Websense Q4 2006 Earnings Call Transcript

Jan.30.07 | About: Websense, Inc. (WBSN)
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Websense (NASDAQ:WBSN)

Q4 2006 Earnings Call

January 30, 2007 4:30 pm ET

Executives

Gene Hodges – CEO

Doug Wride – CFO

Kate Patterson – VP, Investor Relations

Becky Wheeler - IR Manager

Analysts

Daniel Ives - Friedman Billings Ramsey

Todd Raker - Deutsche Bank

Dino Diana - UBS

Garrett Bekker - Merrill Lynch

Phil Winslow - Credit Suisse

Gregg Moskowitz - Susquehanna Financial Group

Samuel Wilson - JMP Securities

Walter Pritchard - S.G. Cowen Securities

Katherine Egbert - Jefferies & Co.

Brian Essex - Morgan Stanley

Robert Breza - RBC Capital Markets

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to the Websense conference call. (Operator Instructions) I would now like to introduce your host, Kate Patterson, Websense's Vice President of Investor Relations. Ms. Patterson, please go ahead.

Kate Patterson

Thank you. Good afternoon, everyone and thank you for joining us to discuss our fourth quarter results. With me today are Gene Hodges, Websense CEO; Doug Wride, our Chief Financial Officer; and Becky Wheeler, Investor Relations Manager.

Before we begin, let me review several upcoming investor events for Q1. We'll be participating in the America's Growth Capital conference on February 5; the Thomas Weisel Partners conference on February 6th; the Credit Suisse conference on February 8th; All in San Francisco during the week of the RSA show. Additionally, we will be hosting our third annual analyst day on February 7. You can RSVP on our website. In the following week, on February 14th, we'll be at the Merrill Lynch conference in New York and we will be participating in the Morgan Stanley conference in San Francisco and the UBS conference in London in March.

Before we begin a review of the financial results, let me remind you that during this call management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties and other factors that may cause the company's actual results to be materially different from the historical results or any preliminary results expressed or implied during the call.

The potential risks and uncertainties which could cause actual growth and results to differ materially include, but are not limited to: customer acceptance of the company's services products and fees; the success of the company's brand development; the volatile and competitive nature of the Internet industry; changes in domestic and international market conditions; the development of international markets for our products; and risks relating to intellectual property ownership.

The information in this call related to financial results, projections and other forward-looking statements is based on current expectations and we expressly disclaim any responsibility to update forward-looking statements, should situations change. Our discussion also includes financial measures for billing and non-GAAP net income and earnings per share that are numerical measures that cannot be calculated in accordance with GAAP.

The Company believes the non-GAAP billings measurement is useful to investors because GAAP measurements of revenue and deferred revenue in the current period includes subscription contracts commenced in prior periods. The company believes that non-GAAP net income and earnings per share which excludes stock-based compensation expense and tax benefits related to stock-based compensation expense, enhances investor's ability to evaluate the company's operating results and compare current operating results with historical operating results prior to the adoption of FAS 123 R. For more information please consult the press release that was issued this afternoon and which was also posted on the Investor Relations portion of the company's website.

With that, I'll turn the call over to Doug Wride.

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Doug Wride

Thank you, Kate and thank you all for joining us today as we review our financial performance for our fourth quarter and fiscal year 2006. We finished the year with a solid fourth quarter with billings, revenue and earnings per share in line with our expectations. We also posted strong cash generation, a healthy balance sheet and record deferred revenue. However, for a number of reasons, our financial statements have become more complicated including completion of the first acquisition in our history and a change to our revenue recognition policy. Before I go into details on the results, let me review these changes.

First, we accounted for joint marketing payments to Ingram and rebates as a contra item to revenue rather than as a sales and marketing expense or a decrease to billings. This was the first quarter we've actually run transactions through Ingram and had measurable rebates. These marketing expenses are different from discounts on transactions generated through Ingram and value-added resellers.

This is significant, not because the amount is different than we expected, but because when we issued Q4 revenue guidance back in October, we thought the marketing payments would be accounted for in sales and marketing expenses and we did not include them as contra to our billings and revenue guidance. We expected that the rebates would be contra billings and would flow against revenue over the subscription periods, not all be counted as contra revenue in the current quarter. For this reason, I will provide detail on the impact these charges had on billings and revenue, but this will be the only quarter that I do so, because going forward we'll just report billings and revenue net of payments of this nature.

