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A10 Networks, Inc. (NYSE:ATEN)

Q2 2014 Earnings Conference Call

July 30, 2014 4:30 PM ET

Executives

Maria Riley – IR

Lee Chen – Founder and CEO

Greg Straughn – CFO

Analysts

Mark Sue – RBC Capital

Nida Marshall – Morgan Stanley

Ray Smets – VP, Worldwide Sales

Tal Liani – Bank of America

Brent Bracelin – Pacific Crest Securities

Ehud Gelblum – Citi Investment Research

Rod Hall – JP Morgan

Operator

Good day and welcome to the A10 Networks’ Second Quarter 2014 Financial Results Conference Call. All lines have been muted to prevent background noise. Please note, today’s conference is being recorded. At the end of the call, there will be a question-and-answer session and instructions will be provided at that time.

And now, I would like to turn the conference over to Ms. Maria Riley. Please go ahead, ma’am.

Maria Riley

Thank you all for joining us today. I’m pleased to welcome you to A10 Networks’ second quarter 2014 financial results conference call. This call is being recorded and webcast live and may be accessed for 90 days via the A10 Networks website, www.a10networks.com.

Joining me today are A10’s Founder and CEO, Lee Chen; A10’s CFO, Greg Straughn; and our VP of Global Sales, Ray Smets.

Before we will begin, I would like to remind you that shortly after the market closed today, A10 Networks issued a press release announcing its second quarter 2014 financial results. Additionally, A10 published a presentation along with its prepared comments for this call and supplemental trended financial statements.

You may access the press release, presentation and prepared comments with trended financial statements on the investor relations section of the company’s website,

www.a10networks.com.

During the course of today’s call, management will make forward-looking statements, including statements regarding our projections for our third quarter operating results, our expectations for future revenue growth and the growth of our business in general.

These statements are based on current expectations and beliefs as of today, July 30, 2014. A10 disclaims any obligation to update information contained in these forward-looking statements whether as a result of new information, future events, or otherwise. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control that could cause actual results to differ materially.

For a more detailed description of these risks and uncertainties, please refer to our 10-Q filed on May 13th, 2014.

Please note that with the exception of revenue, financial measures discussed today are on a non-GAAP basis and have been adjusted to exclude certain charges. A reconciliation between GAAP and non-GAAP measures can be found in the press release issued today and on the trended quarterly financial statements posted on the company’s website.

We will provide our current expectations for the third quarter of 2014 on a non-GAAP basis. However, we will not make available a reconciliation of non-GAAP guidance measures to corresponding GAAP measures on a forward-looking basis due to high variability and low visibility with respect to the charges, which are excluded from these non-GAAP measures.

Before I turn the call over to Lee, I would like to note that management will attend the Pacific Crest Global Tech Leadership Forum on August 11th in Vail, Colorado, the Oppenheimer Technology, Internet & Communications Conference in Boston on August 13th, the Jefferies 2014 Semiconductors, Hardware & Communications Infrastructure Summit in Chicago on August 27th and the Citi Global Technology Conference in New York on September 4th. We are looking forward to seeing many of you there.

Now I would like to turn the call over to Lee Chen for his opening remarks. Lee?

Lee Chen

Thank you, Maria. I would like to thank you all for joining our second quarter financial result conference call.

We delivered second quarter revenue of $45.1 million, representing year-over-year growth of 50% and relatively in line with Q1 revenue. Outside of Japan, we delivered a strong quarter across all of our geographic regions including the U.S., EMEA and China, demonstrating the progress we have made in diversifying our customer base and market footprint.

However, total revenue came in slightly below our guidance of $46 million to $48 million due to lower than expected revenue from service providers in Japan as several large deals were pushed out. Enterprise sales in Japan grew nicely year-over-year and we believe our competitive position there remains very strong.

Our revenue in the U.S. was robust and grew 154% year-over-year and 44% over Q1 to reach $26.2 million, with healthy demand across both our service provider and the enterprise customers. We saw notable growth in the financial, federal government and Web 2.0 verticals. This brings our enterprise revenue growth to 64% for the six-month period over last year.

We believe our impressive performance in the U.S. is being driven in part by the rapid adoption of our recently launched high-end Thunder products with scalability and performance that we believe significantly outpaces our competitions. We are seeing more and more customers turn to A10’s high-end solutions as the amount of encrypted traffic increases driving the need for scalable SSL acceleration and intercept.

Additionally, we are seeing initial results from the investments we have made to expand our sales team and channel partner program. We have seen a healthy increase in the number of deals in our pipeline from both our sales teams and those initiated by the channel. We are pleased with the progress we have made in such a short period of time. We are now starting to roll out our new channel program into our international regions.

We expanded our market footprint in the quarter and added 240 new customers, largely representing our enterprise expansion. New customer acquisition is an important aspect of our future success given our land and expand model. As a reminder, our top 25 customers have made follow on purchases in over 80% of the quarters following the initial sales.

