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BMC Software (NASDAQ:BMC)

Q3 2011 Earnings Call

February 02, 2011 5:00 pm ET

Executives

Derrick Vializ - Vice President of Investor Relations

Stephen Solcher - Chief Financial Officer and Senior Vice President

Robert Beauchamp - Chairman, Chief Executive Officer and President

Analysts

Derek Bingham - Goldman Sachs Group Inc.

Yun Kim - Gleacher & Company, Inc.

Matthew Hedberg - RBC Capital Markets, LLC

Aaron Schwartz - MKM Partners LLC

James Wood - Susquehanna Financial Group, LLLP

Philip Winslow - Crédit Suisse AG

Walter Pritchard - Citigroup Inc

Tim Klasell - Stifel, Nicolaus & Co., Inc.

Israel Hernandez - Barclays Capital

Michael Turits - Raymond James & Associates

Gregg Moskowitz - Cowen and Company, LLC

Operator

Good day, everyone. Welcome to today's BMC Software Third Quarter Fiscal Year 2011 Earnings Results Conference Call. At this time, for opening remarks, I'd like to turn things over to Mr. Derrick Vializ. Please go ahead, Derrick.

Derrick Vializ

Good afternoon, everyone. I'm Derrick Vializ, Vice President of Investor Relations, and I would like to thank you for joining us today. During our call, Bob Beauchamp, our Chairman and CEO, will provide an overview of the third quarter performance of our company and business units and update you on recent initiatives. After that, Steve Solcher, our CFO, will provide additional financial and operational details. Bob will then provide an update on our expectations for fiscal 2011 before we open the call to questions.

These prepared comments were previously recorded. This call is being webcast and a complete record of the call will be made and posted to our website. In addition to today's earnings press release, we have posted a presentation, which we will refer to at various times during the call. Both of these documents are available on our Investor Relations website at investors.bmc.com.

Before we continue, I would like to remind you that statements in this discussion, including statements made during the question-and-answer session, regarding BMC's future financial and operating results, the development of and demand for BMC's products, BMC's operating strategies, acquisitions and other statements that are not statements of historical fact are considered forward-looking statements.

These statements are subject to numerous important factors, risks and uncertainties, which could cause actual results to differ from the results implied by these or any other forward-looking statements. Cautionary statements relative to these forward-looking statements and BMC's operating results are described in today's earnings press release and in our annual report on Form 10-K. All of these documents are available on our website. These forward-looking statements are made as of today based on certain expectations, and we undertake no obligation to update these forward-looking statements.

I would also like to point out that the company's use of non-GAAP financial measures is explained in today's earnings press release, and a full reconciliation between non-GAAP measures and the corresponding GAAP measures is provided in the tables accompanying the press release and in our GAAP to non-GAAP reconciliations found on our website at investors.bmc.com.

At this time, I'll turn the call over to Bob.

Robert Beauchamp

Thank you, Derrick. Good afternoon, and thank you for joining us on today's call.

I'm pleased to report that BMC Software delivered a strong fiscal third quarter. We generated solid results across our key financial metrics, including total bookings, license bookings, revenue and cash flow from operations. We also enhanced our technology leadership, launching new products and solutions that position us more strongly than ever to capture the growing demand for cloud computing.

With our strong bookings performance and with the visibility we have to our fiscal fourth quarter, we're raising our fiscal year 2011 expectations for certain key metrics, including total bookings and ESM license bookings and cash flow from operations.

Let's look more closely at our fiscal 2011 third quarter results compared to the year-ago period. Total bookings grew 10% to a company record of $594 million. License bookings grew 19% to $295 million. Revenue was up 6% to a company record of $540 million. Cash flow from operations increased 117% to $180 million. Non-GAAP diluted EPS increased 4% to $0.79 per diluted share. And our balance sheet remains strong with $1.6 billion in cash and investments and $1.8 billion in deferred revenue.

That's a snapshot of our overall financial performance. But let me turn next to provide a brief overview of our ESM and MSM business units during the third quarter.

Our ESM business generated solid growth, with ESM license bookings increasing 8% to a company record of $163 million, off a challenging compare to the year-ago period. On a trailing 12-month basis ESM license bookings have increased 15% year-over-year, in line with our longer-term objective of mid-teens growth.

We were pleased that performance was balanced across the product lines, with exceptionally strong performance in our automation products. We were also excited to see strong growth from EMEA and Asia-Pacific.

We also seeing a positive impact from our efforts to strengthen our ESM sales organization. During the quarter, the average number of productive sales reps increased from the prior year. And we are on track to achieve a 20% increase in the average productive sales headcount in fiscal 2011 as compared to fiscal 2010.

Our execution regarding our BSM platform continues to trend higher, as evidenced by our continued ability to win large, multiproduct platform deals. During the third quarter, we had 30 ESM transactions with over $1 million in license bookings, up 11% from a year ago. More than 75% of these transactions were multiproduct license transactions. Major ESM wins during the third quarter included the United States Army, Capgemini, CSC, BBVA, the Federal Bureau of Investigation, Cisco Services, MetLife and BMW, to name a few.

In addition to the impressive growth in the number of large deals, we also saw our average selling price continue to increase. Our MSM business also performed very well in the quarter with strength in new product sales and increased capacity upgrades.

During the quarter, we expanded our relationships with existing customers with 65 new product placements. Some key MSM mainframe wins included Banco Bradesco, Bitmarck, Crédit Suisse, Deutsche Bank, Kaiser Foundation Hospitals, National Australia Bank and WellPoint. In the quarter, we also saw strong double-digit growth in the annual run rate spend for our top 15 MSM deals, with 13 of the 15 transactions resulting in an increase in spend with BMC.

The mainframe continues to be the trusted platform for critical business transaction processing, as evidenced by our Fifth Annual Worldwide Survey of Mainframe Users and IBM's successful launch of its zEnterprise 196 system. According to our survey, 84% of respondents expected to see steady or growing MIPS usage on the platform. In addition, almost 60% of respondents indicated that the mainframe will attract new workloads over the next year. This year's survey results and the success of IBM's zEnterprise 196 confirm that our continued investment in the mainframe is the right direction.

