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

VMware, Inc. (NYSE:VMW)

Q2 2010 Earnings Call

July 20, 2010 5:00 p.m. ET

Executives

Paul Maritz – President and Chief Executive Officer

Todd Nielsen – Chief Operating Officer

Mark Peek – Chief Financial Officer

Michael Haase – Vice President of Investor Relations

Analysts

Kash Rangan – Merrill Lynch

Derek Bingham - Goldman Sachs

Walter Pritchard – Citigroup

Brent Hill – UBS

Adam Holt - Morgan Stanley

John DiFucci - JP Morgan

Brian Marshall - Gleacher and Company

Heather Bellini – ISI Group

Scott Zeller - Needham & Company

Kaushik Roy – Wedbush

Jayson Noland – Robert Baird

Rob Owens - Pacific Crest Securities

Michael Turits - Raymond James

Operator

Welcome to the VMware Q2 2010 earnings call, and thank you for standing by. At this time all participants are in a listen only mode. (Operator Instructions.) Today’s conference is being recorded. If you have any objections you may disconnect at this time. I will turn the meeting over to Mr. Mike Haase, Vice President of Investor Relations. Sir, you may begin.

Mike Haase

Thank you, and welcome to VMware’s Q2 2010 earnings conference call. On the call we have Paul Maritz, our CEO; Todd Nielsen, COO; and Mark Peek, CFO. Following their prepared remarks we will take your questions. A press release was issued after close of market and is posted on our website, where this call is being simultaneously webcast.

Statements made on this call include forward looking statements, such as those with the words “will”, “believes”, “expects”, “continues”, and similar phrases that denote future expectations or intent regarding our financial outlook, product offerings, customer demand, and other matters. These statements are based on the environment as we currently see it and are subject to risks and uncertainties. Please refer to the press release and the risk factors in documents filed with the Securities and Exchange Commission, including our most recent reports on Form 10Q and Form 10K for information on risks and uncertainties that may cause actual results to differ materially from those set forth in such statements.

In addition, during today’s call we will discuss certain non-GAAP financial measures. These non-GAAP financial measures, which are used as measures of VMware’s performance, should be considered in addition to, not as a substitute for or an isolation from GAAP measures. Our GAAP measures exclude the effect on our GAAP results for stock-based compensation, amortization of intangible assets, employer payroll tax and employee stock transactions, the net effect of amortization and capitalization of software, and acquisition related items. You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP measures, in the press release and on the investor relations page of our website.

Our Q2 quiet period begins at the close of business September 16, 2010. Also, unless otherwise stated, all financial comparisons in this call will be in reference to our results of the comparable period of 2009. For your planning purposes, VMworld 2010, the industry’s leading virtualization conference, takes place at San Francisco’s Moscone Center August 30th through September 2nd. As part of this we will be hosting our first Analyst Day on August 31st at the same location. We plan on sending more details around registration, agenda, and logistics next week.

With that, let me hand it over to Mark.

Mark Peek

Thanks, Mike, and good afternoon, everyone. VMware had a great Q2 with record revenue, operating profit, and trailing 12-month free cash flow. Our business was strong across all geographies, transaction types and products. During the quarter we continued to see strong demand in the SMB-focused vSphere packages, which were a factor in achieving a record number of transactions in the quarter. With this increase in transaction volume, driven by small- and medium-sized business, the blended ASP per vSphere unit declined sequentially by $100. However, we displayed strong discipline around discounting as ASPs in our enterprise products increased modestly.

Customers continued to adopt the vSphere platform as a strategic investment that delivers substantial cost savings, improved efficiency, and flexibility for their business. Our message is clear and is resonating with our customers, as they begin the journey to the private cloud: Cloud computing is not a destination, it is an architecture. The foundation of that architecture is vSphere, which enables customers to leverage their existing IT investment and greatly simply their data centers while providing the flexibility to take advantage of the offerings from vCloud providers.

In early April, we acquired certain of the management, products, technology, and people from EMC’s Ionix Group. We’re very pleased with the integration process and recently announced the integration of two of Ionix’s products into our management portfolio. We also closed the acquisition of Gemstone and RabbitMQ. We want to welcome the more then 400 people from these acquisitions to VMware. In addition to acquisitions, we are continuing to invest in our core virtualization products to maintain and extend our multi-generational lead over commodity virtualization offerings.

Last week we released vSphere 4.1. With this release we not only added functionality and performance to our enterprise SKUs, but we introduced vMotion to the SMB packages. So today, at very low price points, customers have the advantage of this mature, robust technology. We also introduced per-virtual-machine pricing for our management products. This will allow customers to scale into management offerings more aligned to their specific usage. We do not expect a material near-term financial impact from these changes.

We ended the quarter with $2.8 billion of cash, cash equivalents and short-term investments, and $1.5 billion of deferred revenue. Strong operating performance and capital efficiency led to trailing 12-month free cash flows of just over $1 billion, growth year-over-year of 33%. We are pleased with the quarter and want to thank all of the people of VMware, our partners, and our customers.