Let me share with you a few of our key customer engagements in the quarter.

A large U.S financial services firm and a retail financial institution in Europe both selected our Thunder ADC to replace their Cisco ACE equipment. Both of these companies are new A10 customers. We won the business from the U.S. firm in a competitive bake-off because of the ease of migration from ACE to A10; our simplified administration and management capabilities; our all-inclusive licensing models and our superior customer references and support.

We continued to expand our footprint within a large security technology company that is rearchitecting its data centers in North America. We have significantly increased our market share with this customer because of the simplicity and ease of deployment for our solution and all-inclusive licensing model. Specifically in the second quarter, they chose our recently introduced high-end Thunder model to load balancing their customer facing applications because of our superior SSL throughput.

A large U.S. cable provider where we have been replacing the competition’s equipment in this customer’s existing data centers, has selected our high end Thunder ADC for two of its new data centers for load balancing between its video servers and in-home equipment. Our ability to continue to help simplify their data centers, improve return on investment and our SSL performance in a 1 RU appliance were key factors in expanding our relationship with these marquee customers.

A leading U.S. based cloud storage company chose A10’s high-end Thunder ADC solution to replace their homegrown open source solution. We won this new customer because of our ability to scale, our layer 4, layer 7 throughput and our superior price performance. We are very excited by this win and believe it creates an opportunity for A10 to win future business with young web 2.0 customers that may be outgrowing their homegrown solutions.

We have also expanded our web 2.0 presence in Asia by leading gaming companies in China, Japan and Korea and a very large cloud storage company in China. These companies are choosing our Thunder ADC solution for its high reliability and high performance.

These are just a few of many customer success stories in the quarter that demonstrate the power of our differentiated application networking platform and all-inclusive licensing model.

Our application networking platform built on our ACOS software delivers an increased level of scalability and performance. We have continued to leverage our flexible platform to deliver new products, functionality and features to our customers. In April we launched the industry’s first 100 Gigabit Ethernet ADC for layer 4 to layer 7 services and we expanded our Thunder Series of appliances filling out our product portfolio with four new mid-range and high-end models.

In May, we formally launched TPS, our first standalone security solution for large scale DDoS protection. Our marquee customer for this product has already placed follow-on orders and we are very pleased with our traction and growing pipeline. We also recently announced the addition of integrated DDoS protection to our Thunder CGN product line. Given our ability to integrate this functionality quickly and deliver higher-performance solutions, our CGN solution was selected by a leading U.S. service provider with an urgent need to upgrade their CGN infrastructure due to a significant increase in DDoS attacks.

We also launched our new Thunder SPE, Security Policy Engine, line of high-speed, high-capacity application networking appliances that leverage specialized hardware to perform security and policy enforcement at ultra high speeds without impacting CPU usage.

Across our solution portfolio, we continue to gain industry recognition. In May, our Thunder TPS product line won two Best of the TechEd 2014 awards including the Breakthrough Technology category.

And in June at Interop Tokyo 2014, our Thunder CGN received the Best of Show Award in the Carrier and Service Provider Networking Category; and our A10 Thunder 6630, the industry’s first 100 Gigabit Ethernet ADC received the Best of Show Award in the ShowNet Product Category.

In closing, we are very excited by our growth in North America and the expansion of our footprint globally. Our innovative and differentiated platform continues to perform very well in the market as scalability, performance, flexibility and security are growing concerns for networks around the globe.

Given the superior price performance and flexibility of our application networking platform, our customer-friendly business model and our outstanding customer support, we believe our competitive position is very strong within all of our markets. With our growth initiatives and strategic plans on track, we are very excited by the momentum we see going into the back half of the year.

With that, I’d like to turn the call over to Greg to review the details of our second quarter financial performance and third quarter guidance. Greg.

Greg Straughn

Thank you, Lee. And thank all of you for joining us today. Second quarter revenue grew 50% year-over year to $45.1 million. Product revenue was $34.1 million, up 48% from the prior year and represented 76% of second quarter revenue. Service revenue was $11.0 million, up 56% year-over-year, representing 24% of revenue. As a reminder, nearly all of our service revenue is from ongoing maintenance and support contracts and grows as the installed base of product grows.

Our professional services revenue, while currently a small part of the total, grew significantly in Q2. Deferred revenue, which primarily consists of maintenance to be recognized in future periods, grew 50% year-over-year and 4% sequentially to a record $45.8 million.

The increased investments we have made in building our U.S. sales team and enhancing our channel enablement program are clearly paying off in our results this quarter. Revenue from the United States grew to $26.2 million, more than double the prior year second quarter and up 44% sequentially.

US revenue represented approximately 58% of second quarter revenue. Japan declined 27% year-over-year and represented 19% of total revenue, while APAC grew 24% year-over-year, representing 10% of revenue. EMEA revenue grew 20% year-over-year and represented approximately 9% of total revenue.

