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Executives

Gil Shwed – Founder, Chairman, and CEO

Tal Payne – Chief Financial Officer

Kip Meintzer – Investor Relations

Analysts

Sterling Auty – JPMorgan

Robert Breza - RBC Capital Markets

Katherine Egbert - Jefferies & Co.

Jeff Evenson – Sanford Bernstein

Shaul Eyal – Oppenheimer

David Ives - Friedman, Billings, Ramsey

Israel Hernandez - Barclays Capital

Gregg Moskowitz - Cowen and Company

Rob Owens - Pacific Crest Securities

Walter Pritchard - Citigroup

Kash Rangan – BAS-Merrill Lynch

Keith Weiss – Morgan Stanley

Phil Winslow - Credit Suisse

Stephanie Withers - Goldman Sachs

Kash Rangan – Merrill Lynch

Jonathan Ruykhaver - ThinkEquity

Scott Zeller – Needham & Company

Brad Zelnick – Macquarie Research

Check Point Software Technologies Ltd. (CHKP) Q2 2010 Earnings Call July 21, 2010 8:30 AM ET

Operator

Welcome to the Check Point Software Second Quarter Earnings Conference Call. (Operator Instructions.) It is now my pleasure to introduce your host, Mr. Kip Meintzer, head of investor relations for Check Point Software Technologies. Thank you Mr. Meintzer, you may now begin.

Kip Meintzer

Thank you. I'd like to thank all of you for joining us today to discuss Check Point's record financial results for the second quarter of 2010. Joining me today on the call are Gil Shwed, our founder, chairman, and CEO, and Tal Payne, our chief financial officer. As a reminder, this call is being webcast live on our website and is being recorded for replay. To access the live webcast and replay information, please visit the company's website at checkpoint.com. For your convenience the conference call replay will be available through August 5. If you'd like to reach us after the call, please contact investor relations at +1 650 628 2040. Before we begin with management's presentation, I'd like to bring the following to your attention.

During the course of the call, Check Point representatives will make certain forward-looking statements, and these forward-looking statements may include our expectations regarding demand for our security products, our expectations regarding the introduction of new products, and the success of those products, and our expectations regarding our business and financial outlook for the third quarter and full year of 2010. Other statements which may be made in response to questions, which refer to our beliefs, plans, expectations, or intentions, are also forward-looking statements for the purpose of the safe harbor provided by the Private Securities Litigation Reform Act.

Because these statements pertain to future events, they are subject to various risks and uncertainties and actual results could differ materially from Check Point's current expectations and beliefs. Factors that could cause or contribute to such differences include, but are not limited to, the risks discussed in Check Point's annual report on Form 20F for the year ended December 31, 2009, which is on file with the Securities Exchange Commission. As a reminder, Check Point assumes no obligation to update its forward-looking statements.

In our press release, which has been posted on our website, we present GAAP and non-GAAP results along with reconciliation tables, which highlight this data, as well as the reasons for our presentation of non-GAAP information. Now, I would like to turn the call over to Tal Payne, Check Point's chief financial officer, for a review of the financial results.

Tal Payne

Thank you Kip, and thank all of you for taking the time to join us on the call today. Once again, I'm happy to review another excellent quarter with record results. Our revenues exceeded our projections, with 17% growth over the same period in 2009, while our non-GAAP earnings per share came in at the high end of our projections and was $0.68, representing 21% growth.

Before I proceed further into the numbers, let me remind you that our second quarter GAAP financial results include equity based compensation expenses according to ASC-718, expenses relating to acquisitions, including the motivation of intangible assets and restructuring costs and the related tax effects from such items. Keep in mind that non-GAAP information is presented excluding these items.

This quarter we consolidated Liquid Machines for the first time in the results since June 9. GAAP results for the quarter include the effect of certain charges relating to this acquisition. These charges include the motivation of intangible assets and restructuring charges which in aggregate total $700,000.

Now let's take a look at the financial highlights for the quarter. In the second quarter, revenues exceeded the high end of our projections. Revenues reached $261 million, representing an increase of 17%, compared to $223.6 million in the second quarter of 2009. This growth was driven by exceptional product sales.

Products and license revenues were $104 million, representing a 25% increase over the same period last year. The growth came from all main product lines, including the IP series, Power-1, UTM-1, and Smart-1. Our software update maintenance and service revenues reached an all-time high of $157.2 million this quarter, a 12% increase year-over-year.

The growth in deferred revenues was also significant this quarter. Deferred revenues as of June 30, 2010 reached $415 million, an increase of $53 million, or 15%, over June 30 last year.

We had growth in revenues across all geographies, with America delivering 20% growth over Q2 2009. Revenue distribution by geography for the quarter was as follows. America contributed 44% of the revenue, Europe with 41% of the revenue, and Asia-Pacific and Japan, Middle East, and Africa regions contributed the remaining 16%.

From a deal size and quantity perspective, this quarter we continued to see an increasing number of larger deals. Transactions greater than $60,000 accounted for 68% of the total order value, compared to 51% in the same period a year ago. We have 25 customers that each had transactions with a value greater than $1 million, compared to 21 customers in the same period last year.