Now I’ll walk you through the details. Total revenue for the Q2 was $674 million, up 48% from a year ago. Total license revenue was $324 million, an increase of 42% from the Q2 of a year ago. Demand was strong across all global regions and customer segments. In Europe, despite the growing macroeconomic concerns, demand remained strong; however, we are cautious about Europe as we look at the second half of 2010. Large markets such as Germany and the UK were down sequentially from Q1; however France, Ireland, and Russia were up sequentially.

In the Asia/Pacific region we saw strong demand across geographies, including China, Japan, India and Australia, with total bookings for the region increasing more than 80% year-over-year. We’re beginning to see more interest in ELAs from our customers in this region, with enterprise license volumes at a new high. This is another indicator that our investment efforts in the global markets are bearing fruit.

The Americas were strong across the board. In Latin America bookings increase 85% year-over-year. In the US we are seeing enthusiastic demand for Essentials and Essentials Plus, primarily in the SMB markets. We are also progressing very well with our ELA renewals, and pleased that customers are typically renewing their ELAs at a dollar value more than the original deal. The total order value of renewed ELAs for the quarter exceeded the original contract value.

Software maintenance and support revenue was $290 million, an increase of 54% from last year. As expected, our backed maintenance revenue decreased sequentially. The maintenance recovery program has now been in place for over a year, and we expect backed maintenance for the balance of 2010 to be lower than compared to the same period of 2009. As in previous quarters, customers continue to buy on average more than 24 months of support and maintenance with each new license purchase, illustrating their strong commitment to VMware as a core element of their IT infrastructure.

Professional Services revenue was $60 million, an increase of 54% from last year, and up 11% sequentially. The increase was largely due to incremental service revenue from our M&A activity and customer training related to vSphere deployments. We do not envision strong growth in our PSO revenues as we continue to invest in our partners and the ecosystem to broadly offer the best set of solutions to our customers.

US revenues increased 43% from a year ago to $334 million, representing half of total revenue. International revenue grew 53% to $340 million, driven by strong demand across geographies, particularly Australia, France, China and Japan. Enterprise license agreements were approximately 20% of total bookings, and transactions with order values less than $50,000 represented approximately 44% of total bookings.

I’ll now provide some details on our operating expense. Unless otherwise noted, all reference to our expenses and operating results are on a non-GAAP basis, which are reconciled in the press release tables and posted on our IR website.

Total operating expense, including costs of services and costs of licenses, increased 6% sequentially to $487 million, driven largely by increased headcount and our 2010 merit increase that took effect at the beginning of the Q2. During the quarter, we added over 850 people, approximately half of them from the acquisition of Ionix, Gemstone, and RabbitMQ. In addition, we continued to add people in sales and marketing to support increased volume and geographic expansion. Our core engineering and product groups also grew organically as we continued to invest and innovate.

As a percentage of Q2 revenue, costs of revenues were 12.6%, a sequential increase of 40 basis points, largely due to increased M&A and headcount expenses and professional services. Q2 R&D expenses increased sequentially to $136 million, or 20.2% of revenues, as compared with 19.5% in the Q1 of 2010. The increase reflects the addition of people from our acquisitions, as well as organic growth to our core virtualization, Spring, and Zimbra businesses. Sales and marketing expenses were $215 million or 31.9% of revenues, compared with 31.6% in the prior quarter. The increase was largely due to continued geographic investment and larger marketing spend, particularly in the SMB and desktop.

G&A expenses were $51 million, or 7.6% of revenue, compared to 9.1% of revue in the Q1. The sequential decline was largely due to reductions in various corporate expenses and higher Q1 expenses, due to our first quarter global leadership meetings and 2010 kickoff events. Our operating profit, measured on a non-GAAP basis, increased 7% sequentially to $187 million, or 27.7% of revenue. This beat our forecasted range due primarily to operating leverage from our revenue performance. The net impact of currency during Q2 was not significant. Q2 M&A activity was dilutive versus Q1 by approximately 150 basis points.

The non-GAAP diluted EPS was $0.34 a share on 422,000,000 diluted shares. The share repurchase program did not have an impact on EPS during the quarter.

Now on to our balance sheet and cash flow statement. Our balance sheet remains strong with cash, cash equivalents, and short-term investments at quarter end of nearly $2.8 billion, about flat compared to the prior quarter. You will notice that our short-term investments increased significantly, and the cash and cash equivalents declined. As part of our investment strategy we have begun utilizing outside money mangers to help manage our short-term investments, but continue to require investment-grade quality with relatively short durations.

During the June quarter we used approximately $375 million for M&A activity, capital spending, and our share repurchase program. During the Q1, we announced authorization to repurchase up to $400 million of our class A common stock through 2011. The objective of the VMware program is to partially offset the dilution from employee stock issuance. Through the first half of 2010 we purchased $145 million of our class A stock.

During the Q2 we completed our acquisition of several management products from the EMC Ionix portfolio for $175 million. Total deferred revenues were $1.5 billion, up 58% from the same period last year, and an 8% sequential increase. Over 90% of our deferred revenue is recognized with the passage of time and the delivery of professional services revenue. The remainder is solely tied to product release events.

At the end of the quarter we had approximately 8200 people, an increase of 1100 from the beginning of the year. About half of them are from our first half M&A activity. Without reference to a mix of organic or M&A, we expect that we will continue to add headcount at a similar pace in the second half of the year.