From a customer perspective, our revenue in the quarter has continued to diversify. Our top 10 customers represented 45% of total revenue and we had only one 10% customer, versus in the first quarter, 54% of our revenue was from our top 10 and we had three 10% or greater customers.

Our strong performance and expansion in the enterprise is helping drive this diversification. Revenue from enterprise customers was $27.4 million, up 37% from Q1 and 85% from Q2 of 2013. Enterprise revenue represented approximately 61% of total second quarter 2014 with the remaining 39% of revenue from service providers. While we expect our go-to-market investments to continue to drive growth in the enterprise vertical, we expect our vertical mix to continue to fluctuate from quarter to quarter.

Moving beyond revenue, all further metrics discussed on this call are on a non-GAAP basis, unless expressly stated otherwise. Second quarter total gross margin was 77.6%, within our expected range and in line with our historical trend. Comparatively, second quarter total gross margin increased 41 basis points from Q2 of ‘13 and decreased 64 basis points from Q1 of 14. Product gross margin was 78.3%, also in line with our historical trend of 77% to 80%. Services gross margin was 75.2%.

On the operations side, we are executing on our plan to build a deep foundation for A10’s growth. We are on track with our targeted investment plans and operating expenses were slightly below our expectations. We ended the quarter with staff of approximately 740. Over the past four quarters, we have expanded our sales and marketing team by 30%, and we have seen improved sales productivity metrics across our sales team.

Sales and marketing expense was $22.5 million, compared with $20.7 million in Q1. On a percentage basis, sales and marketing expense was 49.9% of revenue, a 469 basis point increase over Q1 of 14.

In Q2, R&D expense increased to $10.9 million or 24.2% of revenue, compared with $10.7 million and 23.5% in Q1.

Combined G&A and litigation expense was approximately $6.3 million or 13.9% of total revenue, compared with $6.9 million or 15.0% of revenue in Q1. In total, non-GAAP operating expenses were $39.7 million or 88.0% of revenue.

Second quarter non-GAAP operating loss was $4.7 million. Our non-GAAP net loss in the second quarter was within our guidance range at $5.3 million or $0.09 per share, compared with a net loss of $3.3 million or $0.06 per share in Q1. Basic and diluted weighted shares outstanding for the quarter were approximately $60 million shares.

GAAP net loss for the second quarter was $1.3 million or $0.02 per share, which includes a $7 million benefit to legal expense as a result of a negotiation that reduced a $12 million services fee to $5 million in exchange for a onetime cash payment.

Moving to the balance sheet, at June 30, 2014 we had $112.1 million in total cash and equivalents. During the quarter cash used for operations was $6.7 million, which largely reflects the $5 million one-time payment I just mentioned. We expect cash used in operations to decrease in Q3.

We ended Q2 with $40.5 million of net accounts receivable, up from the Q1 ‘14 balance of $38.8 million. Average days sales outstanding were 80 days, up from the 76 days in the prior quarter.

Moving on to our outlook, we entered the third quarter with a fall backlog, a growing pipeline and momentum driven by our standard sales reach in North America. These factors, balanced with the market dynamics we have seen in Japan we used [ph] to expect third quarter revenue to be in the range of $48 million to $50 million. In total, this represents 21% to 26% year-over-year growth and 6% to 11% sequential growth.

We expect to hold gross margin within our normal range of 77% to 78% and deliver a non-GAAP net loss between $0.07 and $0.09 per share using approximately 60 million shares on a basic and diluted basis. With that, I would like to open the call up for your questions. Operator?

Question-and-Answer Session

Operator

Thank you so much. (Operator instructions) We’ll take our first question from Mark Sue with RBC Capital.

Mark Sue – RBC Capital

Thank you. Gentlemen, in Japan, both of your competitors had year-over-year declines. But the drop that you saw, minus 27% seems to imply a reversal of the market shares you have gained in Japan in the past. So maybe a little bit more detail in the service provides; is it wireless, landline, market loss, competitor pricing changes, and how long you would think it would take to recover in Japan. If I look at it on the fiscal year point of view, Japan was about 45 million in the 12.5, 12 months. So how should we think about Japan this year in terms of your business and pace of recovery? Thank you.

Lee Chen

Yes, the mark – we are clearly at this point, we saw revenue performance in Japan this quarter; late in the quarter we saw a slowdown in spending from our service provider customer that delay and push out the planned purchases, consistent with others in the sector have reported. We were expecting Q2 revenue from services provided in Japan to be low in the very high Q1 performance, but it was significantly lower than what we have expected. Greg, you want to add any other?

