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Riverbed Technology (NASDAQ:RVBD)

Q2 2010 Earnings Call

July 22, 2010 5:30 pm ET

Executives

Jerry Kennelly - Co Founder, Executive Chairman, Chief Executive Officer, President and Member of Stock Option Committee

Renee Lyall - Director of IR

Eric Wolford - Senior Vice President of Business Development & Marketing

Randy Gottfried - Chief Financial Officer, Principal Accounting Officer and Senior Vice President of Business Services

Analysts

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc.

Scott Zeller - Needham & Company, LLC

John Slack - Citigroup Inc

Alex Henderson - Citigroup

Troy Jensen - Piper Jaffray Companies

John Marchetti - Morgan Stanley

Jess Lubert - Wells Fargo Securities, LLC

Ryan Hutchinson - Lazard Capital Markets LLC

Tim Long - BMO Capital Markets U.S.

Mark Sue - RBC Capital Markets Corporation

Jeffrey Kvaal - Barclays Capital

Daniel Ives - FBR Capital Markets & Co.

Jack Monti - UBS Investment Bank

Jason Ader - William Blair & Company L.L.C.

Min Park - Goldman Sachs Group Inc.

Operator

Good afternoon. My name is Pia, and I will the conference operator today. At this time, I would like to welcome everyone to the Riverbed Technology Second Quarter 2010 Financial Results Conference Call. [Operator Instructions] Thank you. At this time, I would like to turn the conference over Ms. Renee Lyall, Director of Investor Relations. Ma'am, you may begin.

Renee Lyall

Thank you. Good afternoon and thank you for joining us on today's conference call to discuss Riverbed's second quarter fiscal year 2010 results. I'm Renee Lyall, Riverbed's Director of Investor Relations. Joining me on the call today are Jerry Kennelly, Riverbed's President and CEO; Randy Gottfried, Chief Financial Officer; and Eric Wolford, Senior Vice President of Marketing and Business Development.

Before we begin, let me cover some administrative items. A press release detailing our second quarter financial results was distributed today at 1:05 p.m. Pacific Time via Businesswire. The press release is also available on our website at riverbed.com. This conference call is being webcast live via the Internet at riverbed.com/investors and will be archived on our website for the next 12 months.

The information the presenters discuss today will include forward-looking statements including, without limitation, statements about Riverbed’s current and future products and partner, our financial outlook, our sales pipeline and our competitive and market position. These forward-looking statements are only predictions and involve risks and uncertainties such that actual results may vary significantly. These risks are set forth in detail on our Form 10-Q for the quarter ended March 31, 2010. These forward-looking statements reflect beliefs, estimates and predictions as of the date of this call. Riverbed disclaims any obligation to update any forward-looking statements. Unless otherwise stated, financial information that we review on today’s conference call is presented on a non-GAAP basis. Non-GAAP net income excludes the impact of stock-based compensation, stock-based payroll expenses, amortization of acquired intangible assets, acquisition-related expenses and related income tax affects. Non-GAAP financial measures should be considered in addition to results prepared in accordance with GAAP, but not as a substitute for or superior to GAAP results. The most directly comparable GAAP information, reasons why management uses non-GAAP information and a reconciliation between non-GAAP and GAAP figures, is provided in our Q1 2010 press release which has been furnished to the SEC on Form 8-K today. Any future product, feature or related specification that may be referenced in today’s call are for informational purposes only and are not commitments to deliver any technology or enhancements. Riverbed reserves the right to modify or cancel future product plans at any time. I'd now like to turn the call over to Riverbed's President and CEO, Jerry Kennelly.

Jerry Kennelly

Thank you, Renee. Welcome, everyone, and thank you for joining us this afternoon. Riverbed is reporting a record-breaking quarter today, having achieved the highest revenue, operating profit and net income in our history. Revenue for the second quarter was $126.2 million, up 12% sequentially and up 38% compared to the second quarter of last year. Our year-over-year product revenue growth was 40%, the highest growth rate we have experienced in two years.

Our operating profit increased 31% over the previous quarter and doubled over the prior year to $30.5 million as we achieved operating margins of 24.2%. The strength of this quarter was broad-based. We experienced sequential and year-over-year growth in all major geographies with notable strength in EMEA. We also saw sales increase across most major industry verticals, with particular strength in healthcare, pharmaceutical, government and manufacturing.