Non-GAAP operation cash flows, which exclude adjustments of capitalization of stock for development costs and excess tax benefits from stock compensation, were $261 million for the quarter and $1.1 billion for the trailing 12 months. Free cash flows for the quarter were $232 million and $1 billion for the trailing 12 months. Free cash flow per diluted share was $0.54 for the quarter; free cash flow per diluted share was $2.42.

As we’ve mentioned, free cash flow per share can be volatile in the short term, so we believe looking at it over a trailing 12 months is a better indicator of progress. Corporate cash flows were negatively impacted by a difficult comp, as last year we collected $88 million from EMC in an income tax refund. We’re paying increasing attention to the metric as a measure of financial progress in our business, as it balances operating results, cash management, capital efficiency, and share dilution.

The fully diluted share count increased to 422,000,000 shares in the second quarter, driven by the impact of higher share price on the calculation of dilutive securities. We expect our Q3 2010 diluted weighted average share count will be approximately 430,000,000 shares, and for the full year we expect the diluted share count will be approximately 425,000,000 diluted shares

Before I hand it off to Todd, I want to share with you how we are looking at the business to give you some assistance in developing your estimates for the second half of the year. Although we saw positive momentum for the business during the quarter, there are four items I want to call out as you consider our guidance.

First, the US dollar has strengthened significantly against the Euro, Pound, Sterling and Aussie dollar during the Q2, which negatively impacts our top-line license revenue when converted from those currencies. Second, like the rest of the world, we have renewed concern about the macroeconomic environment, particularly in Europe. Third, we repackaged our flagship vSphere product, and while adding significantly more performance to the Enterprise and Enterprise Plus package, we also migrated vMotion into lower-priced packages. Although we expect the reduced average ASP will be offset by increased volume, we cannot be certain that will occur. Finally, the US federal government is carefully reviewing its IT spend leading into the fiscal year end, and we are not yet certain what if any impact this will have on our federal business.

Despite this backdrop, given the strength we are seeing in our business, Q3 revenues are expected to be within a range of $680 million and $705 million, or year-over-year growth of between 39% and 44%. We expect license revenue to be flat to slightly down from Q2. Revenue from our recent M&A activity represents low single-digit percentage of our guidance. Taking into account our adjustments to GAAP operating incomes that Mike disclosed at the start of the call, we expect the Q3 non-GAAP operating margins to be within a range of 26.5% and 28%. We expect our GAAP operating margin to be approximately 14 to 15 percentage points lower than our non-GAAP operating margin.

We have established a high bar given our performance over the past three quarters relative to expectations. The Q4 of 2010 is a much more difficult year-over-year comparable than the first half, as Q4 2009 included the impact of our promotion to upgrade customers to Enterprise Plus, and as mentioned, we are in a very different currency environment from a year ago. We are currently planning on 2010 revenue of between $2.725 billion and $2.8 billion, or growth of 35% to 38% compared to last year. From a margin perspective, we will continue to invest organically and possibly through acquisitions. Our current expectation for the full year non-GAAP operating margin is a range of 27% to 28%, but this could be disrupted by future M&A activity. We expect our 2010 GAAP operating margin to be approximately 13 or 14 percentage points lower than our non-GAAP operating margin.

To summarize, we’re very pleased with our execution and solid performance in the first half of 2010. We continue to manage our resources prudently while making the key investments necessary to maximize our long-term growth and free cash flow per share. Todd?

Todd Nielsen

Thanks, Mark. Good afternoon. It appears the technological industry continues to be broadly benefiting from pent-up customer demand, and VMware is no exception. But as we look at our Q2 performance, VMware also benefited from strong field execution around the world and solid product line performance across all customer segments. As we hit the midpoint of 2010, I’m very pleased with the progress we have made operationally, within R&D, and across our go-to-market efforts. We’re working to establish a solid foundation that will enable VMware to support significant growth moving forward.

A few highlights from the first half of the year that I’d like to call out include our customer count continues to grow at VMware, now serving more than 190,000 customers worldwide, up from 170,000 six months ago.

We are making progress with industry analysts. Gartner recently positioned VMware as the sole leader in their virtualization magic quadrant, and signaled the tight linkage between virtualization and cloud computing.

vSphere Essentials units are growing at 100% sequentially, indicating solid traction in the SMB market. Our SpringSource division is doing well, posting their best quarter ever and signaling that we are effectively growing near-term revenue while advancing our strategy to position Spring as the programming model of the cloud. As you’ll recall, we announced two important partnerships with Google and SalesForce.com that pivot on the technology and community associated with our SpringSource efforts.

And lastly services attach rates - either our own or our ecosystem’s - are increasing, signaling our shift to a more consultative, enterprise-oriented engagement model.

These are just a handful of examples illustrating VMware is growing stronger and leading the industry into the next era of computing. As our portfolio grows both organically and through acquisitions, our field is engaging with customers across a wide spectrum of opportunities. One example: a large financial services company is a long-time VMware virtualization server consolidation customer. As they progress on their virtualization journey, they are making investments to enhance quality of service for their millions of users. As such, we are working with them to create a modern architecture that will provide them benefits of cloud computing. In this pursuit they signed a large ELA in the second quarter and are taking advantage of much of our portfolio, including vSphere, VCenter, View and SpringSource.