Greg Straughn

Yes, hey, Mark. This is Greg. Our competitive position in Japan actually remains quite strong. We analyze our win rate in detail and, in fact, our win rate hasn’t changed. So we had not lost any significant deals to any competitors during the quarter and we think we’re actually in a good spot once growth comes back on line. In terms of market share, we’re still waiting to see what happens. We rely on third-party industry analyst to publish that data, but our win rate remains quite high and it’s above 70%.

Lee Chen

I think we have a very high market share among service provider in Japan. So it is fair to expect a slow has had a bigger impact on A10 than the others.

Mark Sue – RBC Capital

Okay. So, Lee, would you say it’s a couple of quarters of flattish trends from Japan before an improvement? Maybe just to how you’re planning your assumptions for Japan. And then the separate question is just on DDoS, how you hear that pipeline as it relates to the quarter [ph] and just interesting, some of your new security offers.

Lee Chen

I think we expect some of the deal to close in Q3 while others have been pushed out further. And we did a very thorough review of our pipeline and we are keeping our expectations very conservative at this moment. In terms of DDoS, I think, we are seeing a significant increase and the really tremendous pipeline. We also received a very positive feedback on the initial conversation and the PLC [ph] with the potential customers.

Mark Sue – RBC Capital

Okay. That’s helpful. Thank you and good luck, gentlemen.

Operator

Thanks. And next we’ll move on to James Fawcett with Morgan Stanley.

Nida Marshall – Morgan Stanley

This is Nida Marshall [ph] filling in for James. Quick question, if you could just speak for a moment about kind of general ADC trends and whether you were kind of seeing similar interest in ADC versus security. And second, just whether the Japan orders that were pushed out were CGnet or ADC.

Lee Chen

Yes, I think the general trend on the ADC remains very positive. If you exclude Japan, in all geographic region, we are seeing tremendous – we had tremendous growth in North America, in EMEA, in APAC. In North America, our growth rate over last year is about 454% [ph] year-over-year, APAC grew 24% year-over-year and the EMEA grew 20%.

In terms of DDoS, maybe, Ray, you can provide an initial pipeline and expecting –

Ray Smets

So, Nida [ph], just to get back to your question regarding Japan-related decline in either – or different products. Our service provider market in Japan combines both our CD and ADC products. So this slow down really has affected both products in that particular market. However, we just introduced our TPS product in the market including in Japan. And it’s a new product. It is getting traction and we certainly do expect this business to grow.

Nida Marshall – Morgan Stanley

Great. Thanks. That’s helpful.

Operator

And next we’ll move on Tal Liani with Bank of America.

Tal Liani – Bank of America

Yes, hi guys. A few things but it’s all the same topic. Your guidance for next quarter is even a tad higher than the consensus we had before. You missed the quarter and that means you expect even the stronger sequential growth than we expected before given that the guidance is nice. Where is this growth coming from? That’s number.

Number two. If I removed Japan, Japan was down 50% or so. If I removed Japan, the rest of your revenues are much higher than expected. And the question is again, same question, where is the strength coming from and how sustainable it is and what can you tell us about this part? Thanks.

Greg Straughn

Look, Tal, this is great. I’ll jump in first and then turn it over to Ray to add a little bit of color on some of the opportunities we’re dealing with. And I think the core question there is as we look at guidance how are we looking back and how do we have confidence in that number. And I think that as we’ve built up the guidance, we’ve applied the appropriate level of conservatism on Japan but also looked at each of our individual markets. And as you’ve noted, we saw a great deal of strength in all those other markets. And it’s driven by a lot of the dynamics that Lee had mentioned in the call on the continued adoption of our land and expand with our existing customer base as they move across products, our expectations of DDoS bring some revenue into Q3, not a great amount but we expect to see wins there that will be contributory.

And then, within the other markets that we have here, the sales productivity gains that we had plus the sales heads that we’ve added are contributing and then our channel expansion is another major factor there. So we feel like there are several different areas that contribute to the growth. We’re dependent upon any particular one. And then related to that, as we look at guidance as well, over the last year the range of business that we’re getting is much more diversified where a year ago Japan was nearly 48% of our revenue stream. This quarter growing 50% year-over-year, they’re down to 18%, 19%. So a much greater diversity both in the customers and the regions that are contributing to our growth numbers.

Ray, do you want to add anything to that, Ray.

Ray Smets

Sure, sure. Hey, Tal, just to add a little – additional color. In terms of what’s really driving the growth here, it’s coming from a couple of different areas, some which Gregg already mentioned. But the amount of encrypted traffic that we’re seeing is increasing which is driving the need for a scalable SSL, acceleration and intercept solution. And we’re in the right place at the right time to capitalize on that need with our high-end Thunder platform. So that’s been part of it.

Yes, absolutely, the Web 2.0 penetration continues to grow for us. We’re very excited about that as well as strengths in the financial industry sector. But Greg talks a little bit about our land and expand strategy, our existing customers continue to buy more products from us, both in the ADC space and also considering our TPC products at this point which is great.