We exited the quarter with more than 8,300 cumulative customers. New customer additions exceeded 500, and we now count 71 of the Forbes Global 100 as Riverbed customers with the vast majority of these customers still in the very early stages of their potential deployments.

Our second quarter results clearly demonstrate that WAN [wide area network] optimization continues to be a strategic priority as organizations consolidate and virtualize their IT infrastructure. Riverbed is in a very strong position of selling the market-leading technology that makes possible the vision of sharing enterprise resources across the wide area network.

If you think of the enterprise today and how it is evolving, the network is the heart of the IT infrastructure. Collaboration, file sharing, consolidation and its many forms, from VDI to cloud computing, require a high-performance, reliable and fully optimized wide area network. The enterprise WAN supports a heavy load that is only growing as companies embrace the cost savings or productivity gains achieved by leveraging virtualization, consolidation and collaborative applications such as SharePoint and others.

The WAN is the new LAN, and Riverbed's leading technology and products are what enable the network to support these IT initiatives. Our product reach extends beyond the remote office into the data center. We have seen strong uptick of our top-end appliance. We still have 7050 as the data center solution since its launch in February 2010, marking the most successful product launch in our history. We expect sales to continue to ramp in the second half of the year. During the second quarter, the 7050 was qualified to work with EMC SRDF/A for both their DMX and V-Max high-end Symmetrix products. And Riverbed was awarded the 2009 EMC Partner Solution Award offering of the year for Symmetrix.

Another important highlight of Q2 was the launch of RiOS 6.1. This new software release allows us to boast more industry firsts. With 6.1, Riverbed is the first WAN optimization vendor to offer optimizations for Lotus Note 8.5, Microsoft Exchange Server 2010, SharePoint 2010 and Microsoft Online Services for both Exchange and SharePoint. And 6.1 supports auto configuration and optimization for EMC SRDF/A at both the network and application layers and provides strong storage networking optimizations for Fiber Channel over IP traffic on the Brocade 7500 and Cisco MDS gateways. These unique optimizations further enhance our already unmatched competitive position. Riverbed continues to lead in technology innovation within our existing Steelhead appliance products and extensions of that product line.

During the quarter, we added five new supported partner modules to the Riverbed Services Platform, bringing the number of qualified solutions to 14. McAfee's Firewall Enterprise software and Vyatta's routing solution were available in April. In June, we added Hewlett-Packard's Client Automation software or HPCA, which helps reduce operational cost and improve quality of service by automating many tasks.

We qualified Microsoft's Forefront Threat Management Gateway, providing layers of protection from web-based attacks and malware outbreaks. And we added Polycom Video Edge delivered streaming media. The Polycom-Riverbed enterprise video solution captures and manages live and on-demand video, distributes Flash and Windows Media formats and reduces the impact of video bandwidth consumption over the WAN.

The Riverbed Services Platform is a real competitive ops advantage for Riverbed, allowing us to offer a customizable solution to our users and the ability for multiple services to be consolidated to the Steelhead appliance. RSP [Riverbed Services Platform] is the stepping stone to a complete branch office in a box solution that can combine more local services like routing, security and others on a single appliance to reduce footprints, capital and operating expenses.

Furthermore, today we announced the Virtual Steelhead. Virtual Steelhead extends the market reach for our technology. It enables customers to deploy Riverbed WAN optimization solutions in space-constrained, highly specialized or heavily virtualized environments. The Virtual Steelhead, a software-only WAN optimization solution, can be deployed on equipments such as harden military boxes or first responder gear, news vans, construction trailers. This product will begin shipping later this quarter.

In the coming quarters, we will bring to market our cloud storage acceleration product and a software-only version of our Steelhead appliance for public cloud deployment.

Before I turn the call to Randy, I want to provide an update on our transition to a two-tier sales model in North America. Through the second quarter, we successfully migrated the majority of our North American VARs [value added resellers] to value added distribution. We are already beginning to see the positive impact of this shift in our operating activities. With more business flowing to the VADs [value added distributors], our sales force is better able to focus on key account management and closing business. In addition, we are beginning to see efficiencies that will benefit both our P&L and balance sheet.