From an operating perspective, we posted great results. Our non-GAAP operating income was $145 million in the second quarter of the year, an increase of 24% compared to the same period in 2009. Non-GAAP operating margin for the quarter was 65%, an increase of 3% compared to the same period last year. This was achieved primarily as the result of the top line performance and realizing synergies after the acquisition of Nokia in Q2 last year.

GAAP net income for the second quarter of 2010 was $103 million or $0.48 per diluted share, up from $76 million or $0.36 per diluted share a year ago, representing an increase of 33% year-over-year.

Non-GAAP net income for the quarter was $122.4 million, or $0.58 per diluted share, up from $101 million, or $0.48 per diluted share a year ago.

Earnings per share was at the high end of our guidance, representing 21% growth year-over-year.

Our casual operation this quarter was $149 million, an increase of 32% from $113 million in the second quarter a year ago. This was mainly the result of strong collections, as reflected in our DSO, which was 68 days this quarter compared to 79 days in the same period last year.

During the quarter we purchase approximately 1.5 million shares for the total cost of $50 million, as part of our share repurchase program.

Finally, our cash balance at the end of the quarter was $2,141 million, compared to $1,630 million as of June 30 last year.

Now let's turn the call over to Gil for his thoughts on the second quarter.

Gil Shwed

Thank you Tal, and good morning and afternoon to those of you joining us on the call today. The second quarter once again produced some exceptional results, and is a quite nice way to complete the first half of the year.

The results exceeded our expectation for the quarter. This year we focused our strategy on delivering more security, better security, and simpler security. Our software blade architecture and appliances are a reflection of this strategy and our continued top and bottom line groth are the results.

A particular area of strength this quarter was the 25% growth in product sales. The best part about this growth is that it came from all of our product lines, which is always a good testament to the strength of our business.

As you're all aware, we continue to pursue an acquisition strategy, and have now made five acquisitions of varying sizes over the past few years. During the quarter we completed the acquisition of Liquid Machines, which will complement our data security strategy that is focused on securing new data throughout its life cycle in a unified way.

Our full disk encryption keeps data secure when left on the hard drive, the integrated VPN secures it when it's being transmitted over the Internet. Our new DLP solution keeps documents from being leaked outside your organization and in the future the technology acquired from Liquid Machines will help us build solutions for sharing documents securely. This complements the Abra solution we've already introduced since the beginning of the year. Abra for secure mobility, and the DLP which I have just mentioned, both extended our addressable markets.

In terms of sales, we increased our revenues and sold more products in all geographies. The Americas demonstrated the very strong results we have. Asia produced very good results, and in Europe, while we're seeing some softness, also generated good growth this quarter.

As for financial projections, the first half of the year has provided us with a great starting point for the second half. So with that, we are increasing our guidance for the full year 2010 and providing guidance for the third quarter. So let's start with the third quarter.

For Q3 we expect revenues in the range of $255 million to $265 million and non-GAAP earnings per share of $0.56 to $0.60. GAAP-based EPS is expected to be approximately $0.09 less. For the full year we expect revenues in the range of $1,040 million to $1,070 million, and non-GAAP earnings per share of $2.30 to $2.40. GAAP-based EPS is expected to be approximately $0.30 less than that.

Thank you for being with us on the call today and now let's open the call for your questions.

Operator

Thank you. We will now be conducting a question-and-answer session. (Operator instructions.) Our first question is coming from Daniel Ives of FBR

Daniel Ives - Friedman, Billings, Ramsey

Thanks. Great quarter again. Gil, can you talk about, specifically in Europe, what you guys saw throughout the quarter. Any changes? And maybe just, as you're going to allow those engagements what are you hearing from customers? Anything different there geographically?

Gil Shwed

I think there's no one good conclusion to say. I think overall we had good results in Europe and in the particular we saw some softness. I think it's too early to deduct anything out of that and I think we'll keep watching it. There are good reasons to be optimistic, and at the same time we have to be cautious because we know the economy like all of you and again I think in some countries we saw strength and in some countries weakness. I can't even completely correlate it to what we see from the global economy perspective.

David Ives - Friedman, Billings, Ramsey

And again, just on the blade, are you getting more interest in that going into the latter part of the year, in 2011, from customers. Can you just talk about what you're seeing there?

Gil Shwed

Absolutely, we are seeing an increase in sales of everything, and that includes our blades, both a la carte, the bundle blades. Keep in mind that there is a use potential for the entire install base we have to purchase more blades, but this will take some time because all the customers need to upgrade to R-70 to use that. R70 is the release that we are doing blades and (inaudible) and now we are continuing to monitor that. Every week we have a few hundred customers upgrading to our R70 and we are seeing it on a weekly basis and tracking that, but absolutely the blade sales are showing an increase in all aspects.

Operator

Our next question is coming from Shaul Eyal of Oppenheimer and Company.