Our operational progress and strengthening customer relationships are absolutely essential as we expand our business. The launch of vSphere 4.1 earlier this month illustrates how we are executing on all cylinders to ensure that VMware is the source for customers, including those moving to the cloud. Beyond the significant technical advancements of vSphere 4.1, like better scale and improved performance which extend vSphere’s technical capabilities further into a class by itself, we also announced some strategic moves to expand our go-to-market efforts and further align our business model with customers’ needs. For example, we announced a per-VM pricing model for our management products. This new model aligns license costs to the number of virtual machines being managed, rather than to the physical hardware. As virtualization and cloud computing become prevalent models of IT infrastructure, the virtual machine is rapidly becoming a standard measure of infrastructure deployments. In a virtualized environment, the hardware configuration is abstracted, and the physical compute resource required can change frequently due to the virtual machine migrations across the data center, thus making hardware-based licensing difficult to manage.

A virtual machine-based license model offers customers better alignment between customer costs and benefits delivered. We also expect this model will better support customers’ needs as workloads move across diverse hardware configurations, including multiple CPU scenarios without incurring additional costs. In discussions with customers and industry analysts about this pricing model change, the feedback has been very positive. Our per-VM pricing will be in effect on September 1st for VMware vCenter management products only.

Next, we’ve quickly integrated the Ionix management products we acquired from EMC in April, launching them with vSphere 4.1. This broadened our management portfolio to deliver a more complete set of solutions to automate the management of dynamic, virtualized systems. Specifically, we launched vCenter Configuration Manager and vCenter Application Discovery Manager, both former Ionix products.

Another exciting announcement we made this month will further expand our value proposition and reach to the SMB market with vSphere 4.1. As we’ve mentioned before, in general the SMB market, once it begins the virtualization journey, moves along at a much faster pace than enterprise, partly because they have fewer servers but also they have fewer people, processes, and cultural implications to deal with as they transform their IT departments. Our pricing and packaging of vSphere 4.1 for the SMB market significantly changes the game for smaller organizations that want to experience high-value virtualization from the market-leading and proven vendor.

Analyst surveys have acknowledged that well over half of the smaller organizations that are adopting server virtualization highly desire disaster recovery and business continuity capabilities. Beyond the proven functionality we provide today to the SMB market, we are now expanding the value proposition of vSphere 4.2. Specifically we have made vMotion available within our Essentials Plus SKU. We have seen tremendous momentum with our Essentials products in the first half of 2010, and I expect this move will pay dividends in the form of further customer acquisition and expansion in the SMB market.

Now turning to our desktop business. We continue to hold high expectations for the desktop virtualization market, yet it remains difficult to predict at what pace customer interest and evaluations will turn into accelerated buying. We are seeing Windows 7 upgrades, and the proliferation of new end-user devices such as the iPad and Smart phones are fueling public discussion and customer interest. However, no single technical or economic tipping point is emerging as the accelerant to VDI adoption.

What is emerging is a trend where IT executives are exploring much broader architectural implications of managing users in dramatically different ways. Many customers are not looking at a traditional product/feature/cost/benefit analysis, but rather asking larger questions about how they’re going to manage users in a dramatically changing world defined by mobility, ubiquitous computing, and increasing end-user demand and expectations.

We believe this bodes well for VMware, as we further position our desktop strategy within the context of these broader requirements and architectural changes. We’ll be advancing our offering with the public availability of our next version of View, View 4.5, planned for the Q3; as well as helping our customers engage the end-user computing journey at our user conference, VMworld in San Francisco in five weeks, and then Copenhagen in October.

Overall I’m very pleased with our execution and results in Q2. From an operations perspective our goal is to consistently strike the right balance of delivering on our quarterly plan while building upon the foundation of our business that will allow us to scale and grow over the coming years, all while maintaining excellent customer engagement and service that keep our customer satisfaction scores among the highest in the industry.

Finally, I’d like to especially thank our customers, our employees around the world and our partner community for a great first half of 2010. With that I’ll hand the call over to Paul.

Paul Maritz

Thanks, Todd. Todd and Mark have given you a good overview of our Q2 performance. On a broader level we continue to execute on our three-layered strategy of firstly infrastructure, secondly applications, and thirdly end-user or desktop computing. Our investment in the first layer, infrastructure, is designed to allow customers to modernize their infrastructure, run it and manage it more efficiently, and build true secure private clouds for their existing applications and bridge those clouds to the external cloud; and generally operate in a more business-like way, behaving as internal service providers.

In this context we’re particularly pleased with the release of vSphere 4.1. It’s a great product. It’s tangible evidence of the commitment of our vSphere team to deliver a series of high-quality releases as we seek to flush out the secure private/public or hybrid cloud. vSphere is now amongst the most sophisticated pieces of software in the world, and being able to deliver it with quality and in a predictable way is no small achievement. It’s this kind of execution that will allow us to stay ahead. We will now move to release a series of products that will fill out the additional aspects of the secure cloud – specifically security and management services – and we expect to have a full roster of announcements from both ourselves and our partners at VMworld at the end of August.