Looking forward, we are working with Arrow and Avnet to strategically target new VARs whose business is concentrated in storage, networking and virtualization to resell Riverbed's products. As a whole, we feel very positive about our current position and the outlook for the future. We are the market leader by all measures in an under-penetrated and extending market.

Exiting the first half of 2010, we are poised to exceed our gross rate achieved in 2009, a period in which our relative growth outpaced most technology peers. I will now turn the call over to Randy to review the financials and provide guidance for our third quarter.

Randy Gottfried

Thanks, Jerry. As a reminder, unless stated otherwise, the numbers I'll discuss today are non-GAAP. For your reference, in addition to the reconciliation included in the press release, we posted the supplemental reconciliation of non-GAAP financial measures to the directly comparable GAAP measures on the Investor Relations portion of our website.

As Jerry said earlier, Q2 was a record-breaking quarter for Riverbed. Revenue increased 12% sequentially and 38% year-over-year. This quarter, we posted the strongest sequential growth rate for the company since the fourth quarter of 2007. Second quarter product revenue increased 13% over the first quarter and 40% over the prior year to $84.5 million. This is our fourth consecutive quarter of accelerating product revenue growth. 95% of our product revenue was generated by Steelhead and related products, with Cascade contributing 5% to the product revenue. Inclusive of services, Cascade's total revenue contribution was $6.4 million.

Sales of both our remote office and data center appliances increased in the second quarter, and we experienced exceptional growth in our data center line, led by the newly launched Steelhead 7050. Second quarter service revenue grew 11% sequentially and 33% year-over-year to $41.7 million. The majority of our service revenue is from maintenance contracts with a small contribution from professional services.

Turning to channels, in Q2, 94% of our revenue came from indirect channels with the remaining 6% coming from direct sales. We transitioned much of our North American VAR business to distribution in the second quarter, and Arrow represented just over 10% of revenue in the period. Sales tied to our systems integrator and service provider partners grew both sequentially and year-over-year and represented about a third of our revenue.

As a reminder, Riverbed recognizes revenue on sell-through basis with our list of channel. We saw a sequential and year-over-year growth in every major geography during the second quarter. Sales in the U.S. grew 9% sequentially and 27% over the prior year. EMEA grew 17% quarter-on-quarter and 48% year-on-year. Revenue in rest of world increased 13% sequentially and 56% year-over-year. As a percentage of total revenues, U.S. represented 51%; EMEA, 29%; and rest of world, 20%. Overall, our business remains very well diversified across all major industry sectors.

Shifting to cost and expenses, gross margins were up moderately on a sequential basis in the second quarter at 77.3%. Product gross margin was 79%, and service gross margin came in at 73.7%. Total operating expenses were $67 million, up about 6% compared to the first quarter. Operating profit increased 31% over the previous quarter and 99% over the prior year to $30.5 million.

Operating margin for the quarter was 24.2%, up from 20.8% in the first quarter and 16.7% one year ago. The strong uptick in operating margin this quarter illustrates the significant leverage in our operating model. We exited the second quarter with 1,102 employees, an increase of 34 compared to Q1.

The tax rate for the quarter was 37%. Net income was $19.2 million or $0.25 per diluted share. Net income increased 30% sequentially and 87% year-over-year.

Moving to the balance sheet and cash flows, Riverbed ended the June quarter with cash and investments of or $422.1 million, an increase of almost $35 million over the balance at March 31 and an increase of $153 million over the last year. We continue to have no debt.

Cash flow from operations was $20.8 million compared to $50.4 million in the first quarter and $8.2 million in the year-ago period. Stong collections resulted in Q2 day sales outstanding of 32 days compared to 34 days in the first quarter. Good linearity and a shift to two-tier distribution in North America also have contributed to this improvement.

As planned, our inventory balance increased to $9.9 million compared to $6.7 million in the first quarter due to the replenishment of finished goods. Total deferred revenue was $102 million, up 46% year-over-year and 1% compared to the first quarter.