Beyond on the core mainframe solutions, we also saw strength in our Workload Automation business. As we discussed at our recent Investor Day, Workload Automation is about 1/3 of our MSM business. During the third quarter, we saw strength in BMC's Control-M, our industry-leading enterprise workload automation solution. We added 21 new BMC Control-M customers and expanded our existing relationships with 55 new product placements. Some key MSM workload automation wins included Banco Santander,, China Construction Bank, Expedia, Imation, Logica, Waste Management and Woori Bank.

As we discussed at our recent Investor Day, one of the key drivers of our performance is enterprise adoption of cloud computing. Cloud computing gives enterprises a flexible IT infrastructure to deliver applications, while offering service providers a platform for new revenue streams. Properly managed clouds can dramatically reduce the time required to respond to changing business demands while reducing operational costs.

The key to successful cloud computing is service management. Fortunately, this directly aligns to our long-standing strategy for BSM, Business Service Management. Business Service Management really is the killer app for cloud computing. Our dynamic BSM platform supports public cloud, private cloud and hybrid environments with solutions for planning, deploying, operating and optimizing the cloud.

Our leadership was validated by more than 20 significant Q3 wins for BMC's Cloud Lifecycle Management solution, including cloud wins at Accenture, Vodafone and MetLife. In response to this growing demand for cloud computing, we continued to invest in our product capabilities through internal development and through acquisitions and in our strategic alliances with other cloud computing leaders.

Our internal R&D efforts delivered new cloud relevant capabilities across our portfolio that further differentiated BMC. In January, we extended our Cloud Lifecycle Management solution to enable clients to customize their clouds using the first platform-agnostic solutions for delivering and governing internal and external Cloud services. We also launched BMC Control-M Self Service, the industry's first BSM self-service solution that empowers business users to work directly with the workload automation processes to power their business.

In December, we announced the enhancement of our Proactive Operations solutions, which integrates planning, predictive analytics and preventive automation to improve availability and performance in physical, virtual and cloud infrastructures. We also extended our BMC Control-M workload automation solution with new capabilities for Informatica and SAP BusinessObjects. We also released our latest BMC Atrium Discovery and Dependency Mapping solution that combines the depth of Tideway's best-of-breed discovery capabilities that we acquired one year ago with the breadth of our existing Atrium solutions.

In addition to investing in our own R&D efforts, we also expanded our capabilities by investing in companies that enhance and easily integrate into our BSM platform. In December, we acquired GridApp Systems, the privately held industry leader in automating heterogeneous database provisioning, patching and administration.

And as we mentioned during last quarter's call, in October, we acquired the software business of Neptuny, a European-based capacity management and IT performance optimization solution. The addition of Neptuny's technology extends BMC's existing leadership in physical and virtual capacity management.

During the third quarter, we built upon our strong network of strategic partner relationships in strengthening our sales footprint, our service capabilities and our portfolio of solutions. Our expanding partnerships with salesforce.com, Cisco and Accenture underscore the strength of BMC's competitive advantages in the IT management software business. We started working with salesforce.com, the market leader in business applications delivered from the cloud, last year, with the release of BMC ServiceDesk on Force.com.

This December, our two companies escalated our partnership with the announcement of RemedyForce, salesforce.com's eighth and newest cloud offering that combines BMC's market-leading ITSM solutions with salesforce.com's leading enterprise cloud computing platform. This is the best of both worlds. Cutting-edge delivery of proven solutions that provide businesses a simple and fast path to better IT service management. It is also significant that RemedyForce will be sold and marketed as a salesforce.com product in addition to being sold by BMC.

Our most recent alliance with Cisco targets a very different but equally significant market opportunity, new solutions for large-scale, multi-tenant cloud computing infrastructures. We're already delivering the first product of this alliance, a new Integrated Cloud Delivery Platform that combines both companies' technologies. The Integrated Cloud Delivery Platform enables enterprises and service providers to build and operate large-scale infrastructures that make mission-critical cloud services a reality. Some of our most significant cloud wins for the third quarter included this new solution and were sold in partnership with Cisco.

During the third quarter, we also announced the expansion of a long-standing relationship with Accenture. The two companies will jointly develop, market and implement packaged and custom BSM solutions, all built on BMC's BSM platform. Our platform approach enables customers to extract maximum return on their IT investments, as they take advantage of virtualization, cloud computing, Software-as-a-Service and other new technologies. In addition, BMC will leverage Accenture technology professionals to increase the capacity of our delivery and implementation capabilities with a dedicated Accenture team, providing consulting and integration services to BMC's professional services organization.

Our cloud strategy and solutions underscore our leadership in helping enterprises improve the way they manage IT. This has been demonstrated not only by our growth in bookings and revenues, but also by the recognition we continue to win among industry analysts. For example, we are happy to note that Gartner positioned us in the Leaders Quadrant of their recent report, Magic Quadrant for IT Service Desk. Please download and read this important document. We feel this affirms what we already knew, that our ServiceDesk solutions are the industry's most comprehensive. It also shows that the market is responding positively to RemedyForce and Remedy OnDemand, the Software-as-a-Service ServiceDesk solution we launched earlier this year.

Gartner also positioned us once again in the Leaders Quadrant of their December 13 report, Magic Quadrant for IT Event Correlation and Analysis 2010, which is available also on our corporate website. We believe this shows that we differentiated ourselves from the competition with our complete vision for event correlation and analysis.

Looking forward, we are encouraged by the number of analysts that expect enterprise software spending to show solid growth in calendar year 2011. A number of independent research studies such as a recent one by Gartner, indicate that IT operations management will be among the areas showing the most growth. Research like this confirms the positive trends we're seeing in the marketplace, which, combined with the visibility we have into the fiscal fourth quarter, supports us in raising our guidance for total bookings, ESM license bookings and cash flow from operations for the current fiscal year. These are among the many factors that make us confident about our future prospects.

In summary, let me underscore that our strategy of growth and investment is working very well and generating attractive returns. Our service automation, Software-as-a-Service and cloud solutions all continue to show strong increases in customer demand. Our partnerships are enabling us to expand the market opportunities we enjoy. At the same time, we remain committed to our ongoing strategy of optimizing efficiency, productivity and operating leverage to improve profitability.

Before I turn the call over to Steve Solcher for more details in our financials, I would first like to update you on a management change. As you saw in our earnings release earlier today, John McMahon will be taking a new role with the company, effective April 1, when we enter our new fiscal year. We told you last year how John was focused on building the ESM sales and services organization into competitive differentiators for BMC. The result of his efforts speak for themselves and are reflected in our earnings results we're announcing today and in prior quarters since he took a senior leadership role at BMC. John has been instrumental in shaping our ESM sales force and services organization, and we're now asking him to help us across both business units.