At the second or application level we seek to allow customers to write, run, and manage new applications more efficiently and take full advantage of modern cloud infrastructure, infrastructure not only from VMware but from other providers as well. We’ve continued to fill out the space there, too. The acquisition of Gemstone takes us into the sophisticated distributed data caching services business. And a nod toward the announcements that Todd mentioned with SalesForce.com and Google – these partnerships are important as they underscore the role new programming frameworks and the Spring framework in particular will play in providing an open layer of new applications in the private and public cloud.

At the third layer, the end-user or desktop level, we seek as Todd noted to build upon the current level of desktop virtualization and speak to the need of enterprises to focus more on managing users and spend less time managing devices, particularly in a world where endpoint devices are becoming increasingly heterogeneous. We'll be providing a path to our customers whereby they can move forward in an evolutionary way from their current Windows-centric environments, and in this context we’re looking forward to the release of 4.5.

As Mark said, we’ll continue to make the investments needed at each of these three layers, mainly through organic development but also through focused technology acquisitions. By doing this we believe we can provide the bridge for our customers from today’s world of IT to tomorrow’s world of IT as a service.

Finally, we look forward to spending time with you and providing additional background at the analyst event that we are planning for VMworld in San Francisco at the end of August. With that I guess we’ll open up for questions.

Mike Haase

Okay Operator, let’s start the polling process please.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator instructions.) The first question comes from Mr. Kash Rangan of Merrill Lynch. Your line is open.

Kash Rangan – Merrill Lynch

Hi, thank you very much. Nice quarter. As you give consideration for the first half of the year, clearly the results are very impressive. There’s been a big rebound in several markets. And how does your business look as you start planning for 2011? Should we expect a continuation of these kinds of growth rates or should we expect some moderation given that you have proper comps for the server market ahead? That’s my question, thank you.

Mark Peek

Hi Kash, this is Mark. You know, certainly the first half of 2010, we saw a rebound in the economy and we, like most of the IT industry, benefited from this rebound. Sever growth rates were in the 20% range; they’re forecasted to grow at somewhat similar rates although moderating a bit in the second half. The early indications for 2011 on server growth rates is that they’ll decline somewhat significantly in 2011. So that said, our business, although it’s influenced by server growth and also is impacted by installed bases which are moving to virtualization, and then on the other side of that is enterprise agreements that we’ve sold in which companies have inventoried some of their licenses. So certainly the growth rates for 2011, we’re not going to give guidance at this time. We've just finished planning the second half of 2010 – we continue to be on six-month quota assignments. But we’ll give you more color as the year progresses.

Kash Rangan – Merrill Lynch

Thank you very much.

Operator

The next question comes from Derek Bingham, Goldman Sachs. Your line is open.

Derek Bingham – Goldman Sachs

Hey gentlemen, congratulations on the quarter. I have a two-parter on ELAs. One is you had mentioned that they’re coming in typically over the size of the initial contract value. So I just wanted to be clear – when you're referring to that you’re just referring to the maintenance renewal portion of that contract that’s coming in kind of larger than the complete contract value that was signed in the first place. And then also just curious about what color you can give us in terms of any kind of associated license sales when you’re doing those ELA renewals in terms of how much people are increasing their deployments and buying new kinds of platform licenses, or SKU upgrades, new management tools, desktops, etc. Thanks.

Todd Nielsen

Sure, this is Todd. The first point, just to clarify, when we said it was more than originally it’s not just the maintenance renewal but it’s the original value of the ELA. So in an original ELA there is a license component and then a maintenance component, and the renewals are coming in greater than 100% of the original ELA value. This is partly due to further expansion of more servers or more of the original product expanding its reach or scope within the customer, but as you mentioned it’s also a result of additional products or upgrades being brought into the mix. So the example I talked about was the financial services company that started off with our vSphere product and has now moved to View and SpringSource and expanding that way. And we’re seeing that trend across all of our ELA renewals.

Derek Bingham – Goldman Sachs

Thank you.

Operator

The next question comes from Walter Pritchard, Citigroup. Your line is open.

Walter Pritchard – Citigroup

Thanks. I’m wondering if you guys could talk a little bit more in detail about the comment you mentioned about your margin targets with I guess the potential that there could be disruptions from M&A. And I’m wondering, you had a little bit of disruption in the beginning of the year. I'm wondering are you contemplating disruption of that magnitude or is it possible that you guys would consider doing deals that are greater than what you’ve tackled so far? Thanks.

Mark Peek

Walter, this is Mark. We guided 27% to 28% for the full year, and with the caveat that that could be disrupted by M&A but not that we had planned M&A in addition to the margins that we were currently targeting. In the second quarter we did have about a 150 basis point sequential change in margins as a result of M&A, but as a reminder in addition to Ionix, Gemstone and Rabbit, that also includes a full quarter of Zimbra in the quarter.

Walter Pritchard – Citigroup

Just one follow-up, Mark. In the comments I think I heard you say that there was no impact from currency, and yet we all did see currency weaken pretty significantly. I was wondering was that a comment on your year-over-year currency or was that a comment on the sequential impact from currency?