Shaul Eyal – Oppenheimer

Good quarter. Congrats. Two questions on my end. Gil, how many blades do you guys sell right now, by the end of the second quarter? And then Tal, any discussion on the foreign exchange impact this quarter?

Gil Shwed

So first thing we are not breaking out the sales by particular blades or product families, and so on. And, keep in mind that many of our blades are sold in a bundled way using the product. But overall I think we are talking about tens of millions of dollars every quarter, a combination of multiple blades, multiple selling forms, and that's a significant part of business right now.

Shaul Eyal

And with respect to the foreign exchange?

Tal Payne

I'll remind you that we are ahead, so just to give you the basic data again, out of the 100% of our expenses, about 40% are in local currencies, and 60% is in dollars, and out of the 40% the main currencies are obviously the Shekel, the Euro, and the Pound, and many other currencies. The Israeli Shekel didn't do much this quarter, so we didn't move much, it had no effect at all, and the Euro moved significantly but we are hedged significantly as well, so all in all a difference of a few hundred or $200,000 net. So no effect on this quarter.

Operator

Our next question is coming from Michael Turits of Raymond James

Michael Turits - Raymond James

First of all, on the software blade side, what percentage of your base is now on the R70 release and so in a position to be actively buying blades?

Gil Shwed

I don't have the data in front of me but it's still a small percentage. As I told you we're moving customers, hundreds a week, and on one end it's a good number of people actually upgrading, on the other hand, it will take us a long time to (inaudible) our install rate.

Michael Turits - Raymond James

And also, how is Endpoint doing? You said you were doing tens of millions in blades. Any sense for whether Endpoint is contributing the same amount?

Gil Shwed

Again, I don't want to break it separately, but I did say very clearly that all product lines contributed to growth this quarter and that means that Endpoint did start to contribute to the growth and hopefully that's a good sign.

Michael Turits - Raymond James

Last question is more of a general question from a demand perspective. How much would you say that you're seeing of a product refresh cycle around firewalls along with data networking in general? How much of the demand right now is cyclical and is pent-up demand from last year, and how much of it seems by contrast to be coming from expansion of data center capacity, movement to 10-gig ethernet, things like that?

Gil Shwed

First I think it's not necessarily separate. Refresh means people need higher bandwidth and they want to purchase faster solutions to address their needs. There are new data centers that we are seeing companies operating and there is a refresh. The refresh I don't think is typical because we don't see a cyclical pattern. What we see more is an ongoing pattern of people upgrading their infrastructure, so it's an ongoing phenomenon and I think we see a combination.

Every quarter we have the more-than-a-thousand-view customers, for example. And every quarter we sell to tens of thousands of existing customers. So we are doing a lot of work these days to analyze the data and get much better demographics on the exact sales we are doing. So far there is no one conclusion that would tell us that growth is coming from one area or another. It does come from multiple sources.

Michael Turits - Raymond James

Any update on when application control is coming out using the new FaceTime database?

Gil Shwed

It will come Q4 this year as an integrated blade and in the next few weeks we will share more data publicly with our channel and partners and with our users. So I think we will be able to demonstrate that and show that within a few weeks and the plan is for this year.

Operator

Our next question is coming from Jonathan Ruykhaver of ThinkEquity.

Jonathan Ruykhaver - ThinkEquity

I'm wondering if you could provide some color of the unified, if so, and flat operating systems in terms of when that will be delivered to the market. And secondly, is there a revenue opportunity associated with that integration?

Gil Shwed

Yes, it will be integrated. We will demonstrate it and start shipping this year. I think it will take a more centerpiece and more center stage for our new appliances and new solutions that we will roll next year, again on an ongoing basis. So the target is next year. In two or three weeks we have a conference, our customer and partner conference in Singapore, the first conference in (inaudible) and that's part of the agenda. It's called project Gaia. That will show the unified operating system. I don't know how much of that I can quantify as a new revenue opportunity. It clearly will help us internally in consolidating product lines and making things internally a little bit more efficient. It will clearly help customers because they will be able to move from one product line to another. For example, today on the IPSO platform not all software blades are supported. So once we have a unified system people with IPSO will be able to buy more blades. On the other hand, customers that today like features that we have in IPSO and can't it are limited in some ways so it's good to have a unified line and if we have good products in many case it will generate more sales.

Jonathan Ruykhaver

I'm just curious about the Smart-1 and SmartEvent appliances in terms of what kind of adoption you've seen in the marketplace and how large can that opportunity be for Check Point?

Gil Shwed

Actually very good adoption. Many people are buying it. The sales are growing at a very high percentage. It's still a small base but it is millions of dollars every quarter, so it has a positive and meaningful influence on our product sales.

Operator

Our next question is coming from Katherine Egbert of Jefferies & Company.

Katherine Egbert - Jefferies & Co.

I wonder, has there been a permanent change to your collections process? Your DSO seems to have reached a new lower level in the last couple quarters. Anything significant there?