In April, John will move to Ken Berryman's Strategy and Corporate Development organization, where he will focus on new go-to-market initiatives for all of BMC, helping us develop new sales and distribution models to serve us, as we continue to grow organically and via acquisitions. John has built a strong and impressive leadership team in his tenure as SVP of Worldwide Sales and Services and will continue to rely on those key leaders, notably, Luca Lazzaron and Vance Loiselle will continue to run ESM sales and services organizations respectively, as they have over this past year.

And now here's Steve to provide you more insight into our financial results during the third quarter.

Stephen Solcher

Thank you, Bob and good afternoon to everyone. As Bob mentioned earlier our third quarter was a quarter of strong top line results. Our bookings results were balanced with strong performance across both our ESM and MSM business units as well as across our major product lines and major geographies. We continue to make focused investments in R&D, sales and services in order to capitalize on our leadership position in these fast-growing markets. We remain disciplined in our approach of balancing additional investments along with improved profitability.

Our bookings momentum through the first nine months of our fiscal year and our outlook for the fourth quarter, position us well to deliver strong fiscal year results across key financial metrics, including total bookings, ESM license bookings, non-GAAP diluted EPS and cash flow from operations. With that let me now turn to our results for the third quarter.

In the third quarter, non-GAAP operating income decreased 2% to $188 million from $191 million in the third quarter of last year. Non-GAAP operating margin declined three points to 35%. Third quarter non-GAAP operating margin was negatively impacted by the loss associated with our Professional Services business, the slight dilution related to two acquisitions that we completed in the third quarter and an unexpected $3 million expense related to a legal case. Please refer to Slide 5 for highlights of our ESM and MSM business unit operating results.

ESM's non-GAAP operating income in the third quarter decreased 7% to $72 million. ESM's operating margin was 21%, four points lower than the year-ago quarter. This decline was primarily driven by the loss in our Professional Services business.

MSM's non-GAAP operating income for the third quarter increased by 2% to $116 million. MSM's non-GAAP operating margin was 57%, flat with the year-ago quarter.

Non-GAAP net earnings for the third quarter were $143 million, an increase of 1% from the third quarter of fiscal 2010. Non-GAAP diluted EPS for the quarter was $0.79, up 4% from the year-ago quarter. This reflects a non-GAAP effective tax rate of 24% for the quarter.

GAAP operating income in the third quarter was $139 million compared to $148 million in the year-ago quarter. GAAP net earnings and diluted EPS were $109 million and $0.60 compared to $111 million and $0.59 in the third quarter of fiscal 2010. These results reflect diluted shares outstanding in the third quarter of $182 million compared to $187 million in the year-ago quarter.

Turning now to bookings. In the third quarter, total bookings of $594 million were up 10% as reported and 12% on a constant-currency basis compared to the year-ago quarter. Total license bookings for the quarter increased 19% as reported and 20% on a constant-currency basis to $295 million as compared to the year-ago quarter.

Total bookings on a trailing 12-month basis were $2.1 billion, up 10% compared to the year-ago quarter. The weighted average contract length for total bookings on a trailing 12-month basis was 2.17 years, flat with the year-ago quarter. After normalizing for contract length, trailing 12-month annualized bookings for the third quarter were $958 million, up 10% from the year-ago quarter and up three percentage points from the second quarter. Please see Slide 7 in our presentation.

From the geographic perspective, we have particularly strong bookings growth in Europe and Asia, across both our ESM and MSM businesses.

Now let me turn to bookings performance of each of our business units. For ESM business unit, license bookings are the best measure of performance. We generated strong growth in our ESM business with ESM license bookings at $163 million in the third quarter, up 8% from the year-ago quarter. For the first three quarters of fiscal 2011, ESM license bookings are up 23% compared to the year-ago period.

We closed 30 ESM license transactions over $1 million in the third quarter, up 11% compared to the year ago. Of the license transactions over $1 million, 23 included multiple product lines. The momentum in our service automation discipline continued in the third quarter, as service automation license bookings are up 59% for the first nine months. The number of productive ESM sales headcount is tracking to plan. And we continue to expect average productive sales headcount to increase by 20% for the fiscal year.

Turning to the MSM business. We believe MSM is best evaluated on the basis of total and annualized bookings over the trailing 12 months. In the third quarter, total MSM bookings on a trailing 12-month basis decreased 5% to $761 million compared to the year-ago quarter and had an average contract length of 2.88 years. After normalizing for contract length, total annualized MSM bookings for the trailing 12 months were $264 million, an increase of 1% compared to the year-ago quarter.

We are encouraged that capacity upgrades in our MSM business returned to more historical levels in the third quarter, which contrasts with the low level of capacity upgrades in the first half of our fiscal year. We are also pleased that we had strong growth in new MSM business, which includes attracting new customers and selling additional products to existing customers.

Turning to revenue. Total revenue for the quarter was $540 million, up 6% as reported and 7% on a constant-currency basis from the third quarter of fiscal 2010. ESM's total revenue was up 8% to $335 million, and MSM's total revenue was up 3% to $205 million.

License revenue in the third quarter was $235 million, an increase of 9% from the year-ago quarter. ESM's license revenue was $149 million, up 9% from the year-ago quarter. MSM license revenue increased by 8% to $86 million from the year-ago quarter.

During the third quarter, the percentage of license bookings that was deferred was 54% versus 55% in the year-ago quarter. For the third quarter, maintenance revenue was $259 million, flat with the year-ago quarter but up $7 million sequentially. I am pleased with the sequential improvement in maintenance revenue in both our ESM and MSM businesses. Our renewal rates remain stable. And our license bookings strength over the last several quarters is starting to positively impact maintenance revenue trends.

ESM's maintenance revenue was $140 million, flat compared to the year-ago quarter and up $4 million sequentially. MSM maintenance revenue was $119 million, also flat compared to the year ago and up $3 million sequentially.

Professional Services revenue, which is included in our ESM business unit, increased by 45% from the year-ago quarter to $46 million. Our Professional Services business generated a non-GAAP operating loss of $7 million compared to a $2 million loss in the year-ago period.