We also decided during our year end audit and Sarbanes Oxley review that we needed to begin recognizing revenue on a daily rather than monthly basis. We have now done that and accounted for the cumulative historical impact through the transition provision of SAB 108. The tables in the press release quantify the historical impact of this change to deferred revenue and retained earnings on the balance sheet, and how we've adjusted our previously reported 2006 quarterly revenue results.

As you can see from these tables, what we have always contended is true. The P&L impact on any one quarter or year of not recognizing revenue on the GAAP daily method has been immaterial at about 1% or less. The cost and complexity of tracking revenue on a daily basis for a smaller, high transaction volume company such as Websense didn't seem to be cost justified. However during this year's work, we spent great amounts of time calculating the impact on deferred revenue that has accumulated over the 11 years that we have been doing this, and we could not ignore the $10.4 million cumulative impact at the end of 2006 on deferred revenue. This is what prompted our corrections of past practices and change in how we account for revenue going forward. Keeping these changes in mind, let's look at the details.

Gross billings for the quarter were $69 million, coming in at the low end of the guidance range and up 2% over a very strong Q4 2005. This brought us to $211.1 million in gross billings for the year, an 8% increase over 2005. Net billings reflect approximately $578,000 to Ingram for joint marketing programs, and channel rebates were $68.4 million for the quarter, and therefore $210.5 million for the year. The payments to Ingram were to support reseller recruiting and education programs and all began in the fourth quarter.

When comparing our billings performance to our expectations early in the quarter, the single most significant factor was the decline in the average contract duration compared to Q4 a year ago. One-year contracts actually contributed 50% of total billings; two-year contracts contributed 11%; and three-year contracts contributed the remaining 39%, resulting in an average duration of 22.7 months, which is down from 23.2 months in Q4 last year and flat with our Q3.

In past years, contract length has extended significantly in Q4 and it was our expectation that this would happen again this year and the contract length would be the same as Q4 last year, or 23.2 months. This is what was built into our guidance for the quarter and the difference this represents is about $1.5 million of billings. I view this stabilization of contract length as healthy for our business, especially when viewed in combination with other positive metrics including the average annual contract value, the number of large deals, the percentage of new business versus renewal, and the progress we're beginning to make attracting middle market resellers through Ingram.

I believe this metric is demonstrating that drivers of growth in our web filtering business are gradually shifting away from large, lengthening enterprise deals to smaller customers, especially in North America. These smaller customers tend to choose one-year contracts over multi-year contracts.

On a geographic basis, both Latin America and EMEA again posted strong results. As is normal, we had a few large transactions that slipped or failed to close at the end of the quarter, but we still closed a record 110 transactions greater than $100,000 in Q4, up from 107 in the same quarter last year. These seasonally strong billings, combined with the addition of $9.9 million that had been previously recognized as revenue through Q3 under the prior monthly revenue recognition policy throughout the years, brought deferred revenue to an all-time high of nearly $220.3 million.

Looking further at the billing metrics, we find that the average annualized contract value was approximately $9,900 for the quarter, up 8% sequentially and up 10% over Q4 last year. This is significant because the attach rate for add-on products for the quarter was flat with Q3 and remained at 63%, suggesting that the increase was the result of customers purchasing more add-on products. In fact, this metric was mostly driven by upgrades to the Full Security suite.

Turning to revenue, subscription revenue for the quarter was $47.3 million, slightly below our guidance range of $47.5 million to $48 million. Revenue was reduced by a total of about $1 million due to the Ingram marketing payments -- not the rebates, but the marketing payments -- and the change in revenue recognition to a daily basis. The Ingram marketing payments totaled about $455,000 and due to the change in revenue recognition, we recognized about $556,000 less in the quarter than we would have recognized on revenue by a monthly basis.

The more back-end loaded nature of Q4 tends to exaggerate the difference a little between daily and monthly recognition compared to other quarters. This brings total revenue for the year to $178.8 million, up 20% from 2005. International revenue for the quarter was 38% of total, up from 37% last quarter and up from 34% for 2005. This increase reflects our ongoing investment in expanding our worldwide presence and increasing our market position, as well as the contra revenue payments made to Ingram.

Just this year, we put sales people in place for the first time in Canada, Malaysia, Taiwan, South Africa and Dubai. We also significantly expanded our presence in Israel with the PortAuthority acquisition and completed the first steps in opening our new engineering center in Beijing, China.