Mark Peek

It was really a comment on year-over-year currency. And we’ve had, remember that a lot of our operating costs are in those local currencies and so we benefited from that end; and then when we're talking about the top-line revenue it’s only the portion of license revenue recognized in the period that is in the foreign currencies in which we’re operating.

Walter Pritchard – Citigroup

Great, thanks a lot.

Operator

The next question comes from Brent Hill, UBS. Your line is open.

Brent Hill – UBS

Thanks. Mark, you saw a nice acceleration in deferred revenue, up 58% year-over-year. I was curious if you could just comment on what the role of ELAs had with that versus an increase in transaction volume. It seems it’s a combination of both, but if you could just give us a sense. And as you head into the second half of the year I would assume that many of these ELAs that you started back in 2007 are going to continue to come up for renewal, so should we expect the continuation of that deferred trend in the second half of the year?

Mark Peek

Sure. Well certainly most of the deferred revenue is driven by the maintenance component of all of our transactions, and across the board we have seen transactions coming in at more than two years of maintenance. So companies are taking advantage of modest discounts that we’ll give to add on an additional year of maintenance, and we bill and collect those within 60 days. This quarter ELAs ticked up sequentially. They had been in the mid-teens in Q1; they were at 20% during this quarter. But that said, even the traditional business through the channel has multiple years of maintenance associated with it. And the second part of your question?

Brent Hill – UBS

Just in terms of how you’re viewing the second half of the year for ELAs in terms of the renewal rate. Is there anything that changes in the second half in terms of the dynamics on the renewals?

Mark Peek

Well, we’re just beginning. This is really our second data point on ELA expirations within a quarter. We really started the ELA program in the first quarter of 2007. Most of them are set at about three years – some companies will vary outside of that norm. But there are a lot, there are more expirations coming up in the second half of the year and so we’ll have more data for you as the year progresses.

Brent Hill – UBS

Thanks.

Operator

The next question comes from Adam Holt, Morgan Stanley. Your line is open.

Adam Holt – Morgan Stanley

Great, thank you. The European business seemed like it was strong in the quarter. You obviously called out a number of countries that were particularly strong, yet the commentary for Q3 reflects I guess increasing concern about the environment. Did you see any change in Europe that would lead you to that or are you just being a little more cautious with respect to the guidance? And are you forecasting that the demand environment is a little bit weaker in Q3 than it was in Q2 in that geography?

Todd Nielsen

This is Todd. When we look at the results and the performance in Q2 we certainly saw solid performance across the entire region, and the transaction business and the ELA business and the like. I think the conservative guidance is we watch the news and we hear what’s happening in Germany and Greece and Spain and some of the concerns – we just want to be cautious. But we look at our performance and results in Q2 and we are definitely pleased with the way we were able to execute.

Mark Peek

And one thing I’d add to that is the results of the summer slowdowns in Europe. There will be this trend where companies will come back and begin their own planning exercises for the back part of the year with uncertainty in their business, and it becomes uncertainty in our business as well.

Adam Holt – Morgan Stanley

Mark, if I could just ask a quick follow-up on margins. If you net out the dilutions this quarter your margins were 29.5% ahead of where you guided to for the year. You talked about a 30% plus long-term operating margin. Is that still the mindset we should be thinking about in terms of longer-term margins or are you maybe a little bit ahead of that kind of longer-term goal in the current trajectory? Thanks.

Mark Peek

Well, first and foremost we’re going to invest in the business organically, through technology acquisitions, and take advantage of the opportunities that we have in front of us. And so we are not margin-oriented. Certainly longer-term 30% plus is something that we should be able to achieve if we execute on the growth of the business, but first and foremost and what drives the margin performance over a year ago is the growth that we’ve had and the deferred revenue, and the renewals that come with it that we’ve put on the balance sheet.

Adam Holt – Morgan Stanley

Great, thank you.

Operator

The next question comes from John DiFucci, JP Morgan. Your line is open.

John DiFucci - JP Morgan

Thank you. Mark, you had, when you gave guidance for this quarter, for the Q2 you said license would be down sequentially and obviously we saw it up so you guys did a great job there. But I’m just curious, can you just refresh us why you thought you’d see a decline in the quarter when you and just about everybody sees a sequential up tick into the Q2? And I guess sort of an add-on to Adam’s question, why would you assume license to be flat in this quarter when you typically see growth? Is it just being cautious about Europe? It sort of sounds like what Todd was saying.

Mark Peek

You know, walking into the Q2 we benefited from some fairly large enterprise agreements in Q1, and so as we looked at our pipeline we weren’t expecting to have quite the strength that we had in the enterprise segments in the Q that we had. You may recall that we did a $10 million plus deal in Europe. We also had some OEM carryover in the Q1 which we didn’t carry over into the Q2, and so that was really what our guidance was about as we looked at Q2.

As we think about the third quarter, you know, we’re saying flat to slightly down really because of Europe and the slowdowns that we expect to see in Europe, as well as we benefited in APAC from the year-ends in Australia and other regions. And we don’t expect to have the strength in our international geographies in Q3 that we had in Q2.

John DiFucci – JP Morgan

Thanks, just one quick follow-up. You said that headcount in the second half, you said headcount in the first half was plus 8200 and you expect, I just wanted to clarify that you’d expect something similar in the second half. Does that include any M&A or is that excluding any M&A?