Moving next to operating expenses. During the third quarter, non-GAAP operating expenses were $352 million, up 11% from $317 million in the year-ago quarter. This increase was driven primarily by a $20 million increase in expenses related to our Professional Services business, driven in part by higher third-party subcontracting costs. In addition, this increase reflects the continued focus investments we have made in our ESM business, the impact of our recent acquisitions of Neptuny and GridApp and an unexpected $3 million legal expense.

Looking at our business units, ESM's non-GAAP operating expenses were $263 million, an increase of 13% compared to the year-ago quarter. MSM's non-GAAP operating expenses were $89 million, an increase of 5% from the year-ago quarter.

As a result of our current business momentum and improving market opportunity, we believe it is prudent that we remain focused on making investments in ESM in order to capitalize on our strong leadership position in this market. These investments include enhancing our cloud and SaaS offerings, supporting our strategic alliances, increasing sales headcount and strengthening our services organization. Other income in the third quarter was $2 million compared to a $1 million loss in the year-ago quarter.

Now turning to the balance sheet. Total deferred license revenue at the end of the third quarter was $661 million, a company record, and up $60 million sequentially from $601 million. During the quarter, we deferred $160 million of license revenue or 54% of license bookings and recognized $100 million of deferred license revenue from the balance sheet. Total deferred revenue increased by $54 million sequentially to $1.8 billion. The current portion of deferred revenue now stands at 54% of total deferred revenue.

Software development costs on the balance sheet were $185 million as we capitalized $33 million and amortized $19 million during the quarter. Capitalization of software development costs was slightly higher sequentially due to the timing of our development efforts around several products. Given the timing of development efforts and release dates of new products, we expect capitalization of software development costs to decline sequentially in the fourth quarter.

Cash and investments at the end of the quarter totaled $1.6 billion, up $72 million sequentially. Our net cash position was $1.3 billion.

For the quarter, cash flow from operations was $180 million, up 117% from $83 million in the year-ago quarter. For the first three quarters, cash flow from operations has now increased by 43% to $475 million.

During the quarter, we remain committed to share repurchases. We repurchased 1.7 million shares for a total of $75 million. At the end of the quarter, we had $771 million remaining in our current share repurchase program. Given our revised outlook for cash flow from operations, our strong cash balance and current market conditions, we expect to increase the pace of share repurchase in the fourth quarter.

So let me briefly sum up the quarter. We are pleased with our solid execution and performance across both of our business units during the quarter. Our strong competitive position, focused investment in key growth areas and commitment to generating growth and improving profitability position us well to achieve both our short-term and long-term goals.

With that, I'll turn the call back over to Bob to discuss our revised expectations for the year and his concluding remarks.

Robert Beauchamp

Thank you, Steve. The improving economic outlook has created an appetite within businesses for new technologies like cloud computing that leverage IT investments of the past to support innovation, faster responsiveness to changing business needs and efficiency. Our commitment to providing a path to the future that does not rule out the past has contributed to yet another strong period of financial performance for BMC.

Given our strong bookings performance in the third quarter and our visibility into the fourth fiscal quarter, we are raising our fiscal year 2011 expectations for certain key metrics, including total bookings, ESM license bookings and cash flow from operations.

We are reiterating our non-GAAP diluted earnings per share expectation in the range of $2.92 to $3.02. At the midpoint, this would represent a 12% increase over last year.

Our non-GAAP diluted EPS estimate excludes an estimated range of $0.43 to $0.48 per diluted share for non-GAAP adjustments, including share-based compensation; the amortization of intangible assets, severance, exit costs and related charges; as well as the related tax impacts of these items; and certain discrete tax items.

The assumptions underlying this full year fiscal 2011 estimate include: Bookings growth in the high single digits compared to our prior expectation of mid to high single-digit growth; ESM license bookings growth in the high teens to low 20s compared to our prior expectation of high teens growth; MSM total bookings growth in the low single digits; total revenue growth in the mid single digits; at current rates, we do not expect currency to materially impact full year bookings or revenue growth rates; non-GAAP operating margin flat to the year-ago period; a license bookings deferral rate in the low 50% range; other income slightly down compared to a year ago; weighted shares outstanding slightly down compared to the prior year; and a non-GAAP tax rate of 24%.

We now expect full year fiscal 2011 cash flow from operations to be between $710 million and $760 million, an increase from our prior expectation of $675 million to $725 million. At the midpoint, this would represent a $100 million or 16% increase over last year.

With that, we will now turn the call over to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to Phil Winslow with Crédit Suisse.

Philip Winslow - Crédit Suisse AG

Just wanted to dig in a little bit on the gross margin line in terms of services. You mentioned a couple of reasons why that gross margin or expenses ticked up this quarter. How should we think about that rolling forward? Is this sort of a just a new run rate we should think about? Or what should we just think about, sort of the goals of -- the profitability of that service line longer term?

Robert Beauchamp

Let me make sure I heard the question right. So I think the question was around what's happening around the margin with Services. And as we said in our prepared remarks, we had a $7 million loss associated with services. And I think it's really attributable to several things. A lot of that, given that, is the growing demand in our Professional Services business itself. And that demand, we supplemented that demand by hiring a bunch of what we call third-party contractors to help us fulfill that demand. I think what you should expect is over time is that business becomes more in line profitability-wise. So we'll continue to improve the profitability of that, as we kind of do not do what I would say is kind of double-dipping where we're using our own people and then subcontracting more, because I really do expect the BMC personnel to drive a lot of that and to have less reliance on the third-party contractors.

Philip Winslow - Crédit Suisse AG

So do you think -- we've made improvement over the past few quarters, in actually getting that segment in gross margin more profitable? And do you think we can go back there, or should we just continue to model this as sort of a loss, at least for the next couple of quarters.

Robert Beauchamp

I would probably cautiously say to expect a slight loss maybe in Q4. But my expectation is, is going into the next fiscal year to run this at flat to slightly profitable. And I think it's this transitional phase that we're in as a company that we really are being asked to do something that's a little bit unique and different, and that is really around this emerging opportunity that I think you heard us speak about in our prepared remarks, and that's around cloud BSM implementations. I think what's important for everybody on the phone to really pick up is the growth is there. And what we're really trying to do is to supplement that growth, which is fueling bookings growth. It's fueling the ESM license bookings growth. It's fueling ESM total bookings growth. And so this is something that I think we're all pretty excited about. And I think temporarily, if we've got to run the unit at a slight loss, I think the overall performance of the unit and company is probably something that we're willing to kind of offset.