Tal Payne

We do have very strong collections, that's correct. I wouldn't say there's any material change in the processes. We always had great collection, and if I check the DSO based on the last month and not based on the quarter then the DSO is pretty much stable for the last 3 years. So I think it's been always great and it continues to be great.

Katherine Egbert

With machines, does that become a blade? Does DLP become a blade?

Gil Shwed

Yes, DLP will become a blade in our gateway. Liquid Machines will eventually become a blade in the endpoint. Again, still a long time. Liquid Machine is clearly a strategic investment on our part. It's something that I think will come to fruition in . . . hopefully we'll be able to show some products in 2011 but I think the results that we'll see out of that will be 2012-2013.

It's a very strategic investment. Everything we will do will be a blade, and in particular the DLP which I think is a huge thing from the standpoint that every Check Point gateway in the world, and every Check Point customer that before needed to invest hundreds of thousands of dollars in building a DLP solution, I think we will make it extremely simple, 10 times simpler, 10 times more efficient, and in terms of cost comparison I think our cost will be 50% to 80% lower just on product sales themselves and if you take into account the complexity and the total TCO in managing the DLP solution, it will really create a new category in the marketplace. So what you're looking at in the DLP is actually not to compete with the existing complicated solutions, but rather create a new category and bring DLP to every enterprise, to every company.

Operator

Our next question is coming from Phil Winslow of Credit Suisse

Phil Winslow - Credit Suisse

I just want to touch on the large deals. I think possibly this is a record high that we've seen for Q2 in terms of the percentage of your bookings that come from deals over $50,000. I'm just curious what trends you're seeing there and what's really driving that. Is it uptake of additional blades, or just broader standardization agreements with corporations? What are you seeing that's driving that up?

Gil Shwed

I think it's a combination of all three. I think one is the combination of customers buying more products from us. Second is the unification of the way we work with customers renewing contracts together, combining all contracts for one customer and doing it together. A third element of that is the fact that we're selling more appliances and the IT business between the unified menu for our larger customers have now become bigger customers when we unified their account. And last and not least is execution by the sales force. Our sales force became much more focused, producing great results on large accounts and again when we start to analyze the demographics of our sales we clearly see a very nice achievement there. Again, they aren't built overnight but suddenly you start seeing the results to be very meaningful on that.

Operator

Our next question is coming from Robert Breza of RBC Capital Markets.

Robert Breza - RBC Capital Markets

Just two housekeeping items. Tal, was there any deal greater than $5 million in the quarter? And then could you talk us through how we should think about deferred revenue going through the year?

Tal Payne

I don't think we had any transaction higher than $5 million, so the answer is no, but I don't have the paper in front of me. To the second question, the deferred revenue is a regular phenomenon we used to see. We used to see the deferred revenue going up in Q4 and then reducing in Q2 and in Q3 or flat, maybe slightly increased and then in Q4 going back up again.

Gil Shwed

So Q4 and Q1 are usually up and Q2 and Q3 are usually down, based on the fact that many customers prefer to renew their contracts around year end, year end meaning December, January, some time around Q4 and Q1.

Operator

Thank you. Our next question is coming from Gregg Moskowitz of Cowen and Company.

Gregg Moskowitz - Cowen and Company

Wondering if you could talk a little bit more about Europe along the lines of possibly which regions perform well and which may have a little bit of softness.

Gil Shwed

I've tried to analyze it before and I've looked in all the countries and again I can't give you any pattern that will be very meaningful. We sold more in the UK. We sold some less in Germany. We sold much more in France and we sold more in Greece. So you really can't correlate it. There are some correlations to what you see in the global economy and there are a lot of things that don't correlate, so I can't just tell you that there's a clear phenomenon that I can describe here.

Gregg Moskowitz

Okay, and then I know it's early but how did Abra do relative to your expectations in its first quarter?

Gil Shwed

Actually, it's very early so that's true, but it actually did very very well. We have many many customers, we have many thousands of units, the interest level is very high, and I hope that it will come to fruition. There are good signs and good bookings for that.

Gregg Moskowitz

And then just lastly, a quick housekeeping for Tal. What were security appliances as a percentage of product revenues?

Tal Payne

Around 75%.

Operator

Our next question is coming from Keith Weiss of Morgan Stanley.

Keith Weiss – Morgan Stanley

Again, good quarter. Also, a very impressive increase in your guidance for the full year. I was wondering if you could delve into that a little bit on two fronts. One, what are you guys assuming for Europe into the second half. Is there any conservativeness in your forecast given the softness that you saw in Q2? And the second part of the question would be, is there anything in there for Liquid Machines and what woudl the impact of Liquid Machines be on in the increase in your guidance?

Gil Shwed

Liquid Machines has nothing to do with it. I don't know if we've factored much or not factored, but it's really not significant, so I'm not counting it as a big part of our contributors or anything like that for the next 2 years. And I'm hoping that in several years it will become very meaningful, but for the time being we are not trying to be very (inaudible) right now. For Europe yes, on one end it looks like we've ramped up our guidance, and it's higher and it's even, as you said, aggressively higher, so that's good. On the other hand, I try to factor in some risk factors in the world in general and in Europe in particular, so I hope it's like we do all the time, we provide a balanced forecast and that we will be able to make it.