Let me shift to our third quarter outlook. Our third quarter guidance is non-GAAP. We expect 29% to 33% year-over-year revenue growth, with total revenue of approximately $132 million to $136 million. Gross margins are expected to be within our targeted 76% to 78% range and roughly flat with Q2. We're planning for operating expenses between $70 million and $72 million. We're targeting a tax rate of 37%, which assumes the R&D tax credit is not renewed. This results in forecasted earnings per share of about $0.27 based on about 78 million diluted shares outstanding. I'll now turn the call back over to Jerry for his closing comments.

Jerry Kennelly

Thank you, Randy. The second quarter was one of significant achievements for Riverbed. From our financial results to our product enhancements and future product plans, we continue to lead by all measures. We were also awarded another honor in the quarter. Riverbed was recognized by the San Francisco Business Times as one of the 2010 best places to work in the Bay Area. We recognize that our value as a company and the results we are able to achieve are attributable to our employees, so thanks to the Riverbed team for a job well done.

We are proud of what we have accomplished and even more excited about what lies ahead. With that said, Eric, Randy and I would now be happy to answer your questions. I will go to our operator. Pia, let's start the questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question will come from Troy Jensen with Piper Jaffray.

Troy Jensen - Piper Jaffray Companies

I wonder if you could touch quickly maybe on federal expectations going into Q3. I think that last year you guys had a very good September quarter in the fed verticals. Just curious what you see in there.

Jerry Kennelly

Yes, we expect a very decent quarter in Q3 for federal. We're not depending on an extraordinary quarter, but we did well in Q2. There's a strong pipeline. Actually, I just came from all the U.S. formal reviews, including federal, and it's a very upbeat group. And that number's baked into our guidance.

Troy Jensen - Piper Jaffray Companies

And then I guess maybe for Randy, EMEA was up pretty strong this quarter here. Was that broad-based strength, or was there just a few big deals that kind of boosted the numbers there?

Randy Gottfried

It was broad-based strength. EMEA, just a reminder, includes Europe, Middle East, Africa. Historically, we've been stronger Northern Europe, and that's where a lot of the revenues has come from. But really across the board, in the most part we've done, we've done pretty well.

Operator

The next question will come from Min Park with Goldman Sachs.

Min Park - Goldman Sachs Group Inc.

Just following up on the question on the government side, you noted particularly a strength in the government vertical this quarter. I was just wondering if you're seeing any impact from all sturdy measures, particularly EMEA kicking in, and to what extent that may impact your momentum in the vertical in the back half of the year?

Jerry Kennelly

No, we haven't seen that. We read that in the newspapers like everyone else. And we've been looking for it, but our pipeline's strong. Our product is a productivity tool and cost-savings tool for everyone and particularly for government departments, and it continues to be one of our top four verticals. And we're pretty optimistic. But we don't need a gigantic government quarter, we just need a normal government quarter because the Commercial business is strong. But we're expecting a good normal Q3 government quarter, frankly.

Operator

The next question will come from Tim Long with Bank of Montréal.

Tim Long - BMO Capital Markets U.S.

Jerry, could you just touch on the data center? Obviously, you highlighted that as one of the real areas of strength. What inning would you say you are with your major customers, specifically with the 7050 and in the data center? And then Jerry, if you could just touch on gross margins pumping up against the middle top end of your range, what are some of the puts and takes that could help you grow the gross margin a little bit more here?

Jerry Kennelly

Sure. So in general, in the main area altogether, we're in any inning two. Data Fact [ph], they were probably in inning one. It's still early stages. If you understand our architecture and technology, you have a WAN at either end. One in the data centers and then one that connects to the remote office. And so our data center has always been a part of our offering. Our new bigger, more powerful boxes combined with the market trend for denser data centers and more virtualization, more consolidation in the onset of cloud computing plays perfectly into our strength. And we expect the data center to grow probably as fast, if not faster, than our branch office offering. And so we're very optimistic about it. The response has been tremendous. People love that big box. So we feel good about that, and we think we'll take a stronger position and back up a data recovery, which is a sort of a side market in data center. And we're going to ride the consolidation data center [indiscernible] wave that takes us into 2010, 2011, 2012. It's going to be huge for us. Then I'll let Randy talk about margins.