But overall our formula and recipe is working pretty well, the expansion of our sales team into places where we’re putting them and our higher productivity because of the way we’re onboarding our sales team is actually driving that growth. And we continue to have very strong products in the market.

Tal Liani – Bank of America

Got it. Just a follow up on competition. Your competitor F5 is doing quite well for a few quarters now. And the question is – and Cisco is of course out of the market. You mentioned a few wins. They mentioned a few wins of the Cisco base. Overall, how do you see the competitive environment? How do you respond to F5 great efforts and successful efforts to grow in this almost the same areas that you’re targeting and have you had to change any of your pricing strategy or go-to-market strategy against F5 given their focus and kind of renewed momentum in their business? Thanks.

Ray Smets

Well, I guess I’ll take the competitive question first. We actually do see F5 as our most frequent competitor but our win rate actually remains quite high in North America exceeding 70% win rate which is great. We’re also seeing them across other global markets in Europe and Asia as well. Our revenue grew nicely across Asia and EMEA as you noticed. But we continue to win very strategic accounts against F5 in the marketplace.

So we’re really – or formula continues to work here. We’re putting a very good product in front of our customers. We’re leveraging that with a really solid sales team in all of the markets that we’re seeing our competitive profile very, very strong.

From a pricing perspective, we haven’t seen a big change in the marketplace regarding our competitive profile around their current pricing model. We have a very solid all-inclusive licensing model approach in the marketplace, which really puts us in a very strong position to win customer hearts and minds.

Lee Chen

I also do not believe we lost any significant deals to our competitor in Japan this quarter. I think lower than expected revenue is due to our service provider customer pushing out orders.

Tal Liani – Bank of America

Got it. Excellent. Thank you.

Operator

And next we’ll move on to Brent Bracelin of Pacific Crest Securities.

Brent Bracelin – Pacific Crest Securities

Thank you. Wanted to drill down obviously in Japan a little bit more. Obviously, outside of Japan things looked pretty healthy. Japan looks very, very weak here. If I look at the trend line over the last year, clearly, Japan and your largest customer in Japan has been down materially over the last year looking at ‘12 to ‘13 and now looking here over the last couple of quarters. So, I guess, my question is, how much of this is a timing issue? How much of this is tied to a change in spending at your largest customer in Japan, really trying to understand the trend line here that we saw over the last, let’s say, year and a half and then offsetting that with timing risk.

Greg Straughn

So, Brent, this is Greg. When you talk about a period that goes back 18 months, you’re capturing the later part of their very large spend on rebuilding their network and we were a great beneficiary of that in 2012 and that kind of tailed into the very beginning of ‘13. And since that time they’ve started to go through that, acquire, deploy, absorb cycle on a lot of that product.

And so in ‘13, we saw an expected step down in their spending relative to that high standard that they’ve set. As we’ve gone into these most recent quarters, what we’re seeing clearly is a lengthening of decision time wise, both from budgetary reasons and for things that are internal, we’re seeing things stretch out.

So when we look forward, we’re certainly not seeing a return to those levels of 2012 from a spending perspective. We had, I think, as we noted earlier, we had an expectation that this quarter was going to be a step down from the prior quarter and it just turned out to be a little bit more than that.

So what we’ve mostly seen is deal delay and I think that that’s something that been experienced in the market. When they come back, it’s a little harder to call. I think we all have some comments on that in a second but I think that the key thing for us is that as we track these customers we’re not seeing any change in their buying preferences or where the deals are going or the discounting that they’re requiring. It looks to be a time issue. Although we can’t – we’ll put an end date as to when this timing turns around.

Lee Chen

So, I mean, if you look at our revenue from Japan in 2013, Q1, Q2 of last year were our highest quarters of the years. In fact, Q1 and Q2 last year is more than double of what we saw in Q3, Q4 last years. That’s why when we do the quarter Q2 compared to last year’s Q2, the decline seem to be bigger.

Brent Bracelin – Pacific Crest Securities

That’s helpful color. And then I just wanted to follow up that with your assumptions and kind of what’s baked into this 9% sequential guide in the September quarter. Are you baking in the assumption that Japan snaps back meaningfully to similar level of spend you saw in Q1 or is the assumption that you’re baking in to the guide that Japan is flattish with this quarter.

Greg Straughn

So Q1 was a very large quarter for Japan, so there’s no scenario where it steps back to that level. So as we look out into Japan for – our main goal there is to be conservative and to take into account what we’re seeing in the market. So without being specific on the numbers there, we’re being very cautious on win and at what rate Japan returns.

Lee Chen

So our Q3 revenue expectation for Japan is very conservative at this moment.