Robert Beauchamp

This is Bob. We're looking at our PSO revenues and bookings growing significantly faster than we originally anticipated, and Cloud is driving a lot of that. I mean, a few quarters ago we had zero associated with Cloud. We were doing more implementations. Now what's happening is we are winning these Cloud standardization deals. But the way they go down is they want us to come in and set up a proof of concept, essentially open the store before they put any product on the shelf. And so the upsell on these accounts is really exceptionally positive for us. But the expense is somewhat front-end-loaded. So the fact that our professional services group is growing, revenue grew 45% and bookings faster than that just required of us to make some investment in that group so that we can implement those systems and grow it. And if we keep winning these Cloud deals like we're winning, and I expect that we will, we plan on implementing them successfully to these customers. And we have to hire some people to do that.

Operator

We'll go next to Gregg Moskowitz with Cowen.

Gregg Moskowitz - Cowen and Company, LLC

We all know that you look at the MSM business, first and foremost, on a trailing 12-month basis, but the MSM license bookings number this quarter really was quite strong. It sounds like your customers are engaging more often with the enterprise now available. You also mentioned an increasing capacity. Just wondering if you might be able to talk a little bit more about kind of what you saw in MSM there?

Robert Beauchamp

Steve will give you some numbers, but just in general, we had what I would say a very strong MSM quarter. We saw a return of capacity. We saw a return of new product. We saw pipeline build. On competitive replace, we did, I think, the largest competitive replacement we may have ever done last quarter. So the items that Bill Miller had mentioned in New York at the Investor Day that we were hoping would occur and we thought would occur in the quarter did occur. And we had a really exceptionally strong quarter in MSM this quarter. Steve?

Stephen Solcher

Again, I think I would just add with Bob's comments, the license is driven by what we would say capacity upgrades. And again, we saw capacity upgrades in the third quarter equal that of the first two quarters. So we have seen a return to capacity upgrades. We've got one quarter, so I'm hesitant to say that the line is drawn. But I think the good news is at least so far, what we've seen is people are back buying additional capacity. I think, as Bob mentioned, we also have been highly successful in what we call our new product offerings. And that's either new products to existing customers or brand-new customers. And so that also would be treated in the license line. And then finally, when you think about our renewal opportunity, it was heavily back-end-loaded. So again, to remind everybody, as we had a pretty tough first half, the MSM business was actually down in the first half, roughly 17%. And we're looking at the second half being almost a mirror of that, the flip side of that, so really nice renewal opportunity in the second half of the year. And I think with those renewals is the ability to drive additional capacity and to sell additional product.

Gregg Moskowitz - Cowen and Company, LLC

And just curious to get your view or just some increased discussion around how the virtualization management market plays out over the next year or two? And as well, curious if you have any thoughts on when that market potentially hits something of an inflection point looking ahead.

Stephen Solcher

Well, it may be hitting it now. I was in Europe last week with a large Central European manufacturer who, just this last quarter, standardized on our product line for managing their enterprise. They are highly, highly virtualized. I think they gave me the numbers. I want to say it was about 80% virtualized. And in the conversation, the reason they standardized on our products was to manage the entire environment, specifically the virtual environment. He did say in the meeting that he has no intention of acquiring his management environment from his virtualization vendor, because that would be, paraphrasing, this would be a very serious vendor lock-in strategy that he's not going to participate in. So he said he thinks it's centrally important that they have a management environment that is a heterogeneous company who doesn't lock them into one virtual machine. And he said that very explicitly. So in his case, I think that we won one of our larger deals last quarter for a customer that was buying our software, large, contract multiple products for specifically managing the virtual environment.

Operator

We'll now go to Aaron Schwartz with MKM Partners.

Aaron Schwartz - MKM Partners LLC

You've spoken a lot about the sales productivity adds this year. Can you just update us in terms of where you think that productivity is from your hires this year? And also, you've talked about the demand for your business. Do you feel like you have to sort of hire in front of that demand going into next year? Or do you think that the productivity gains you've had can hold this through next year?

Robert Beauchamp

First, in terms of where we are, attrition is in a very good shape. It's actually underneath the numbers we modeled. Sales productivity is on track to meet or exceed our 20% target that we've set for our productive heads in the sales force. And so really, across...

Stephen Solcher

And Bob's productivity statement is that's capacity that turns. The productivity number that we're looking for is somewhere in the low single digits. And that's where we had planned all around the whole year.

Robert Beauchamp

Yes. And speaking of heads, we're on track to meet that goal. And in terms of next year, we don't need to do the surge in hiring. If you recall a year ago at this time, we were talking about a large surge in sales hiring, primarily because we were ramping. We were coming up with a flat growth and expecting double-digit growth, and now we've obviously seen that. We see ESM total bookings at like 24% for the last three quarters. And then you see ESM license, up 23%. So the effect of that is work. We're moving to a little more of a stable growth model now. And we'll be able to hire people, bring them online and more in line with our productivity, with our top-line forecast and a little more linear through the year.

Aaron Schwartz - MKM Partners LLC

And just a quick follow-up question to Phil's question earlier, but the third-party PS consulting that you have had in the quarter, was that pretty consistent throughout the quarter? Or did you just sort of pick that up mid-quarter or toward the end of the quarter?

Stephen Solcher

I think it was pretty much throughout the quarter, although I would say at the end of the quarter, I think we did see an acceleration. And it's really driven by customers that are requesting that these projects -- there's a sense of urgency to get started in Cloud. And our belief system is, the customer wants to go as fast as they can, and we're there to just get it done.

Robert Beauchamp

With most of our large transactions that we win, at some point, the customer calls us in and says, "Okay, I'm counting on you to get this done, and we need to get started yesterday." And that's put some pressure on the expense side of professional services. This should normalize. We love to see this kind of Cloud wins. We love to see these many transaction, these many customers standardizing on us. But it should this next year, fairly early, begin to stabilize. And we'll be able to really start to work the margin and get that back to where as Steve said earlier it should be. We should be making money in that business. Right now, with this kind of growth numbers, I'm a little less worried about the profit than I am about securing these customers on professional services and getting the people in place and getting the projects implemented so we can do upsell.

Operator

And Matt Hedberg with RBC Capital Markets has our next question.

Matthew Hedberg - RBC Capital Markets, LLC

One last question on the service margins, strategically, I guess longer term, is there an opportunity to offload some of that workload to partners? Or do you feel more comfortable continuing to bringing more of that in-house?