Randy Gottfried

Sure. So gross margins came out a little bit better than we expected in the second quarter. What we saw was, we did have a little bit of a head transitioning to two-tier distribution in the U.S. But more than making up for that, ducktailing with Jerry's comments, is some of the strength in our data center boxes. So we benefited from some product mix shift or strength in the data center side which helped our overall margin profile. You asked also looking forward. We've set for some time our targeted gross margin range is 76% to 78%. We're in the middle to a little bit higher of that range now. As we look forward, the sum of where we end up depends on the strength of some of the software offerings where we come out. So we're actually excited about those new software products. And in the sense they really take off and become a bigger proportion, maybe there's some upside to that gross margin target we've talked about.

Operator

The next question will come from Jason Ader with William Blair.

Jason Ader - William Blair & Company L.L.C.

First, Randy, can you talk about where the operating margins might go to over the next, let's say, a couple of years with Riverbed? You had 24% today, your gross margins are very high. Companies with gross margin in the range of 80% where you are can certainly be 30%-type of operating margin companies at some point. And the second question, maybe for Eric. Eric, can you talk about your cloud storage accelerator and the timing of a potential product there?

Randy Gottfried

I'll take that first question. In general, we've been working a long time for five years of shipping to get to our long-term target which is mid-twenties. The guidance that we gave implies roughly at 25% operating margin. So, yes, we're very pleased at the leverage we're seeing in the business today. There may be some upside to the model as we go forward. Right now, we're going to see how the business goes over next couple of quarters, and we'll talk more about a longer-term model maybe later in the year.

Eric Wolford

And Jason, this is Eric. Yes, the Cloud Storage Acceleration product is on track. We are entering into the alpha testing phase with a set of customers. So far, the tests have gone pretty well. And so we can see that, that product will be coming out in the next few quarters.

Operator

The next question will come from Jeff Kvaal with Barclays Capital.

Jeffrey Kvaal - Barclays Capital

I was wondering if you two might comment a bit on the deferred revenue. It's flattish this quarter versus nice increases in the prior. What should we attribute that to? And then, should we expect deferred revenue to be up again in subsequent quarters?

Randy Gottfried

Sure. This is Randy, I'll answer that one. Deferred revenue did grow a little more slowly than it had in the last couple of quarters. As you know, most of our deferred revenue are support contracts. And in the quarter, deferred service revenue grew about $3 million over the prior quarter, which is probably the smallest number we've seen in a while. What we have seen is a bit of a dynamic where some of our bigger customers who are often buying products and getting support contracts multiple times throughout the year are synchronizing a lot of their renewals around year end. And so we saw, around Q4, Q1 was sort of an abnormally high spike in deferred service revenue. And in Q2, we saw some lower numbers, and we think some of that's just a shift of revenue, a bit more seasonality. And I won't be surprised to see that again as we go into this year end as well. A smaller portion of our deferred revenue are products. So product deferred revenue was down about $2 million in Q2. There are a lot of ins and outs on products deferred. Two of the biggest drivers for why it declined in Q2 were: One, we had some contracts that had acceptance criteria. Those acceptance criteria were met in the second quarter, so therefore we recognized the revenue and took it out of deferred. And also another piece of that, which is often a good chunk of the change in deferred is, we have some stocking of our product outside the U.S. with some distribution. We only recognize revenue on sell through in the channel. So when end users finally buy the product, we take it out of the deferred and recognize it as revenue, which is when deferred product goes down in that respect, it's a good thing. So it isn't overall dynamics.

Jeffrey Kvaal - Barclays Capital

Should we expect deferred to head back in the right direction then over the next few quarters?

Randy Gottfried

Well, we expect it to continue to grow, yes.

Jeffrey Kvaal - Barclays Capital

And do you think the synchronization around year end is something that applies to you specifically, or it that something that we should hear from other vendors?

Randy Gottfried

Well, it depends on the nature of other vendor's business model. We find that we have a lot of customers who have bought hundreds and hundreds of units over time. And for them, for some of their larger support relationships, they want to co-terminate all the contracts at once. It makes it easier for them to do their planning, and so they do all their renewals around year end. So that's not all customers, but it was enough for us to make a difference. If you recall, and looking at our numbers, Q2 was an abnormally big spike in service deferred, Q4 was also a relatively big number as well.