Brent Bracelin – Pacific Crest Securities

Okay. Very helpful there. And then last question for me is really around the US business. Obviously this is the bright spot here more than doubling year-over-year. Obviously, your outlook if the assumption is Japan is conservative that that momentum continues sequentially here into the September quarter to get to your midpoint of the guide. Were there any large deals in the US that kind of drove that strength? Could you talk a little bit more about the breadth of orders you saw that drove this 100% plus growth in the US market and then talk a little bit about the pipeline and visibility into continued strength in the US market in the September quarter.

Greg Straughn

Okay, yes, and just let me start with the second part and I’ll turn right over Ray, is that, yes, we are expecting to see continue strength in North America. There’s a ton of potential net market. And just to correct one thing is that just from a guidance perspective we do expect Japan to be modestly up quarter over quarter from Q2 to Q3 so we’re not expecting further declines there, but we are being conservative even at that estimation.

So, Ray, you could talk about some of the things you’re seeing in North America.

Ray Smets

Yes, I mean, I think we talked about a little but I’ll go ahead and give you a broader perspective. We actually see very strong growth in North America, no doubt about it. You’re seeing the results of that now. We have a really strong growth plan in place to continue to further penetrate the ADC market, both on the service provider side and on the enterprise side and we’re seeing a very nice, strong uptick in business in the Web 2.0 and also in the financial sector.

So north America is running on all cylinders, and we’re going to buy that engine with our new product, our TPS product which we’ve introduced just recently and pipeline developments continues to happen quite nicely. So it’s a combination of having the right product, positioning the product very effectively and gaining some significant traction in various sectors in North America and we’re seeing that growth from that execution strategy.

Brent Bracelin – Pacific Crest Securities

Helpful color. Thank you.

Operator

(Operator instructions) We’ll move on to Ehud Gelblum with Citi Investment Research.

Ehud Gelblum – Citi Investment Research

Hey, guys, appreciate it. Thank you. A couple of question to keep digging in a little bit. First of all let me hit the OpEx side. Your headcount was up nearly 85 people namely in sales and how long we’ll take for those people to kick in. I’m guessing they’re practically all in the enterprise side, not the service provider side and I’m guessing mostly North America but if you can give us a sense as to when you think additionally you’ve had people kick in and what your thoughts are now as opposed to your hiring, with regards to your hiring expectations the next couple of quarters given what happened this quarter?

Greg Straughn

So first of all, I’ll just answer the last part of the question at first is we don’t expect anything that happened this quarter to alter our hiring plans going forward. We look at this as very positive and a sign that we should continue to invest in these markets that have contributed great growth.

From a sales force expectation perspective, we look at a six-month window when a sales rep kind of start to pay for themselves, just they’re kind of modest. They’re getting traction in their market, particularly if they’re in a new territory. And by a year out they should start contributing pretty significantly to the bottom line, and then they would continue their productivity growth out into – two, three years out, they’re still adding productivity to the business. And we see that both at the micro level when we look at individual reps and we see that at the macro level, because I kind of alluded to the increase that we’ve seen in sales productivity. And so as we look across our wholesale scores, the tenure of that group has continued to mature over time as the new ads kind of smaller percentage. So we think those dynamics continue to argue for investing in sales people, putting feet on the street and continuing to take market share, use that win rate that Ray alluded to earlier to our advantage, get more vacs [ph] on a direct sales force. And in parallel, we’ve continued to work on the channel side, so we got more channel partners who are increasing the feed on the street. They were out there for the benefit of A10 as well.

Ehud Gelblum – Citi Investment Research

Okay. Given the success that you’ve seen with these programs, do you have any different or have you thought about possibly having a different concept on your breakeven plan?

Greg Straughn

No, we’ve probably given –

Ehud Gelblum – Citi Investment Research

Perhaps [indiscernible] breakeven earlier.

Greg Straughn

No, I think that our basic model is still investing for the top line. And breakeven, it’s not that far away for us but we’re not giving specific guidance on when it’s going to happen. But it’s on our – it’s not three years out there. It’s on a closer horizon than that obviously.

Ehud Gelblum – Citi Investment Research

And you’re not concerned [ph] that you’re going to keep whatever [ph] was – I know we don’t know the end to this [ph], but in your own mind, you’re sticking to your current plan?

Greg Straughn

Correct, correct.

Ehud Gelblum – Citi Investment Research

Okay. Let’s talk about Japan for one quick second. Is it your impression that your largest customer in Japan as well as I guess some of the other business there pushed out the projects that you’re working on with you or is it your impression that the Japanese service providers are pausing or pushing out a lot of their business across a couple of different areas?

Ray Smets

Yes, it’s a good question. We didn’t really see any one particular issue that we could put our fingers on other than the fact, as Greg already talked to, is about around the availability of budget and the timing of the budget and rapidness of that change late in Q2.

So it was – I guess internal issues we probably associate with a broader market condition, associate with their own customer growth that drove it. But generally speaking, we saw as a timing issue.

