn't hitting the mark with customers today?

Brian NeSmith

There's kind of two questions there. There's the messaging part and then a sales execution part. So I think that let me address both of those in separate parts. I don't think it's a sales execution issue. If that would be true, I would have said that -- we would've found pockets of exception in Europe. It definitely kind of just on a broad-based way across that region. And so, I don't really view it as a sales execution issue. We're still doing very well, winning business and upping to drive profitability. The messaging thing is an interesting question. I don't equate that to what's factoring here, because if they did, it would be something affecting us on a worldwide basis. That being said, do I think that we could approve upon what we're doing and probably make our messaging a bit more related to the value that we provide customers? And I think that's probably true. We've gotten a lot of value out of the idea of the Application Delivery Network and very clearly, as an architecture for solutions for customers. It's working for us. I think that we could provide better clarity from a value proposition standpoint. I think you'll see that gradual migration as we move to do that. But I don't think either one of these things are factors really related to what the short-term situation is.

Jonathan Ruykhaver - ThinkEquity LLC

And when you talk about the big D, just deals getting delayed, how does that happen? Does the customer tell you that they're just postponing for a quarter or for several quarters? Or is it something where you see the slowdown and so you just to put lower close rate assumptions around those deals?

Gordon Brooks

I think there -- Jonathan, this is Gordy, since we used distributors and value-added resellers to fulfill our products, there's a couple of different indicators that we see. One is when those deals actually don't make their way through the distributor, so that we can see that the end user has actually completed them. And same thing with value-added reseller, when a project is actually not moving forward but it is still in the evaluation stage where it's thought to be closed before. So I think that, that level of delay within our channel is a key indicator for us, and one that we've seen before of that type of delay.

Jonathan Ruykhaver - ThinkEquity LLC

Yes, I'm just trying to reconcile, because if you look at last year, 2009, you guys actually performed relatively well as a business. You didn't seem to have the negative impact that some other companies kind of in the networking space experienced. And so, I thought that the value proposition was helping you in some way. And now, here we are with these concerns around macro issues in Europe building. So obviously, you saw some weakness in Europe in the April quarter. I'm just trying to figure out, what level of conservatism is in the guidance, how bad it actually is and how much worse it could get? Or is it just you being ultra-conservatism in terms of some of the assumptions you put around guidance?

Brian NeSmith

It's hard to say how conservative is conservative. I think as we said always, when we do these forecasts, we look and try to be as accurate as possible. And the range we gave you is what we think the two extremes would be in how things like come out. I think if we didn't have a lot of confidence in the range, you'd probably see the range broaden. I mean, you can look and understand that. The range that we've kept has generally been consistent for the last four, five quarters. So I think we've seen the confidence level of going into this quarter, it's probably same versus what we've given you in the previous quarters, if we haven't widen the range, which would probably be a better indicator of how we felt about things.

Jonathan Ruykhaver - ThinkEquity LLC

Just one final quick question, can you disclose the percent of total transactions that reflect cross-selling of ProxySG, PacketShaper web security? Do you have that type of detail?

Brian NeSmith

I don't know the absolute number. We can get it for you, but I don't know it off top of my head

Operator

The next question is from Daniel Ives with FBR Capital Markets.

Daniel Ives - FBR Capital Markets & Co.

Given the softness that you saw especially in Europe, walk me through the rationale with the profit sharing plan? You're renewing that. And especially, the kind of, the 15% to 25%, I mean, given where you were a year ago, it's a lot different right? So I would expect that maybe that range would've moved up. So maybe just walk through the profit sharing plan because obviously that's going to pressure margins, and just the rationale there is my first question.

Brian NeSmith

Yes, I think from a profit sharing plan standpoint, I liken that to being a comparative with what other companies do in the valley with their MBO plan. I think if you look at, at least our last fiscal year, in a calendar year that other companies had, the payout on MBO plans and our profit sharing plans were within the 25% to 50% capacity. I think as we look at the plan this year, we look at what's the probability of payouts with our competitors, who we compete with per employees and try to set the plan within that overall range of the probability of achieving that plan. So I think that the world's changed over the years, between this year and last year as far as the expectation of those types of either plans or MBO programs to pay out. And that is I think a key indicator as to why we have left it within the range that we have, and within the expectation that we'd play out a significant portion of the capacity of that plan.

Daniel Ives - FBR Capital Markets & Co.

And just walk through the quarter. Okay, so if I just think about the month like, is March normal month until it's back-end loaded, but where did it start? I think just walk us through from your perspective. Where did things start to weaken?