Robert Beauchamp

We have, in fact -- there's two kinds of partners we talk about here. One are generally boutiques that will sub to when we need heads in an engagement. But we have part of our strategic relationship with Accenture is a more strategic partnership. And we are also working with CSC and a few others. But Accenture particularly, where we set up a particular partnership that allow us to build, almost outsource, some of our core services capability with hopefully better math. There is a front-end loading cost associated with that. We have to train their people. We have to certify their people. We've to get them up to speed. So Accenture partnership also has a front-end-loaded expense aspect to. I was speaking with the key senior executive with Accenture yesterday on the phone, as he and I were catching up on this. And we both think that, that relationship has got a good opportunity to do even better, and we're still somewhat in the transitional phase of ramping up their people and that there's an expense aspect to that as well. So I'd like to see us offload more to services to some of these larger partners like Accenture.

Matthew Hedberg - RBC Capital Markets, LLC

Bob, you guys have been coming up for two nice quarters here in a row. If you roll into calendar year '11 here, when you're talking to customers, what are their buying assumptions as they kind of roll into this new calendar year? I mean, how you see budgets in your various markets here this year?

Robert Beauchamp

It really boils down to what you're talking about with them. If you're talking about Cloud, I just got a report given to me last week that matches what I've seen. And this is an IDC report. This is a report about worldwide and regional public IP Cloud services 2010 to 2014 forecast. This came out in June of 2010. And what it says is that the rate at which Cloud computing will grow in 2011 is more than 5x the rate of the IT industry as a whole. And so that's what we are seeing. We are seeing Cloud projects, and people just frankly are talking about tight budgets. And they're talking about time-to-market speed, they've got new revenue opportunities, the business is pushing them to implement Cloud. So there's a lot of energy out there around investing in Cloud. We did very well in Europe. I mean, if you think about it, Europe, obviously, we're one of the few vendors, I think, out there that really was bragging about their results in Europe. And these are companies, a lot of these were Cloud standardization and full BSM standardization. These companies are trying to bill for virtualization and bill for Cloud and build a new platform. There's a data center redesign phase going on right now.

Operator

Moving on to Michael Turits with Raymond James.

Michael Turits - Raymond James & Associates

First of all, your maintenance also took a nice upturn here. Do you feel like you turned the corner on that, so we'll start to see acceleration and maintenance?

Stephen Solcher

Michael, I think, yes. So we sequentially have seen $7 million. Both businesses were picked up, and our expectation level is to see that continued growth reaccelerate.

Michael Turits - Raymond James & Associates

Cash flow, increased guide, is that all a function of an increase in bookings, or is there some other factor in cash flows...

Stephen Solcher

No, it's all bookings-driven. We increased the top-line growth rate. We're looking at more than doubling from our initial expectation, and that's flowing directly through to the cash flow statement.

Michael Turits - Raymond James & Associates

So more than them being flat this year over prior year, I know you've been planning to turn that professional services positive. Do you think you returned to kind of a normal 110% of margin increase profile next year?

Robert Beauchamp

Just one want comment I'd make is that we expect to improve margin in both units, and/or. The kind of exciting acceleration of the growth in ESM shifted the overall margin of the company, if you follow me. I mean, both units, we anticipate improving and are improving in their margin. But moving that business from the mix, from more MSM to ESM at a faster rate than we originally thought it would move because if we're growing faster in ESM than we anticipated, is causing some of that. So this is kind of a high-quality problem.

Michael Turits - Raymond James & Associates

But you think that you moved back to a margin increase, normal, 100 bps sort of margin-increase profile as we got out of this year and into next year?

Stephen Solcher

I think it's fair to assume that, although it is early. And that we have do kind of give you any kind of indication for the next fiscal year, but I think 100 bps. And as Bob said, it's really the distribution of ESM versus MSM, which is probably driving a little bit of that compression around the corporate margin.

Operator

Tim Klasell with Stifel, Nicolaus has our next question.

Tim Klasell - Stifel, Nicolaus & Co., Inc.

I just wanted to talk a little bit about the fiscal partnership. Are you getting the attach rates that you had or maybe hoping for a while back, when the relationship was first established?

Robert Beauchamp

You're talking about the UCS deal, the first partnership?

Tim Klasell - Stifel, Nicolaus & Co., Inc.

Yes.

Robert Beauchamp

UCS is probably a little behind what we thought it would be. I'd say it's behind. We are getting -- I mean, it is growing. It's growing nicely. It came off small numbers, and we are getting upsales. We are getting attach rates, it is improving. I think the whole thing time-shifted. If you remember when it first started, there was a time shift of at least a few quarters, and I think we're still in that phase. I would tell you, we talked internally by a factor of 10 more about the more recent partnership where we're going in together with Cisco and winning some of these large Cloud deals. I was with the CEO of -- I think it was actually the COO of one of the world's largest telcos in Europe last week. And I walked up to him and said -- I introduced myself to him. I haven't met him before. And I said, "Your company just standardized on our Cloud environment." And he looked at me puzzled for a second and said, "Oh yes, the Cisco BMC partnership." He said, "Yes, I know about this. This is important to our company." So in that case and in several other cases, the two companies are going in hand-in-hand in the largest public Cloud deals in these telcos and winning. In this quarter, we had some very nice wins associated with that partnership, particularly in the telco space. So I think the partnership, the UCS is a building block for that. And it began the relationship, and we built on top of it. But we're getting more business out of the alliance around Cloud really than with our UCS. But UCS is tracking up nicely.

Tim Klasell - Stifel, Nicolaus & Co., Inc.

You raised the guidance on ESM growth. Is that broad-based and just extra productivity out of your sales force? Are there a specific product or geography you can point to that's...

Robert Beauchamp

It is pretty broad-based. Again, we did exceptionally well in Europe. We did well in Asia-Pacific. Automation had a very strong quarter yet again. And by the way, that's not just Blade. In fact, some people have mistakenly thought that was Blade. Some of the other automation product grow faster than Blade. Our last seven acquisitions that were -- even the one was MSM, but our last seven acquisitions are all ahead of plan in terms of the growth rates that we anticipated that were part of the board plan. So we're seeing a really pretty broad cross-product line cross-geography growth. There's no one area that is holding up the rest of both.

Operator

We'll go next to Walter Pritchard with Citi.