Keith Weiss

And then maybe if you can just update on the competitive environment, maybe in particular Cisco. It sounds like Cisco has some issues with their security appliances in the quarter. Do you guys see any positive impact from that?

Gil Shwed

I haven't seen much from Cisco negatively or positively in recent quarters. I think in general I would characterize that Cisco is the large and quiet competitor. I do think that we sell a lot in our marketplace. I don't think that we compete on strategic deals and things like that. We hardly hear about Cisco as the major competitor. On the other hand we verify account access and so on. I think that we do sell a lot, so I don't want to overestimate that.

Operator

Our next question is coming from Israel Hernandez of Barclays Capital.

Israel Hernandez - Barclays Capital

Could you just give us an update on the Nokia install base and how much of the growth and momentum that you are seeing presently is being driven off up upgrades off the install base versus organic gains or competitive share gains.

Gil Shwed

So first I think everything we are seeing right now is organic because Nokia was part of our results Q2 last year and it's Q2 now, so the results this quarter are organic including Nokia. In terms of the growth, we're actually positively surprised to see that the IP appliance series is growing even better than we anticipated when we acquired that (inaudible). Yet at the same time the UTM-1, the Power-1 series are also growing very nicely. I think this quarter some of them grew faster than the IP series. The Smart-1 new appliances that are our new product are also selling nicely and I think I've mentioned it a few times the growth this quarter came from all product lines, which is very very encouraging to see that from the endpoint to the high-end appliances, everything was growing nicely and contributing to the results.

Israel Hernandez

And just to follow up, I think Gil last quarter I believe you said that you could grow the business 10%. Given the performance through the first half of the year and your implied guidance for the back half, do you care to update that guidance?

Gil Shwed

I think for this year we gave the guidance and for the future we'll see what the future will hold in that, and again we will do whatever we can to grow better and faster and I think there is definitely a (inaudible) potential in that. But I think time will tell. I don't think I can predict what will be the state of the world economy in two or three years.

Operator

Our next question is coming from Jeff Evenson of Sanford Bernstein.

Jeff Evenson – Sanford Bernstein

You've given some discussion in the past on efforts to upgrade and expand the sales force in Asia as well as your efforts around partners and delivering managed services offerings. I'm wondering if you could give us an update on both those now.

Gil Shwed

I think in Asia we're seeing very good traction and very good results for as many countries in Asia for which we see good growth and coming from small bases and becoming countries with low sales to countries with a million dollar in sales in a quarter. In the large countries the trend is also quite positive but in the large countries it varies by quarter.

The seasonality in Asia is somewhat different than in the rest of the world. Like Q3 should be a good quarter there, which is the end of the fiscal year in some countries. Q1 is the end of the fiscal year in other countries in Asia, so it's a little bit different than we see in Europe and the Americas.

Overall I'm very very happy from the sales organization. A few years ago it was a sales organization from which we expected an order of magnitude of $20 million to $30 million per quarter. Now we expect an order of magnitude of $50 million per quarter from Asia. That's a huge change. A few years ago I looked at Asia and I thought for overall Asia I'm looking for $100 million per year, now they're on the way to $200 million, so that's a very nice segue that we've made in that part of the world.

Sales to MSTs? We have sales to MSTs. We want to do more. Nothing much more to report on that at this point.

Operator

Our next question is coming from Rob Owens of Pacific Crest Securities.

Rob Owens - Pacific Crest Securities

Was there any dilution from Liquid Machines in the quarter?

Gil Shwed

No.

Tal Payne

I talked about the motivation, the restructuring. In the GAAP numbers it was about $700,000 and it will affect a few hundred thousand, nothing dramatic.

Rob Owens

So the incremental expense in Q2 was only a few hundred thousand?

Gil Shwed

Yes. It's a small company so it's not expected to be . . .

Rob Owens

That being said, and then the strengthening of the dollar, why did you see the margin compression sequentially? Why didn't you see a little bit more lift there?

Tal Payne

Well, the marketing expenses are typically higher in Q2. You can see it throughout our history. All the Check Point experience in Q2, both in Europe and the U.S., was in Q2. So it's just higher levels of marketing expenses really.

Gil Shwed

And to some extent we sold much more appliances than we anticipated, which is great news and that's also reflected in the cost of (inaudible).

Tal Payne

And if you want the third reason, then the salary increase also happens in the beginning of Q2, the end of Q1, so it's by definition a higher level of expenses in Q2.

Gil Shwed

All our salary increases in the world are being affected in Q2 and not in Q1, so the biggest source of expense from us is payroll, and all the payroll went up in Q2.

Rob Owens

And one year into the Nokia acquisition, understanding it's organic at this point at this anniversary, do you have a sense of how much of their install base you've penetrated at this point?