Operator

The next question will come from Alex Henderson with Miller Tabak.

Alex Henderson - Citigroup

I was wondering if you'd talk a little bit about your service provider end market, how you did relative to that segment and what you see the relative strength is over the next several quarters. Is that expanse?

Jerry Kennelly

Yes, the service provider grew. Actually, it's pretty like just the way we wanted when we started that investment in a couple of years ago. And what we're finding, I think we mentioned that we're up to 71 of the Global 100 customers now. The big global customers like to buy their Steelheads through big global service providers, either just as purchase or through a managed servicer, and that only it is more true. And as we get to more larger deals with some of the bigger companies in the world, but we expect the service provider to continue be a very important channel for us. And it's really a key element of our future. And we have all the major ones signed up now, and that program is running very well.

Alex Henderson - Citigroup

Did you offer a percentage of revenues through that channel?

Jerry Kennelly

Yes, we did. A third.

Operator

[Operator Instructions] The next question will come from Daniel Ives with FBR Capital Markets.

Daniel Ives - FBR Capital Markets & Co.

In terms of larger deals, was there any significant change in terms of the velocity of deals in your called seven-figure range?

Randy Gottfried

It's not a big change. The vast majority of our transactions continue to be under $100,000 with a handful of a sort of $1 million-plus transactions every period.

Daniel Ives - FBR Capital Markets & Co.

And then just from a high level, Jerry, as you've been going around to customers across the globe, is there any sort of change in buying behaviors, maybe just more of an inclination to go with Riverbed or WAN optimization or not as much fence-sitting? Or is there a change that you're starting to detect out there in the market?

Jerry Kennelly

Absolutely. I think the sell cycles there -- surely in a bit -- in the market it's started some little bit of maturation. This is our seventh year where we're selling the product. And there are people that have been kind of sitting on the sidelines for the first four or five years, looking at the domain and trying to figure out, is it a flash in the pen or is it permanent value? And I think the answer's coming back permanent value. And they're getting that answers the same time where our technical lead is never been clearer to the market place. So I think sell cycle are shortening, I think ultimate deployments on their way to be bigger. We've seen some nice sites, first purchases. I think Randy was right, deal size -- plus in a certain range, I would say it's inching up. It's the way I would say it. So it's great to come out of the world recession in the lead position in the domain that's been accepted, which is more than just acceptable, it's actually turning in to be the key technology for all the IT trends coming up whether it be consolidation or just with cloud computing, which is kind of like a free train. So I just feel great about the position we're in.

Operator

[Operator Instructions] The next question will come from Jess Lubert with Wells Fargo Securities.

Jess Lubert - Wells Fargo Securities, LLC

First, what was federal as a percent of product sales? Did you give that?

Randy Gottfried

We didn't give federal, specifically. But government as a vertical, which also includes state, local and non-US, was in the mid-teens.

Jess Lubert - Wells Fargo Securities, LLC

And then on the expense side, R&D has historically been around 13% to 14% of sales. It's now been below 13% for three consecutive quarters. Do you still see leverage on the R&D line, or should we expect that to tick up? And then with regards to selling and marketing, your 25% operating margin guidance seems to imply levels below your longer-term target of 35% of sales. Where do you think this could go as a percentage of sales, longer term?

Randy Gottfried

If you think about the model in general -- we'll start in R&D, as you did. R&D, we continue to hire aggressively. But the revenue, frankly, has been growing faster than we've been spending. But I do think that 13%-ish of our revenue to R&D is about right for us. Technical leadership is a big deal, and we plan to maintain that. We do think that as we think about leverage in other parts of the business, there's maybe some opportunities. Sales and marketing, we've invested a lot, really, over the past few years in partner support, in enhancing coverage and doing all the things to get more efficiency and, basically, more revenue growth. Our G&A with scale, we think there's definitely a little bit more room on that line as well. But we're basically at our long-term model right now with maybe some tweaks between the lines.

Jess Lubert - Wells Fargo Securities, LLC

So it'd be fair to assume that R&D may tick up in coming quarters with leverage coming from selling and marketing and G&A?