Mark Peek

What I wanted to indicate is that directionally we’re going to continue to invest in the business organically. We’re not going to forecast the M&A. But we added 1100 people in the first half of the year – about half of those were through M&A. But we’ve demonstrated that when we make the decision to hire we can execute on the hiring, and that we’re a very attractive place for people to come to work and that we’re able to attract top talent. And as long as we can attract top talent and put them to work productively we’re going to go ahead and hire.

John DiFucci – JP Morgan

Thanks a lot.

Mike Haase

Operator, are there additional questions?

Operator

The next question comes from Brian Marshall, Gleacher and Company. Your line’s open.

Brian Marshall - Gleacher and Company

Great, thanks. Hi guys, nice quarter. I was wondering if you could discuss a little bit about some of the trends you’re seeing in VDI, virtual desktop infrastructure? And based upon some of the checks that I’ve done recently it sounds like calendar year 2011 could actually be the year where this starts to be pretty material for some people including yourself, and I was wondering if you could comment on that as well?

Todd Nielsen

Sure, this is Todd. As I think we’ve said in the past calls there’s a strong interest in VDI and desktop virtualization in general. We’ve in some quarters had as much as 60% of our proof of concept resource focused on desktop and desktop virtualization. With Windows 7 and those sorts of rollouts and upgrades on the horizon there’s definitely a strong interest as many customers are saying if they’re going to make the upgrade to Windows 7 they’re going to make a transformative change like a desktop virtualization effort as well. So I’m a little bit cautious to declare 2011 the Year of the Desktop since for the last few years it’s been declared the Year of the Desktop, but we are optimistic for the opportunity.

That said, as I mentioned in my prepared comments, we are seeing a change or a slight mindset shift where people are starting to look beyond just VDI and consider how they’re going to deal with the proliferation of devices that are out there. And a theme we’re hearing from customers is "Help me manage users and then the devices will take care of themselves.” And so we’re thinking through our strategy and we’ll be rolling out our direction and vision about how we’re going to address this opportunity and the chance to meet these needs.

Brian Marshall – Gleacher and Company

Great, thanks Todd. And final question, I guess with regards to ELA trends, sort of a follow-up question. Basically do you think that there’s going to be a material dynamic where we see large enterprise customers as well as federal guys be pretty strong when it comes to renewals of those ELA contracts, and potentially see some weakness from some of the small- to medium-sized enterprises that sort of bit off more than they could chew and haven’t… I think Mark mentioned they have an inventory left?

Todd Nielsen

At this point in time we track most of our ELAs that we’ve done. We’ve assigned a technical resource to them and we get a quarterly report on the progress of their use and consumption, and where they are on their virtualization journey. And we’re not seeing trends of oh, smaller customers are struggling relative to bigger customers. But across the board we’re seeing, you know, customer satisfaction and progress through that journey, and don’t expect anything except for them to follow the trend we’ve been seeing the previous few quarters, which is folks will renew at greater than 100% of the original value of the ELA.

Brian Marshall – Gleacher and Company

Great. Well done, thanks.

Operator

The next question comes from Heather Bellini, ISI Group. Your line is open.

Heather Bellini – ISI Group

Hi, thanks. I was wondering if you could talk a little bit about you know, the attach rate for management products; if you could help us ascertain that. And also what type of impact do you think the per-VM pricing that you mentioned will have on the contract value for those customers once the pricing change goes into affect? Thank you.

Mark Peek

Hi Heather, this is Mark. You know, the attach rate on management products is, we’ve seen improvement and we’re pleased with what we’ve seen. We are also adding to the portfolio of management products. The per-VM pricing is something that we introduced in reality as a response to how customers consume the products and to make it easier for them to consume and to build their own ROIs on the value proposition that it adds. At this point we don’t expect it to have a material impact on the near-term economics for us, but certainly we introduced per-VM pricing to help both us and our customers.

Heather Bellini – ISI Group

Great, thank you.

Operator

The next question comes from Scott Zeller, Needham & Company. Your line is open.

Scott Zeller - Needham & Company

Thanks. Another question about Europe. Can you give us some color around the activity due to pent-up demand and how much of that still remains as you look forward to the second half of the year, versus strong data center refresh activity, for instance?

Mark Peek

Well, it’s a little bit harder to tell as the year progresses how much of it is you know, pent-up demand versus changes to the business. What we had… Europe for us typically has not been a large enterprise license agreement market, so it’s, we have many more distributors and resellers in Europe and it tends to be very regional and very segmented. And so it's a little bit harder for us to get an overall view of the macroeconomics. We’ve seen more enterprise agreements and certainly we’re focusing our customers now that they’re on the journey of virtualization into the private cloud to enter into ELAs. You know, but as we enter the back half of the year we’re just being cautious really based on the macroeconomic trends and looking at our own pipeline.

Scott Zeller – Needham & Company

Thank you.

Operator

The next question comes from Kaushik Roy, Wedbush. Your line is open.

Kaushik Roy – Wedbush

Thanks, and congratulations again. Can you quantify in any way the license revenues you are getting from the desktop, or can you give a little bit more color on the type of environment or the traction you’re getting from the desktop? Thank you.