Brian NeSmith

Yes, I think a couple of things to contrast. We have talked in Q3 about seasonality within the quarter, that we generally see a 20, 30, 50 type of dynamic month-to-month. And we talked about how we had seen an acceleration into calendar year end or our December month in Q3. I would say that in Q4, the first two months of the quarter were on the normal track that we had seen. And why specifically call that April itself in the script is April and particularly, the end of April is where we saw the significant softness. Again, we have a significant amount of business that happens over the last two to three weeks of the quarter, especially we have that expectation and at Q4 again, with the annual type of dynamics of trying to close big deals and how those completed, and really was over that period of time that we thought significant change.

Operator

And next, we go to the line of Erik Suppiger with Signal Hill.

Erik Suppiger - Signal Hill

Sales force, have you seen any more sales force turnover in terms of -- in light of issues in Europe or also in light of changing sales structures? Does that cause any turnover in the company?

Brian NeSmith

We continue the turnover, but I think it generally fits within the norm of what we've seen historically. I don't have anything that's an aberration from the standpoint of what we had seen in previous fiscal items.

Gordon Brooks

And we've talked about metric of quota-carrying reps and we've been within the range of 145 or so to 150 of quota-carrying reps throughout the year.

Erik Suppiger - Signal Hill

And then you've added a service provider sales organization. What size is that?

Brian NeSmith

I think it's, let me say, it's roughly around eight teams or so. I might be off by about one. Most of that came from people that were in overlay roles that went into direct quota-carrying roles. So it's not a huge change from a standpoint of hiring. Our aim is like that, just providing better focus. As we introduced the CacheFlow 5000, as we've seen opportunities to sell, managed proxy and managed WAN Optimization services, we are getting big enough, with enough with critical mass that we felt like that we could definitely start to get better focus by having an organization focused on carriers. But it came from an overlay group.

Operator

And the next question is from Jess Lubert with Wells Fargo Securities.

Jess Lubert - Wells Fargo Securities, LLC

Can you discuss where within Europe you saw the most softening? Were there any areas of relative strength? And perhaps, can you discuss how conversations have been proceeding during the first couple of weeks of May? Or things continuing to soften? Or have they stabilized to lower level than you would've previously anticipated?

Gordon Brooks

Jess, this is Gordy. Over the last couple of quarters, when I first started, we had talked about Europe in late calendar year and early calendar year, about certain countries in Europe certain -- I remember Brian had talked in various conferences about why we really have to get down to the country level to understand what's going on. I think one of the changes we saw here was that, and as we've said, every country had a similar dynamic with the exception, I believe, of one or two, where we have seen stability in France and Germany in our fiscal Q2 and Q3. We did not see -- we saw declines in, France, Germany, the rest of Southern Europe, the Middle East, as well as a flattening in the U.K. I think we had called out in Q3. We had quite a robust business in the U.K., which seemed to be odd, given their dynamics. But we have seen a flattening and a decline into Q4 as well there. So really, throughout each of the regions, which was a change from what we have seen over the contour of the last year.

Jess Lubert - Wells Fargo Securities, LLC

And then, within Europe, can you discuss maybe a little bit of what you're seeing with respect to some of your different product categories, particularly WAN Optimization and Secure Web Gateways? Is one doing better than the other or were both products equally soft?

Brian NeSmith

Yes, I'll have to break it down. I don't have a product by region breakdown, but I can certainly follow up with that type of data.

Jess Lubert - Wells Fargo Securities, LLC

And then, can you discuss how the close rates embedded in the current guidance as compared to what you experienced this past quarter?

Brian NeSmith

Yes, we had in the guidance, we had used and we've seen close rates in Q4, really see a decrement from what we have seen in Q3, and more towards what we had seen in the beginning of the fiscal year. So we went ahead and applied those lower close rates going into Q1 from the overall calculus of how we did our guidance.

Jess Lubert - Wells Fargo Securities, LLC

Is it fair to assume that the close rates in the guidance are below those you actually experienced this past quarter? Or are they comparable?

Gordon Brooks

They would be comparable in most areas. And then, we judgmentally took a look at what we had seen in Europe to see if we needed to go ahead and adjust those.

Operator

And the next question is from Alex Kurtz of Merriman & Co.

Unidentified Analyst

This is Amelia [ph] in for Alex today. In regards to your PacketShaper products, what's the pipeline for any new PacketShaper products you're coming out with? And how was that being communicated to the partners?

Brian NeSmith

So fairly imminent on the horizon, I don't -- we've had a series of ongoing releases where we deliver further granularity on the classifications of type of applications that we can support in what we're doing. We do have a release coming up this quarter, where we have moved our URL classification technology that runs on ProxySG on the PacketShaper. So it's going to expand in a significant way, the types and level of granularity that PacketShaper can actually classify applications that are Internet-related content. One thing we're excited about that is we think that it's going to open up a new tool for us to do security assessments. We already use PacketShaper to do network assessments in the WAN Optimization world. And now, we'll be able to use the PacketShaper product to do security assessments, which can point out the efficiencies with our competitor products, our customers that don't have things configured in a way that allows them to get the necessary levels of security and comfort, that they're getting what they expect with other security infrastructure. But we continue in investing, and there'll be -- I'm sure, as we go through the course of the fiscal year, the incremental releases that we deliver other functionality as well, but that's the one that's on the near-term horizon.