Walter Pritchard - Citigroup Inc

I'm wondering, you came into this year, fiscal '11, with a big ramp in terms of productive reps that came as a sort of a benefit of the restructuring you did last year. And I'm wondering as you look out at fiscal '12, what is your hiring right now in terms of sales? And how are you thinking about what sort of base of productive rep ramping that you need to build here for what you're trying to do?

Robert Beauchamp

We began last year. A year ago, we were talking about, at this time, that we were going to ramp heavily into sales. We had two things: We had a significant shift in talent. We were bringing in a lot of new people, and we also saw the beginning of a high-growth phase. We were coming off kind of some more flat growth. And we felt confident with our product line. And where we were positioned, we want [ph] to grow. So we had a big jump in sales if you recall. We estimated we would have about 20% growth in productive capacity in the sales force. We're on track to do that or better. We had attrition issues about a year ago. Those are gone. In fact, we're in very good shape right now in attrition. And so now, we're entering a little bit of more -- we're not in a startup mode. we're in more of a steady-state mode. So we will grow headcount. We will grow services people. We will grow pre-sales people. But we're not going to do it in some burst. It's going to be more linear throughout the year.

Walter Pritchard - Citigroup Inc

And just on the M&A side, I know you've been fairly aggressive with smaller tuck-ins. And I'm just wondering, as you look at the product portfolio you've built out now at this point, is that what we should continue? Or is there any -- are you seeing any more opportunity beyond that in the current market?

Robert Beauchamp

I think in general, the strategy, this workforce as I mentioned, I was recently reviewing all of our -- we do have a board meeting actually with our M&A committee, but reviewing our M&A performance. And I don't think there's many -- I don't mind if I can just unabashedly self congratulate, I don't think there's many software companies out there that can say their last seven acquisitions are all ahead of plan and growing exceptionally well. Ours are. So we feel good about the model we've been using. I wouldn't expect us to deviate sharply from that. I never want to say never. And there are circumstances, we did Blade, it was unusual for us. We did Remedy, it was unusual for us, but those deals were transformative. We'll always leave that open as an option if we see the right thing that we think can really change the company. But the model we've used on M&As is the model that is the primary model we use, more of the midsize smaller tuck-ins.

Operator

Israel Hernandez with Barclays Capital has our next question.

Israel Hernandez - Barclays Capital

As I look at your domestic versus international split over the last two quarters, it seems to be skewing more towards international. Could you maybe talk about some of the strengths that you're seeing in EMEA and Asia-Pac? And how does that compare on a relative basis compared to the U.S. market?

Robert Beauchamp

I'm not sure that it's anything much different than others other than I think we're executing better are in Europe. If you remember, our sales transformation began first in Europe. And Luca Lazzaron, who ran Europe for us, he moved over, if you remember, a year ago. He has been running worldwide sales now for the company for over a year, and we've put together three of the best quarters in our history. And so Luca is now reporting directly to me. He's in charge of the entire worldwide sales force for the second year. And he's continuing to evolve the sales organization as he did in Europe. Asia has been a relatively small but a very effective sales force for us. I mean, one of our wins, China Construction Bank, this quarter is one of multiple successes we're having in China where we're getting great references in some of the largest, most well-established, recognized Chinese enterprises and agencies. So we're doing well there. Australia, we just won the NBN deal, the National Network for building the National Cloud System and Public Cloud for the Australian government. That was in cooperation Cisco. Then we won a large transaction there. And we've been ramping heads. We kind of ramped heads pretty well, pretty solidly over in Asia last year. And I think that's paid off for us. The team's on the ground there. It has been on the ground now for long enough to establish good customer relationships. And we're seeing that bear fruit. But I'd say, overall, the area that's -- well, we had a good quarter in federal this quarter. I think we're kind of keeping our fingers crossed and watching federal because all of us, I think, are unsure as to what the latest austerity measures might mean in the federal space. But we had a really solid quarter in federal. And part of the reason, I met with the CTO of a large government agency. He told me they've got a major austerity program. And that is why they standardized on our Cloud offering. So they standardized on our Cloud because of the costs. But I'm still a little cautious about federal. I want to see what happens there. We had a great team in federal. We just had a federal event with 1,000 customers signed up for our two-day there. But we just got to see what austerity measures would mean to federal.

Israel Hernandez - Barclays Capital

I know it's just been a few weeks here. But can you comment on any momentum that you might be seeing around RemedyForce at this point?

Robert Beauchamp

Yes, RemedyForce was about half. We grew our SaaS business, almost doubled it from Q2 to Q3. So now, I think we've only been out a little while. We're basically seeing it double every quarter. Half of the SaaS business was Remedy OnDemand and half of it was RemedyForce, and here's what's exciting about that is its sales forces didn't -- fiscal year didn't start until February 1. And so they did not want to rock the boat and do anything heavy with their sales forces. Any company would not during the last month of their quarter. So after we announced our partnership on stage, DreamForce, the real incentives and the promotions and the sales execution engine that is now salesforce's eight Cloud, has not begun until two days ago. So it's about how we're getting good balance. So in the high end, Remedy OnDemand is doing very well competitively, we have some smaller SaaS competitors that had a free run for a while and win rates are good and getting better there. Now that we've got good references, it's really going to make a huge difference. And then we've got this monster sales organization of salesforce.com, who is about to launch on it with a product we're going to invest a lot of money in to make sure it's a strong product for them and us.

Operator

Moving on to Yun Kim with Gleacher & Company.

Yun Kim - Gleacher & Company, Inc.

For your services organization, is there a specific plan to increase capacity by a certain percentage in the near term?

Robert Beauchamp

We have plans. It's a little bit a function of how much software we sell. If tomorrow, we closed another large global, today, although it's not material, today we closed a large insurance agency on Cloud Lifecycle Manager [Cloud Lifecycle Management], one of the larger Cloud Lifecycle Management deals we've won. We've got good people on that project. So as license keeps growing, if it grows and keeps growing at 23% like it's growing, then we're going to need to fund that. As this Accenture partnership matures, we'll be able to slow and use more outsourced services there, which should help us. But it's more of a function right now of software. That being said, we do have a model that Steve can talk to. It's kind of -- ultimately, we don't want services to be too large a percentage of our overall business.

Stephen Solcher

We're looking today, historically, as a percent of BSM, services revenue has been about 11%. And we're tracking to about 13% for this fiscal year. And I would think that would be kind of a ballpark number we would like to see.