Randy Gottfried

Yes.

Operator

The next question will come from Ryan Hutchinson with Lazard Capital.

Ryan Hutchinson - Lazard Capital Markets LLC

Going back to Troy's question, is it fair to assume that the government as a whole won't be at the levels that it was last year at 29% and it will be made up in other verticals?

Jerry Kennelly

We expect a more normal government to Q3 and that -- yes, exactly. The commercial verticals will take up the difference.

Ryan Hutchinson - Lazard Capital Markets LLC

And then the question is for Eric. Just on the WAAS release that's out, 4.2, can you speak to any new features, capabilities, et cetera, that potentially could impact you? Or is it sort of the same status there with your key competitor?

Eric Wolford

Ryan, I can only talk to our experience with it, and so we obviously ran against it this quarter. Our win rate versus Cisco was actually higher than it's been in a while. From our competitive position, it doesn't feel like there is a big dramatic change. Some of the same fundamental challenges and problems that existed before still exist. So it feels more like an incremental change rather than a major change.

Operator

The next question will come from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets Corporation

Randy, will product deferred revenues be up at the end of third quarter, if you had to guess? And the spike in inventories, was that mostly finished goods? And then Jerry, data centers, any thoughts of what that might be as a percentage of sales by the end of the year?

Randy Gottfried

Sure, I'll take the numbers questions. But on product deferred revenue, I'll remind everybody, it's a pretty small number, and there's a variety of ins and outs on that. Over the past 10 quarters, it flipped five or six times in both directions. It depends on what's going on. Again, if they sell through the channel, if there's any kind of revenue issues that we have to flow in and out of deferreds. So I wouldn't necessarily forecast one way or the other in Q3. The other question you had was on...

Jerry Kennelly

Yes, we don't forecast. I'd say the direction is positive in data center, but we don't forecast or guide by specific segment like that.

Mark Sue - RBC Capital Markets Corporation

And nothing in the inventories that...

Randy Gottfried

I'm sorry, inventory were basically -- last quarter it was abnormally low. I mean, I view the increase as good news in Q3 where we're consciously trying to rebuild and replenish our finished goods inventory. And I think we did that pretty successfully in the second quarter.

Operator

The next question will come from John Marchetti with Cowen and Company.

John Marchetti - Morgan Stanley

You mentioned in response to one of the gross margin questions that you took a little bit of a hit this quarter from the two-tier model, but you talk about getting some efficiencies, longer term and all that. Can you just sort of balance those out a little bit, Randy, just so we'd get a better sense of -- ultimately as you move into two tier, you don't kind of "wow" of what the ultimate impact would be on the model and whether or not, I guess longer term, you guys would expect to roll that model out beyond the North American market?

Jerry Kennelly

As you recall and prior to the second quarter, most of our U.S. business flowed through single-tier VARs. When we added another layer into the channel, they took some points. And so therefore there was a bit of immediate hit on the gross margins. But you do that for a purpose. And for us, the first priority is just to get revenue growth. And we think we get better reach, better sort of overall caring and feeding of the VAR channel with the help of our VAR partners. But you also get some efficiencies. So one of the things we'd even start to see now but longer term we think are meaningful are just overall efficiencies of managing and caring for hundreds of VAR partners throughout the region. So you see that in the SG&A line, you also see that a lot in the sales and marketing line where our people in the field are spending more time with end users dealing with transactions rather that some of the administration and overall sort of partner caring that you'd have to do otherwise. Outside the U.S., I'll remind you that a lot of our business already had two tier, more regional two tier, around the world. So it's not necessarily something we'd -- it was more like we transitioned the U.S. to look more like a lot of our business outside the U.S.

Operator

The next question will come from Nikos Theodosopoulos from UBS.

Jack Monti - UBS Investment Bank

This is Jack Monti in for Nikos. Just curious on the regional growth challenge. Rest of world has been leading growth. I was just curious if there's anything in particular, initiatives the company is undertaking that's driving that growth. You to kind of dominated the general pipeline in the region if we can expect this to continue.