Unidentified Analyst

And just as a follow-up, could you reiterate your long-term growth rate for PacketShaper?

Gordon Brooks

I think we've been generally clear that the growth rate is approximately zero. It's a flat business, up or down a little bit.

Operator

And our next question is from Alex Henderson.

Alex Henderson - Citigroup

So just wanted to go through the trajectory on the seasonal swing month-to-month over the course of the quarter, the linearity of it. So you're saying that your normal linearity is 20, 30, 50. It sounds like you were 20-30 in the first two months and then did something substantially below the 50 in the final month. Is that an accurate restatement of what you had said earlier?

Brian NeSmith

I think that's fair. I think we were tracking to what we saw as other March 31 companies in their reporting. Some of which had robust, maybe over performance against their guidance. And yes, it was really kind of the track that would believe we're on through the first two three months of the quarter.

Alex Henderson - Citigroup

So you hadn't seen any erosion in closure rates in Europe through the end of March, and then all occurred in April?

Brian NeSmith

Yes, I don't know that -- we don't necessarily track the closure rates granularly by month. We really look at the actual expected business and how much is it closed in each of those. There may have been some underlying data that we could have parsed out earlier in the period, but that didn't represent itself through what we saw in the deals that we've closed.

Alex Henderson - Citigroup

No, there's no local competitors. So the change in prices shouldn't alter the competitive balance at all, correct?

Gordon Brooks

I'm sorry, could you repeat the question?

Alex Henderson - Citigroup

So there's no local competitor here out of Europe. Therefore, there's no changes result of the exchange rates in the competitive balance between you and any of your competitors?

Brian NeSmith

I believe so, no.

Alex Henderson - Citigroup

Separate question, the guidance you gave for the upcoming quarter, there was two quasi-one-time items in the April quarter as I recall. Approximately $3 million for one and $1 million or $2 million for the other are the R&D piece and staffing issues. Those are falling out in the July quarter entirely, correct?

Brian NeSmith

That is correct.

Alex Henderson - Citigroup

And so, that was a total of what in the April quarter? I got the impression it was $3 million and plus $1 million or so? So that's $4 million?

Gordon Brooks

That's correct. So $3 million that had been in the cost structure in Q3 and Q4 that will drop out in Q1, as well as $1.5 million of discrete incremental spending in R&D in Q4.

Alex Henderson - Citigroup

And that falls out as well. So you've got a fallout of operated costs of $4.5 million, which if I did my math correctly, is about 300 basis points of margin. If everything else had been equal, i.e., the same top line, you would've shown a 300 basis point margin expansion. What's offsetting that? I mean, how much of the revenue decline offsets that? Is there any other things against that, that I should be building into our thinking?

Brian NeSmith

Yes, I think that one of the reasons we call out the headcount is when we did the restructuring in November, we noted that by the end of the restructuring plan at the end of Q1, we would be down approximately 10% of headcount from where we were. So in November, we had 1,500 employees, so that would imply that at the end of Q1, we'll be at about 1,350 employees. So currently, we're at 1,261 employees, so that implies that we actually have some add-backs, some investments to do from an overall employee standpoint. So those at R&D, transitional expense will pull out. Part of that, not all of it, a part of that will be replaced by additional hiring to get back to that original plan of 1,350 employees.

Alex Henderson - Citigroup

How much of the decline is result of Europe, i.e., the decline in -- the pressure to margins and therefore EPS? How much of an offset is the European hit?

Gordon Brooks

I haven't calculated based from a geographic standpoint because you would have commissions related to that and other elements. So I don't have any answer to that for you.

Operator

The next question is from Edward Parker with Lazard Capital Market.

Edward Parker

Can you talk a little more about your product gross margins? Do you think that they're suitable at these levels given the fact that you got some of your products ramping?

Brian NeSmith

The gross margins?

Edward Parker

Product gross margins, yes.

Brian NeSmith

No, I think that one of the things that -- was Gordy coming on Board and I think just brought a level of discipline about how we do things to pay attention to not just gross margins but operating margins. And I think that obviously, in the end, gross margins is a matter of pricing strength that you have competitively. And I think I expect and I don't see any fundamental change that's going to occur, that's going to cause a deterioration in margin in what we're doing. As we highlighted in our prepared comments, we introduced the new 9000 appliance and it's got better gross margins than our previous high-end platform. And that's probably the root driver from it. It's not the only driver. I think just operating efficiency in general is -- we're continue to improve on that. So I think we feel comfortable with the guidance we gave for Q1 on that number.