Yun Kim - Gleacher & Company, Inc.

I mean, I am assuming the ramp-up time for the professional consultings are pretty short. Is that because there are people out there that are available with the right resources?

Stephen Solcher

No, that's not really true. The problem is there's not a pool of experts in implementing BMC Cloud Lifecycle Manager [BMC Cloud Lifecycle Management] out there. The product's only a few quarters old. So we have to build our own expertise. We have to train these people. We have to bring them to use into our offices in Europe or Asia. We have to train them, and we're doing certification programs. Now we've begun, and there's really no shortcut to that.

Yun Kim - Gleacher & Company, Inc.

Just more detailed questions around your services organization. How much capacity right now is dedicated to the services automation side of the business, and how much do you have in terms of Cloud computing in general? And why do you see the need to increase capacity?

Robert Beauchamp

We don't break it out, but it wasn't too many. A few years ago, it was primarily -- I mean, if you go back long enough, it was the PATROL install organization. And it turned into a Remedy implementation organization. And now, it's turned into a real BMC-wide organization to support the entire business. It's still heavy service support around our IT Service Management platform. But the hiring and training has been more around Cloud and automation. And by the way, if you look at our Service Assurance business, what used to be the PATROL business, that business has been growing nicely. So we've been ramping some of that as well.

Operator

Moving next to Derek Bingham with Goldman Sachs.

Derek Bingham - Goldman Sachs Group Inc.

One question is on the shape of fourth quarter revenues in terms of your full year mid-single digit guidance. I think pre-recession, you tended to be up sequentially in revenues. But last year, you're actually down. So just wondering what you expect revenues to do quarter-on-quarter directionally.

Stephen Solcher

Derek, is that a consolidated question or a specific business unit question?

Derek Bingham - Goldman Sachs Group Inc.

In total.

Stephen Solcher

In total, the expectation would be something that would be sequentially flat to up. And that would back into kind of a mid-single digit growth rate for revenue for the year.

Derek Bingham - Goldman Sachs Group Inc.

And then I think there was a pretty decent amount of capitalized R&D this year. And I tended to think of your kind of run rate R&D as about $50 million non-GAAP. We're kind of well below that for a bunch of quarters. Is that not the right run rate? Or is it kind of one-off capitalized R&D quarters, not so one-off? Is that something that we should kind of expect here and there going forward?

Stephen Solcher

Capitalization trends that you've seen in fiscal year '11 is probably here to stay. I actually look at both the capitalized software cost and the R&D expense as one line. And that has been pretty consistent as a percent of total revenue, roughly at about 15% of revenue. And I would just -- technically, all we're doing is there's timing of capitalization that's either on balance sheet or in the income statement. But in the aggregate, that cash spend is very similar.

Derek Bingham - Goldman Sachs Group Inc.

On the P&L, the kind of R&D base for this year, you feel it's kind of a fair base in terms of future growth looking out to next year?

Stephen Solcher

Yes.

Derek Bingham - Goldman Sachs Group Inc.

Could you tell us anything about your renewal rate in the quarter?

Stephen Solcher

Is that a maintenance statement? In relation to what?

Derek Bingham - Goldman Sachs Group Inc.

Well, I guess, as maintenance. I mean, you referenced it as a little below 90% last quarter. I was presuming that was a maintenance statement.

Stephen Solcher

Our renewal rates were pretty stable. And they have been stable, and I think you're seeing the impact of the renewal rate being stable as revenue is starting, at least on the maintenance side, is starting to grow sequentially. Next quarter, our expectation is for the number to actually grow year-over-year.

Robert Beauchamp

We have time for one more question, operator.

Operator

That will come from Derrick Wood with Susquehanna.

James Wood - Susquehanna Financial Group, LLLP

Maybe you could delve into a little bit of what you're doing with respect to your changes on the sales management side, and perhaps highlight what you would like to see improved upon most with the new structure?

Robert Beauchamp

First, it's really -- as we stand today, there's no changes. Luca Lazzaron was running worldwide sales all of last year. He reported to John. John had, essentially, sales. He had three direct reports, basically, sales, pre-sales and services. The pre-sales now reports to Luca. So that's the only change in sales. The next order of management have all reported to Luca now for a full year. So there's no structural changes, no big rocks moving around there. The services organization, the gentleman who runs that, Dan Forsell [ph], is now going to be reporting to Ken Berryman. Ken, you met in New York, for those who attended Investor Day, who has experience in one of the best-run, most profitable consulting organizations on earth, who will be working with Dan. And they've actually been working together for a number of quarters, but now, he officially reports to Ken, as they'll team up and work on that business. No big structural changes there. Pre-sales, no big structural changes there. It's working very well. The thing that is new is that John is going to be focused on, if you think about the Cisco relationship, you think about the Accenture relationship, you think about the salesforce relationship, you think about our Software-as-a-Service models, BMC has entered a whole new world of different distribution models. And in the old days, it was basically just a pure, direct model. We're entering a new era that requires us to expand our sales channels and our capabilities. John is working on those strategies, the go-to-market strategies in the organization, almost like a CTO for sales, working on how we're going to advance sales. He's a master of that and that's what he's going to work on. So what you'll see from that is an incremental change coming out to the quarters as the do acquisitions. As we add on more platforms and these relationships expand, you'll see his effort appear there.

James Wood - Susquehanna Financial Group, LLLP

Just to follow up to that, I guess. As you start doing larger deals, and you've got to engage more on POCs, clearly, you're going to have longer sales cycles. So is there anything you can do or that you feel like you need to do, going forward, with respect to these engagements, to make sure that these sales cycles happened at a pretty good clip?

Robert Beauchamp

I got to tell you, we saw a significant improvement in the link of the transaction this quarter. We closed -- and I don't want to give out the numbers, one thing, I don't have them in my fingertips, but I don't know that we will disclose if I did. But we saw a significant increase in the number of transactions that were discovered, competed upon and won inside the same quarter. So I guess what I'm saying is I'm not prepared to accept that our sales cycles are going to continue to lengthen. I think the lengthening is beginning to contract.

Thank you all very much for joining us. We appreciate and look forward to your calls. And Steve and I will be available, as well as Derrick. So please feel free to set up calls with us. Thank you all very much.

Operator

That concludes today's conference. Thank you all for joining us.

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