Jerry Kennelly

It's a good question. Actually, the classic distribution in tech industry is 45% to 50%, U.S.; 50% to 55%, rest of the world. And so it was always our expectation and hope, frankly, that outside U.S. will grow a little faster than the U.S. for being dipped to the that more profit distribution. And in fact, that's happening. And we have said the emerging markets in Asia, EMEA, includes not only Europe but also the Middle East and Africa. And we're fairly well in trends now down in Brazil and Argentina and Mexico. So we're out there looking for the growth. Where we're going is what's classic for a more mature tech company, and we'll keep doing it.

Operator

The next question will come from John Slack with Citigroup.

John Slack - Citigroup Inc

I was wondering if you'd give a little color on the RSP platform, maybe any sort of a customer traction metrics or kind of what you guys view as a revenue upgrade. You've laid out some of the partners in the prepared comments, but what about from the other end of the perspective?

Randy Gottfried

Yes, sure. It continues to be an important part of our competitiveness. Our sales force loves it, our customers love it. It's a great way for them to continue that trend of consolidation. And instead of consolidation to a data center, it's now consolidation of boxes within our remote sites. It continues to be at about 20% of our remote office boxes, Microsoft and various Windows-based functions continue to be the top driver, although we're seeing more interest in video and firewalls starting to pick up a bit. But the big thing is that our customers want to consolidate. Our sales people know it, that uniqueness that Riverbed has, and so it helps us to sell more Steelhead.

Operator

The next question will come from with Rohit Chopra with Wedbush Securities.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc.

This is Sanjiv for Rohit Chopra. In light of the slowing deferred revenue growth this quarter, I wonder if you could comment whether book to bill was above one. And then on the press release we saw, you called out, Verizon, a managed WAN optimization relationship. Could you talk about that opportunity for management services and what it could do to both the top line and maybe margins?

Randy Gottfried

Sure. I'll start with the first part and then hand it off for the second. This is Randy. On book to bill, we don't call out that metric. I will say we also have very strong quarter. And as we look at the pipeline for the second half of the year, we remain very optimistic.

Eric Wolford

And now with regard to Verizon, yes, Verizon is a more recent announced partnership between Riverbed and the service provider. They're obviously a very large service provider, and we're very enthusiastic about the opportunity that we can collect together. I think Jerry already covered the fact that service providers are key for us, both now and looking to the future, because that's the way big customers like to buy. And so Verizon is a major global player and one that has their own set of relationships and customers, and we can see a lot of opportunity in partnering with them.

Operator

Ladies and gentlemen, we do have time for one final question. And that question will come from Scott Zeller with Needham & Company.

Scott Zeller - Needham & Company, LLC

When you look at the opportunity in EMEA, which performed well, how would do you characterize the maturity of projects that are going on over on the continent? Would you say that the way we have in the U.S., the data center refresh cycle private cloud buildout? How would you compare the opportunity and maturity of the U.S. project versus that in EMEA? Are we early in EMEA, for instance?

Jerry Kennelly

No, I wouldn't say we're early. The EMEA IT, for the visionaries and architects with CIOs are every bit as advanced as the U.S. if not even more forward-looking. And so a lot of our success in EMEA early and all along has been the biggest companies in Europe. And they're all focused on consolidation, they're all looking at cloud, they're all looking at efficiency. They're very driven, and they like cutting edge. I think they like the futuristic stuff, so it's easy. We have almost more CIO-level access in EMEA because those guys are really forward-looking. So it's a good opportunity for us there. As Randy said, Northern and Central Europe has been our strength. It always has been. We're just starting in Southern Europe, but that's more incidental. But we expect that to develop over time as well, but the EMEA opportunity is significant.

Renee Lyall

Thank you again for joining us today, everyone. During the third quarter, we will be participating in the Canaccord Genuity and Oppenheimer conferences in Boston in mid-August and the Think Equity conference in New York in September. We always welcome investors to call or visit us at our headquarters in San Francisco. Our next quarterly conference call to discuss our third quarter fiscal year 2010 results will be on Thursday, October 21. If you have any questions about this call or Riverbed in general, please contact Investor Relations. Have a good evening.

Operator

Ladies and gentlemen, thank you for participating in today's conference call. You may now disconnect.

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Source: Riverbed Technology Q2 2010 Earnings Call Transcript
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