Greg Straughn

I think the other thing to add to that is that we don’t believe it was unique to us because it was both in opportunities where we had existing relationships that were going forward as well as competitive transactions that were in the market where the decision dates got pushed out into future periods.

So we don’t think it’s a unique A10 scenario that was played out there but rather an industry one.

Ehud Gelblum – Citi Investment Research

Okay. I realize that there’s ways that different salespeople can help customers decide when they sort of should book revenue. But assuming Japan had done roughly what you thought it was going to do which is down a little bit, you would have – could easily have been a $52 million, $53 million quarter.

It’s unlikely to believe that you would have been that high. So I’m just trying to go back into the strength of America and was there anything that may have gone on in the Americas to drive that number possibly higher than it otherwise would have been that could possibly make the business a little bit more reliant on the U.S. than it otherwise would have been?

I mean if Japan had actually done roughly what it was supposed to do, I just find it hard to believe that the U.S. would have been as strong as it was. I’m just trying to understand, did something happen mid-quarter to make that happen or is it just kind of coincidence that – because it’s still of course a fairly good number, $45 million.

Greg Straughn

Yes.

Ehud Gelblum – Citi Investment Research

I’m sorry. So I’m just trying to understand the – just trying to put some takes as to Japan falls off an awful lot one quarter and the U.S. comes up an awful lot, practically offsetting it entirely. And I’m just trying to get a sense just to try and look forward as to what this could mean about the U.S. business going forward.

Greg Straughn

Yes –

Ehud Gelblum – Citi Investment Research

Or was it possible you shifted some more salespeople over that something like that could do as well?

Greg Straughn

And it’s not that we’re shifting salespeople. I think that we – if Japan had done their expected – expecting that, we would have had a modest beat [ph] to the guidance numbers that were out there.

Within North America, when this happened later out in the quarter, you can’t just replace a dollar for a dollar. But certainly, you just need to take your salespeople and you try to see what deals we can encourage into the quarter and what deals are not movable.

And so we certainly have that internal dialog. But I think the thing that’s important is that your customers are going to work on their own cadence. And if they need to buy something in Q3, they will buy it in Q3. So there’s a small bubble group of deals where you can perhaps influence how the customers view their timing.

And some of those we were able to encourage into Q2, some are in our backlog and that they’re booked, that they’re going to shift in the next quarter and some of those will just exist in Q3. So it’s not the case where you take a sales force and point them at a bunch of customers and say, grab all those things that we’re going to sell in July and make it happen in June.

Believe me, there were days when I was wishing that was the case. Within the last month, we saw that that’s not the way it works.

Ehud Gelblum – Citi Investment Research

Okay. Two more questions. One is at what point in the quarter did you realize that Japan was going to be as weak as it was?

Ray Smets

Yes, that was a – that’s a good question. It was late in the quarter for us. So for us, that’s in month three. So as Greg mentioned, if we have an earlier heads up in such a shift in spending in a particular market, we can usually react in other ways. This particular shift occurred quite late in the quarter.

Ehud Gelblum – Citi Investment Research

I’m guessing your linearity is roughly 20, 30, 50 service provider, was that the linearity in the quarter and the service provider linearity roughly the same or is that a little bit more linear?

Greg Straughn

Yes, actually, linearity in this quarter was very consistent with what we have seen in prior quarters without communicating directly on those numbers you’ve described. But there was nothing odd about linearity this quarter.

Ehud Gelblum – Citi Investment Research

Okay.

Lee Chen

So the [indiscernible] is very late in the quarter, there were deals we expect to close in the quarter. Late in the quarter, it got pushed out. So we did not expect that.

Ehud Gelblum – Citi Investment Research

Right. Great. Last thing, security I’m assuming you had practically zero negligible revenue this quarter on the new product. Is that true and what is in your guidance for next quarter?

Lee Chen

I assume you mean the TPS DDoS product.

Ehud Gelblum – Citi Investment Research

Right.

Lee Chen

So DDoS product, we did get the follow on order from one marquee customer with TPS. Other than that, that’s a little more deals. But it’s not mean for significant in this quarter but we do see tremendous interest and traction and pipeline in Q3 and Q4 for TPS.

Greg Straughn

Yes. I will add that we did receive a couple of eval unit orders in the quarter which is usually indicative – a very positive indication that a deal is eminent. But we are seeing very good development on the TPS pipeline. And this is global, not just any particular market, but we are positioning in all markets. And it is expected from that we will see some wins in Q3.

Lee Chen

Yes, and normally [ph] our Q3 pipeline is very strong.

Ehud Gelblum – Citi Investment Research

Okay. So TPS is in your Q3 guidance. Helpful.

Greg Straughn

Yes.

Ehud Gelblum – Citi Investment Research

Thank you very much.

Operator

And we’ll take our next Rod Hall with JP Morgan.