Gil Shwed

They are in contact with all their install base, and all their install base was a Check Point install base to be before, so it's not that we are directing new customers. And again, in many many cases we've seen pretty good synergy around that. Customers that were $200,000 customers a year before are now $300,000 or $400,000 customers about, because we've now combined the account. And by the way, that's great, very very good synergy, because it's now one account manager, single discussion about upgrade cycle, single ability to meet their requirements when we control both ends of the hardware and the software, so I would characterize that (inaudible) as very successful from all aspects - customer relations, financial, and so on.

Kip Meintzer

If can add on to that Rob, as far as penetration into the refresh cycle, there's still much more to come in the future. A refresh cycle doesn't happen all in one year, so that's still out there.

Rob Owens

Is there anything we can quantify in terms of what's been penetrated on that refresh cycle?

Tal Payne

Obviously you can't know the exact number, but if you assume that the line of products for IP series existed for many many years, and if you assume that the cycle is over four, five, six years, then you should have approximately 20% per year. There shouldn't be a peak in a certain year.

Operator

Our next question is coming from Walter Pritchard of Citigroup

Walter Pritchard - Citigroup

You talked about an acquisition strategy and you mentioned five deals over the last year or so, but they've all been, with the exception of Nokia, pretty small deals, and I'm wondering if you've contemplated anything larger in the last year, or if you're looking at anything in the future, a la Zone Labs and Pointsec that you've done in the past 3-5 years.

Gil Shwed

First, the five deals are from much more than one year, so I don't want confusion here. I don't have anything right now but I'm planning some. I'm not hinting that something should be expected immediately. We are looking actively and we are scanning the market and we are looking every month at new ideas and new things. And some of them are very obvious, known companies and we brainstorm about the ability to create some synergies there. For the most part we decide no, so it's not that I anticipate that.

We keep looking for that. At this point I wouldn't make any expectations of that. I think we are having a lot on our plate. We have a lot of new fields that we are penetrating. We have a lot to execute in all the areas from, as I said, mobility, DLP, secure documents, EndPoint we should execute, so I'm not expecting any large deals in the short term.

Operator

Our next question is coming from Kash Rangan of Merrill Lynch

Kash Rangan – Merrill Lynch

Two things. One, Tal, can you give us a little bit more detail on what foreign exchange contributed to your bottom line? I know that you guys have a little bit of a different counter movement to the other software companies with respect to your expense and revenue. If you can give us a little bit more color there that would be great. Also, I think you talked about some marketing expenses and salary raises. If you can quantify what that did to the operating margin, that would be great. And then finally for you Gil, it looks like you're clearly gaining share in your core business. Maybe if you can talk about which segments of the market are you gaining share - the low end against one of these startup kind of companies, or at the high end. Any color there? Because the firewall market obviously is not growing at the rate that you're growing and I'm trying to understand what is really driving that, that above-market market share gain.

Gil Shwed

So maybe I'll start. I haven't measured that and again my focus is always providing more value to customers rather than . . . the market share is the result not necessarily the main measure of what we do. My feeling based on the data that I'm seeing is that we're gaining share on the enterprise on the high end. I think there's a lot that we can do on the lower end of the market and I think we are producing good product and we need to get more traction and more focus from our own sales force and from the channel partners to sell more to the low end of the market. Clearly you can understand why. The sales people have great success on the enterprise and high end with prestigious deals, high margin, larger deals, and their focus is rightly so on that.

I feel that we have untapped potential. I think we can grow everything, but I think we have untapped potential at the low and slight-mid markets. I'd say between zero to five thousand users. That's a very large market that we are penetrating in the different levels and also we can do more. And I think that we have also more potential at the very high end. The accounts, we sell to all of them, but in selling solutions that are much more expensive and much faster mainly than what we do today there is also some high potential and I think if I look two to three years down the line that area that we'll keep looking for them. Definitely for the very high end, which is as I said, part of our core market of high end and enterprise customers.

Tal Payne

And maybe I'll take the first part of your question. If you take our expenses and approximately 60% is in dollars, it means that 40% of our expenses are affected by the currency changes. And out of that, probably around 40% or so is the Israeli Shekel, which didn't make a move, no single digit move so no effect there. And the rest of it is the Euro, Pound, and other currencies around the world. Now the Euro did make a move but we have a hedge, so when I look at the net, the net effect was probably around $100,000 and $200,000, so we pretty much break even, no effect on the P&L this quarter. Now on the revenues it's very hard to know because remember that we are pricing everything in dollars, in the majority or substantially all of our revenues, so the effect is not direct. But it can be indirect if it affects the budgets that are available to our customers.

Gil Shwed

Their buying power is slightly lower, but per deal, per product, we get the same amount in dollars.

Tal Payne

So that's to that question, and to the other question, what was the effect of the salaries and the marketing? Well, you can see pretty much that's the main reason for the increase in all the line items, so some of it is salaries and some of it is the marketing expenses and I don't really have the exact breakdown.

Gil Shwed

Look at the R&D line for example, it's pretty much all salary increase.