Mark Peek

Yeah. Kaushik, we don’t break out license revenues by product category. What we have seen is particularly in enterprise agreements is that we will add to an enterprise agreement VDI and View. We’re seeing traction as Todd had mentioned in place of the traction, but we’re not going to break out the specific license revenue.

Kaushik Roy – Wedbush

I mean when do you expect the VDI to be material – do you think Q4 or 2011?

Mark Peek

That’s hard to say, particularly because the steam and the momentum we have with vSphere. But the desktop wins we’re getting are developing… I know there was a number of customers in Q2 that purchased and are in the early phases of their deployments, and as they roll them out it’s only a matter of time before it kicks in to the additional licenses and we see that impact.

Kaushik Roy – Wedbush

Okay, thank you.

Operator

The next question comes from Jayson Noland, Robert Baird. Your line is open.

Jayson Noland – Robert Baird

Okay great, thank you. Just a question on SMB. With the new price point and features in the bundle, I guess is this partially in response to Microsoft? When we hear about success with Microsoft it’s in SMB and fairly rare. But I’m curious about what kind of penetration you have in SMB versus Enterprise, and what sort of market share you have in SMB versus Enterprise.

Todd Nielsen

This is Todd. So historically we’ve made this move throughout the years where we’ve taken you know, some of our core features and we’ve cascaded it down the waterfall to the SMB type SKUs. So the move for vMotion was one we planned on doing and executed with the release of 4.1. As far as the success in SMB, we’ve been incredibly impressed with the traction we’re getting - 100% growth in units sequentially in the Essentials products is a great testament to the opportunity we have in that space, and the success we’ve been getting, and not just in the US but around the world. And so as far as market share gains, we look at the reports and where it goes. If, what we’re seeing, you know, you assume Microsoft is seeing similar stuff. It’s a great opportunity for us to continue to grow and expand our reach, and with this move that we have made with 4.1 we expect good things in the future.

Jayson Noland – Robert Baird

Thanks, guys. Congrats on the quarter.

Mike Haase

Operator, we’re going to take two more questions, please.

Operator

The next question comes from Rob Owens, Pacific Crest Securities. Your line is open.

Rob Owens – Pacific Crest Securities

Great, thank you very much. I wanted to drill down a little bit into View 4.5 and some of the functionality associated with that in terms of personalization or client-side hypervisor. Although the product now hasn’t been released I think it’s been reported that these things have potentially slipped out. I was just curious how critical or how crucial you think that type of functionality is to the long-term success of View 4.5? Thanks.

Paul Maritz

Okay, I’ll do some work here – this is Paul. There are really two things here. One is client-side hypervisor. We are providing client-side, big client-side functionality with our offline View capability which comes as part of 4.5. The feedback that we got from our customers is the market’s not ready yet for a bare metal, naked hypervisor, and instead we are supplying essentially a Windows within Windows hypervisor which gives us much better coverage over the installed base in particular. The challenge with the bare metal hypervisor is how do you address the installed base? So we made that change based on customer feedback.

In terms of the persona functionality, we think it’s important. As you said we’re moving to place the emphasis increasingly on the line of our customers not to having to worry about the peculiarities of devices and worry more about equipping their employees with a certain set of functionality applications and information, and mapping that to whatever particular device that they have. So that’s an area we’re invested in where you can expect to see some very interesting announcements from us down the road.

Rob Owens – Pacific Crest Securities

And along those lines, Paul, PC over IP, are you happy with where it is now? Is there more work to be done on that front?

Paul Maritz

We’re very happy with it. There’s always more work to be done on everything, but as far as the protocol itself is concerned we’re very pleased with where it is.

Mike Haase

Any questions?

Operator

The last question comes from Michael Turits, Raymond James. Your line is open.

Michael Turits - Raymond James

Hey guys, two questions – one on ELAs, one on pricing. On ELAs I know that you said that the average maintenance term length overall is 24 months. Are you still holding at three years for most of the ELA renewals? And then I have another question.

Mark Peek

Um, the blended average is more than 24 months. I didn’t look at the Q2 data but I believe that is the case, that we are doing about three years of maintenance on the ELA renewals.

Michael Turits - Raymond James

Okay. And secondly, on the View script pricing, you’ve gone to VM-based for the management piece but obviously not for the vSphere itself. Are you starting, despite the strength in licensing this quarter, are you starting to see any negative impact on licensing as customers start to move up to 6-, 8-, and 12-core chips? And if so might you move there, move to per diem pricing overall at some point?

Todd Nielsen

This is Todd, again. I would say the answer to that is no. We’re finding as customers have progressed down the virtualization journey, as they move toward phase 2 and phase 3 of the journey, it’s really less about consolidation ratios and more about just the quality of their IT infrastructure and business continuity, and agility and the like. And so I don’t foresee us at the core infrastructure layer with vSphere going to a per-VM type model. It makes sense for customers of some of the management products and arguably VDI is a per-VM model today as well, but it doesn't really make sense at the infrastructure level for us.

Michael Turits - Raymond James

Great, thanks very much.

Operator

Okay, that concludes the call. Thank you everyone for participating.

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

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

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

Source: VMware, Inc. Q2 2010 Earnings Call Transcript
This Transcript
All Transcripts