Rod Hall – JP Morgan

Yes, hi guys, thanks for taking my question. I just want to know – I hate to the dead horse so I’m going to be asking you a couple more questions about Japan and then I’ve got another question or two.

So I’m trying to quantify this, if you look at the 50% reduction quarter-over-quarter you’ve got $89 million worth of deviation from Q1. Last year, you were down like $1 million in Q2 over Q1. So I know, it sounds like maybe $7 million or $8 million of lost revenue, but I just wonder if you guys could help us understand if that’s in the ballpark of what pushed in Japan.

And then I also wanted to kind of talk a little bit, get you to talk a little bit about the sustainability of that. I think one of your comments earlier was you thought maybe that’s related to the service provider customer acquisition. If that’s the case, is this more of a macro issue that drags on and actually that revenue doesn’t come back? I mean could you just comment on what do you think the probability of that is? Thanks.

Greg Straughn

So coming at the first half of the question first on the decisiveness. So we kind of indicated that if Japan had come in as suspected that we would have had a slight beats the guidance range. And we have also indicated the Q2 last year was a very, very strong quarter for us. So the delta between Q2 last quarter last quarter or last year and Q2 this year would overstate the decisiveness there.

So we don’t want to talk about our internal plans and expectations by market. But it’s not as large as that map would take you to. I think on the second half of the second, I’ll hand that over to Ray to talk about what we’re seeing in market relative to trends and timing.

Ray Smets

Yes, I think your question is regarding the service provider segment and whether or not we’re going to see that go later or come back online. We actually do believe that the ADC and CGN business that we’re actively engaged in currently in that market will recover. We just don’t know when that will occur.

We’re going to track this carefully. We are watching what the others in the market are alluding to as well. And it’s a challenge to us like we weren’t the only ones being affected by this. Although, our penetration rate at service provider tends to be high, we may have felt if a little bit more than others.

We’re pretty confident at this point that the demand in our DDoS product will grow. And this problem is one that is becoming more urgent globally. And we think that that will happen actually with the service provider segment in Japan as well. So if you know the DDoS space disappearance [ph], it’s a problem that just never really goes away, but it just keeps getting bigger and bigger. And our DDoS litigation solution with our TPS product is actually a product that’s coming into the market kind of at the right time.

So we don’t think that the ADC and CGN business will be down forever. And our hope is that the DDoS opportunity with our TPS product line will be immune to that change.

Rod Hall – JP Morgan

Okay. And then just in terms of the – Greg, back to the qualification, is there a chunk of that revenue that went away that you have a pretty high confidence level coming back in Q3? I mean is it like – or do you – or is a lot of it sort of questionable and you’re waiting to see what the service providers tell you next?

Greg Straughn

I don’t think it’s questionable. I think the timelines for them are – what we’re really seeing is that the decision timelines are becoming longer. And they’re looking at new projects, they’re considering them, but it’s taking them longer to decide to press the go, no go buttons.

So what I don’t want to have us expect is that all the deals that we’re originally going to be in Q3 are now going to be added to the things that’s still out of Q2 so that we – so we can over expect, right?

So as we look at some of the things, we’ve added a level of analysis to deals that were going to be in Q3 and are open to the possibility that those may slip out a quarter as well. So we’re trying to modulate this. And it’s a very real time activity with these customers. I think that what we saw is that we were very close to customers through the quarter and their decision timelines changed at the end. Their plans changed.

So we’re – in staying close to them, we know which deals landed into Q3. We have a little higher certainty on those on the deals that were on Q3, but haven’t been evaluated and we haven’t gotten close to the end of the quarter which is all these decisions are made. We’re open to the possibility that those might shift as well. We’ve built that into the way we’ve defined our guidance.

Rod Hall – JP Morgan

Okay.

Greg Straughn

I wish I could –

Rod Hall – JP Morgan

And then I just – can you guys just comment on the services margins as well as those margins were up a long ways just maybe give us a little color on what happened there?

Greg Straughn

That’s a matter of our services organization kind of growing in and trying to see economies of scale as our service revenues grow. A lot of that is maintenance and service. And so there’s not a dollar for dollar add in the services, the maintenance and delivery product or the maintenance and support product as there is with the hardware product. So we’re able to leverage that a little bit more aggressively.

Rod Hall – JP Morgan

Okay, thanks.

Operator

And that is all the time we have for questions. And this will conclude today’s question-and-answer session. At this time, I would like to turn the conference back to Mr. Lee Chen for any additional or closing remarks.

Lee Chen

Thank you all of our shareholders for joining us today and for the panels for your support. We would also like to take this opportunity to thank all of our customers, partners and employees. We thank you for all your dedication, commitment and hard work that has helped A10, build A10 to improve the company it is today.

We are in a very strong position to continue all success and I have never been more excited about this opportunity ahead. Thank you and good day.

Operator

And this will conclude today’s conference. We thank you for your participation.

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