Tal Payne

And you can see actually that the gross margin, I think the operating margin, was just about half a percent, so that's a net effect. And the gross margin actually improved near a percent. And I wouldn't look at that way, meaning half a percent up, half a percent down. This is a real business and there can be a shift in the margin between quarters of a percent here or there.

Gil Shwed

I think the way to model the business is that everything that is not over gross margin on the appliance sale is basically fixed expenses. And that depends on the level of investment we decide to make, or spend. Everything (inaudible) for the past two years is that we have real cost of hardware sales. That's reflected in the cost of product sales. Remember cost of service (inaudible) headcount, fixed amount of people. Cost of product sale, that you can find in our financial report, is the valuing part according to product sales, and beyond that everything else is basically headcount and headcount-related expenses that are fixed and depend on the level of investment and are not changing between one quarter to another.

Operator

Our next question is coming from Brad Zelnick of Macquarie.

Brad Zelnick – Macquarie Research

I think most of my questions have been answered but just looking at DLP and Abra, can you talk about how it's been received in that channel. I know it's early. And then what are you guys expecting for that, for the remains of the quarter. What are you guys thinking it's going do with big items?

Gil Shwed

I think it's new products categories and the new products, some of them don't exist. Some of them are emerging, and it will take us time to build the critical mass. But the reaction that we're getting so far is very good. I spent yesterday a couple of hours with our sales champions for DLP that brought me their feedback from all over the world about what they are seeing with DLP and they were very positive, high level of interest and so on. I think we have a challenge and an opportunity, both, to educate the market about our new approach here.

And we have always new approach of making DLP very simple, very straightforward, something you can embed in every system. That opens up a huge market of customers that before didn't think, or couldn't afford, installing such a complicated solution for DLP. And I'm challenging our people always, get us many more customers and the broader install base as we can get because that will be the basis for future growth. Not small number of large deals, but large number of deals all over. That will bring us the sales.

Abra we're already seeing some traction with many hundreds of accounts that are already trying it out. The one thing you have to remember about Abra is that the entry cost for that is very low. Even if you buy a few of these sticks for a $100 or $200 each it can start with small transactions. It's very tangible. You take one of them and you can try it out.

Brad Zelnick

Are customers using Abra more on a trial basis and then testing it out first and then going widespread throughout the enterprise?

Gil Shwed

It's both. Again, if someone wants to try some, obviously they don't want to buy $10,000 the first quarter. They'll buy few, they'll try it, and they'll buy the 100 or thousands or whatever they need.

Operator

Our next question is coming from Sarah Friar of Goldman Sachs.

Stephanie Withers - Goldman Sachs

Hi this is Stephanie Withers on for Sarah with a couple of questions on pricing. So first, are you seeing any impact on pricing from the newer competitors in your core markets? And secondly, since you do price in U.S. dollars, can you quantify at all the impact you may have seen to pricing outside of the U.S.? Are there any kind of offsets to those that have had a more positive impact on pricing? So what have overall ASPs done?

Gil Shwed

First, I don't know many emerging, new competitors that we have in the marketplace. ASPs in general have been doing quite well and for the last two years ASPs have been trending up very very consistently and this quarter was no exception. You see it in several parameters, from the number of large deals, through (inaudible) we are checking about the specific ASP of which product line and each product sale. It's been trending up nicely.

As for sales all over the world, again, we are selling in this model for the last 17 years. All of our sales are in dollars except maybe Japan - one country. It's going well, and customers understand it, it's clear, it's transparent, with not much room for international arbitrage which technology customers know how to do these days very very well.

And clearly when there's currency changes between the Euro and the dollar that in a small way makes these customers' buying power slightly less. But again, with 16 years of experience I think our system is a very straightforward way and it's a very effective way. Our pricing structure is very transparent and it is very straightforward. Every one of you can go to the web site and check our price list and see that it's one, and simple, and straightforward. And it's the same when it goes with partners and so on.

Stephanie Withers

The FX impact to deferred revenue, is there any impact there? Is it held in dollars, or do you have to kind of translate that into other currencies and then mark to market.

Gil Shwed

No impact at all.

Tal Payne

There's no impact. Impact is the seasonality and I'll just remind that the deferred revenues do not include the product bookings.

Gil Shwed

Actually at the end of the quarter we had some product sales that we have achieved, but a shortage of product because of other reasons, we should not reflect that in the deferred revenues or in any financial metrics that we usually publish.

Operator

Our next question is coming from Sterling Auty of JPMorgan Chase.

Sterling Auty – JPMorgan Chase

If you said this I apologize. I got cut off. Can you talk about the linearity in the quarter and what you saw in the strength of business exiting the quarter.

Gil Shwed

It remains back-end loaded. It's much more back-end loaded today than it was 10 years ago but not very different than it was a year ago. The linearity is quite the same. We book between 50% to 60% of our sales in the last month of each quarter. Which stays the same. My challenge to the sales force has remained the same. It's still 30-30-60.

Sterling Auty

I just have a tough time reconciling the DSO sentence. Tal you mentioned that the DSOs for the last month have been stable for the last 2 years, yet you've had a dramatic improvement in (inaudible). I would have thought that that meant that the linearity made you a little bit less back-end loaded.