Gordon Brooks

Ed, if I look back at the gross margins for the company before the acquisition of Packeteer, they generally hovered in the very high 70% range for gross margins. So we believe that we can sustain these as far as the Appliance businesses is concerned. We will look at the virtualized software appliance aspect that'll actually help the gross margins overall. So we feel relatively comfortable this year regarding those gross margins.

Operator

And the next question is from Kevin Shea of MKM Partners.

Kevin Shea - MKM Partners

Just wondering regarding Europe, can you talk maybe to some of the more proactive strategies that you guys are trying to in-place in the April quarter to turn your business prospects around? Or do you sort of view this as more of a waiting game where just the macro pressures are sort of taking it out of your hands on whether or not customers are buying? And is there anything proactive that you think you can do that can sort of turn around some of the negative business prospects?

Brian NeSmith

I think separate from the timing of the situation, we're always investing in the business to try to drive incremental growth. And we try to highlight the purposes there in what we're doing, even independent of the economic cycle, what we would be doing in order to drive benefit. The new CacheFlow product, as we start to get better penetration with the carriers, I think will start to have a positive impact as we outlined the clouds services. We're investing a fair amount in that area, the cloud, and seeing no revenue right now. So it's one that, when we start to see a return on that, it becomes beneficial. We think there's a lot of opportunity to cross-sell and upsell into our installed base ProxyAV, Proxy DLP, even PacketShaper and probably even ourselves doing a better job of executing and selling into that installed base or putting a lot of energy there. I can't control the macro economy, so we focus on the things we can control. And we do think there are things that they can do to drive growth in the year. And I'm not going to put that entirely at the feet of the macro economy. We obviously need to focus and execute.

Operator

And the next question is from Scott Zeller with Needham & Company.

Scott Zeller - Needham & Company, LLC

A two-part question, I wondered if you could explain at a high level the difference between the caching offering for the carrier community now versus the historical caching product that the company has had? Is it really more of a change in sales strategy for targeting these carriers? Or is it truly a significantly different product than what we've seen historically from the company? And the second part of the question is, have there been any changes to the senior team of the company recently?

Brian NeSmith

Well, the short answer is that there is a fairly significant difference in the algorithms that we use on the CacheFlow 5000 versus the ProxySG. At a high level, it's about identifying content that you can store on a desk and serve locally, as opposed to going across the Internet and pulling that from the origin servers. So I mean, the basic construct is the same because the algorithms that you use and how you store that content on the desk. What's changed in this environment, especially for the carriers, is just the explosion of video content, the explosion of Web 2.0 content, and with the CacheFlow 5000, we've optimized that platform for caching that type of content. And really, in the end, driving as much bandwidth savings as you possibly can for those carriers. And it's a fairly straightforward ROI value proposition that we're pitching to the carriers. On the ProxySG, the caching algorithm is not optimized for bandwidth savings, it's optimized for response time improvement. As a side effect, you get a bandwidth savings, but it's really optimized for serving more content faster. And so, it won't necessarily be as efficient and the amount of bandwidth that it consumes. So the underlying parameters as well as assumptions that went into build them are really driven at different directions. Over time, I think you'll see the CacheFlow 5000 diverge even more from the ProxySG as its customized for that environment. You could see things on the CacheFlow 5000 where you put a lot of energy into -- a more scalability just given the size and the length. The carrier is going to worry maybe about content insertions, so they could do advertising on error pages and in failure conditions. So I mean, there's lots of ways that we can see that carriers could end up using the product differently. And the code bases are diverging. Although they started the same, a year ago when we started to develop, they're starting to diverge. And I think they'll continue to diverge as we optimize the platform for the different customer segment. As far as management changes, I think we had already talked to the former VP of Marketing, Bethany, and moved on to be -- and joined HP in their enterprise software group. We don't really have any other senior officer that made changes. I mean, we've got the normal turnover for a company in the Valley than it's pretty much typical for what we've got. In this area, we've been recruiting for a replacement on that front. We did have one business unit manager that resigned that we've made changes and adjustments. But we have a lot of capacity to manage what we're doing on that front as well. But nothing I think that would fundamentally reflect how the company is operating and how we're executing.

Operator

And there's no one else in queue at this time.

Jane Underwood

Okay, thank you. I'd like to thank you for joining us on today's call. A replay will be made available at (800) 475-6701 beginning on May 27,2010 at 5 p.m. An auto archive will also be available on our website. Have a great day. We look forward to speaking with you again soon. Thank you.

Operator

That concludes our conference for today. Thank you for your participation and for using the AT&T Executive Teleconference. You may now disconnect.

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Source: Blue Coat Systems F4Q10 (Qtr End 04/30/2010) Earnings Call Transcript
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