Tal Payne

No, it wasn't.

Sterling Auty

Okay, and then last question would be on deferred revenue. What impact are you seeing on deferred revenue patterns from the increase in product and appliance sales?

Tal Payne

Remember that the product revenue, the way it goes is we book it, you don't see the booking as part of the balance sheet. Whatever we ship is recognized as revenue we received that quarter and whatever we don't ship you don't see it and it's not part of the deferred revenue.

Gil Shwed

One part of the (inaudible) he is right about is the fact that our products today we do (inaudible) conservatively that are embedded in the product prices. So when we sell an appliance with an IDS (inaudible) which is most of our appliances, that does contribute a little bit to the deferred revenue, and that's the only impact. So if we did book a (inaudible) appliance and then ship it when (inaudible) doesn't have any effect on deferred revenue. That's the place where there is an affect or there is no affect.

Operator

Our next question is coming from Scott Zeller of Needham & Company.

Scott Zeller – Needham & Company

I may have missed it earlier, but was there any color on the strength of the lower end enterprise SMB spending. Are we seeing increasing strength there? And also competitively, I know there was a question about Cisco, but anything changing at all with 3Com or TippingPoint?

Gil Shwed

3Com and Tipping Point are more stand-alone IPS. I think we don't really compete in that marketplace. We are in the IPS market but we are much more into the integrated IPS so I can't say that we've seen much of TippingPoint, 3Com in our marketplace. In the small enterprise market I think we're doing okay but I think we can do much better. If I look at our segmentation of sales, anything that's more than 5,000 user enterprise, with more than 5,000 users, I think we are doing very very well. Enterprise with less than 5,000 users we are stable, we are growing, but I think we have huge untapped potential there that eventually we can do more of.

Scott Zeller

Actually I heard that caller earlier about how you feel there's more to do in the mid-market but I was wondering, just commentary about the recover of spending among those customers. Do you think that they are firming up with spending?

Gil Shwed

I think that these customers are actually doing okay. I think in most cases these customers, the smaller they are, the budgets are not very significant. Buying the product for $10,000 to $20,000 -- by the way we do have many new products and we've increased performance dramatically in that marketplace. We've launched sub-1,000 products that have gigabit performance and I think (inaudible) performance in the marketplace we've almost quadrupled the performance for most products under $20,000. We have a software update. All customers can get it. I think we are quite aggressive in terms of the products and we are seeing great results. The UTM-1 product family has produced phenomenal results in the last year. I still think that we can have many many more customers there and a big part of this is the economy, our own execution and focus, and I think I've mentioned that we can do more there and at the same time our sales people are producing very good results in the higher end accounts so there is no reason to complain.

Operator

Our last question is coming from Jonathan Ho of William Blair.

Jonathan Ho – William Blair

In terms of the new products on the software blade side, you guys have added a number of blades. Can you talk maybe about the sales and distribution channel strategy in terms of how you're incentivizing and educating the sales force, just to sell so many new products and maybe how comfortable and how mature the sales force is in upselling at this point.

Gil Shwed

I think the sales force is fairly comfortable with it. We are doing a lot of seminars. We are doing a lot of different programs which we do. In channel for example we come to every city with a group of experts. We sit with our sales force, with the channel sales force and do joint calls and joint account analysis on how to sell additional opportunities. We have a program for that which we are doing in many countries and many cities and it's very very successful. I think what we made selling the blades in a very simple way. The entry cost to selling a new product or a new functionality with the blades is very low. The simplicity of that is also very good. I think we made it easy to sell it.

Now what we need to convince and I think not to convince but to change the behavior is to show partners how much we can actually enlarge their business. And we are doing these metrics with them. We have many many metrics like that which we're showing them. Look at your (inaudible) partner. Look at your install base. Look at what we have. Look at what you're selling (inaudible) event analysis, IPS, two more things, you can generate 30% more sales. And it's straight, simple sales. It's not complicated sales. So I think it will take us some time until everybody upgrades to R-70 version and I feel everybody gets this message but as far as I can tell this message is being accepted in the marketplace quite nicely. No objections. It's very straightforward.

Jonathan Ho

And can you also give us a quick update on IPS and what you're seeing out there in terms of the renewal rates once they've gone through the free period?

Gil Shwed

It's a too early to say, but I think the growth in the IPS blade that we're selling is quite nice. It's 40% year-over-year in the last year so it's quite good.

Kip Meintzer

Thanks everybody for joining us on the call. We'll look forward to talking to you in the coming weeks.

So maybe I'll start. I haven't measured that and again my focus is always providing more value to customers rather than . . . the market share is the result not necessarily the main measure of what we do. My feeling based on the data that I'm seeing is that we're gaining share on the enterprise on the high end. I think there's a lot that we can do on the lower end of the market and I think we are producing good product and we need to get more traction and more focus from our own sales force and from the 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.

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Source: Check Point Software Technologies Q2 2010 Earnings Call Transcript
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