Turning to the operating model, non-GAAP gross margin was 91.7% of revenue, down slightly from last quarter and last year. The decline is largely related to royalty payments associated with our platform OEM agreements. Non-GAAP operating margin was 32.9% of revenue, up from 31.9% last quarter and a little above our targeted range for the second half of this year of 31% to 32%. The increase is due largely to normal seasonality.

Looking at what's going on in our core business, we're running at an operating margin in the 31% to 32% range as we continue to invest in reaccelerating our long-term growth. As a result, we have again begun to recruit and hire, especially in the sales, marketing and engineering areas. Company-wide, head count increased by 50 individuals for a total of 687 at quarter end compared to 637 last quarter and approximately 600 at the end of 2005. We have continued to hire in early Q1, principally in the sales and marketing areas, in addition to adding the former PortAuthority people bringing head count as of today to about 750.

Non-GAAP net income for the quarter was $11.4 million, generating $0.25 of earnings per diluted share. I don't want to get too confusing here, but had we calculated EPS on a monthly revenue recognition basis, which is what you were expecting, it would have been $0.26.

Total stock-based compensation expense was approximately $5.3 million and was spread across all expense categories. This resulted in GAAP net income that was approximately $7.8 million or $0.17 per diluted share. The effective GAAP and non-GAAP tax rates were 40.7% and 38% respectively for Q4, and 36.8% and 35.3% respectively for the year.

The diluted share count was near where I expected at 45.3 million shares. A decrease of just over 1 million shares compared to the end of Q3 as the full impact of the large Q3 share repurchase was reflected in the count. We did not repurchase any shares during Q4 due to the PortAuthority acquisition.

Turning to the balance sheet, we closed the quarter with $326.9 million in cash and investments, an increase of $26.6 million from the prior quarter and zero debt. However, this total does not reflect the cash payment made on January 9, 2007 for approximately $88 million to close the PortAuthority acquisition. This payment will be reflected in the cash balances reported at the end of this first quarter.

We generated approximately $22.1 million in net operating cash flow during the quarter compared to $19.8 million in what was a very strong Q3. For the year, cash flow from operations totaled $83.7 million. Cash per diluted share at the end of the quarter was approximately $7.22 compared to $6.47 last quarter and it will decline to about $5.50 at the end of Q1. This will include the payments that I discussed above regarding PortAuthority, offset partially by Q1 cash collections.

Accounts receivable were $52.7 million at quarter end, up $12.1 million from Q3, reflecting the strong sequential growth in billings. As a result, DSOs based on billing increased slightly to approximately 69 days from 68 days in Q3, but still within our target range of 65 to 70 days.

Turning to our forward guidance, we begin 2007 as a much different company than we were a year ago; a much more exciting company in many ways, but without question a company in investment mode. We are looking for Q1 billings increase of between 5% and 7% versus a year ago to the range of $40 million to $43 million. Revenue is expected to be between $48.5 million and $49.5 million. Both GAAP and non-GAAP gross margin are expected to range between 91% and 92% of revenue. The decline in gross margin is primarily due to the temporary sale of hardware to customers PortAuthority had in their pipeline at the time of closing. We expect hardware sales to diminish in the second half of 2007 and phase out by the end of the year.

GAAP operating margin is expected to be approximately 9% to 10% of revenue. This includes our current estimate of the one-time charge related to in-process R&D and the ongoing charges related to the amortization of intangibles acquired through the PortAuthority transaction. Non-GAAP operating margin, excluding stock-based compensation, is expected to be in the range of 23% to 25%. As I said earlier, I believe our core operating business is operating in the 31% to 32% operating margin.

In Q1 we usually take a 1% to 2% seasonal hit from the preceding Q4 as we book big expenses for the RSA trade show and our worldwide sales kickoff event, combined with the normal ramp up of sales hiring and the increase of payroll taxes at the beginning of the new year. Layering on the PortAuthority expenses, which will be about 6% to 7% of Q1 revenue, you get to the guidance range of 23% to 25%. We expect the operating margin dilution of PortAuthority to decrease by about 1% per quarter, crossing over the breakeven point some time in mid-2008. This is consistent with the expected dilutive impact to earnings per share of between $0.10 and $0.15 for the year 2007, which we disclosed in our announcement of the PortAuthority acquisition.

I need to note here that we have not finalized the valuation and calculations related to the business combination with PortAuthority that just closed three weeks ago and the impact on our operating margin, the balance sheet and statement of cash flows that this will have related to the purchase of intangible assets, goodwill, in-process R&D, et cetera.

So as we move to the rest of the income statement, we expect other income to decrease by $600,000 to $800,000 compared to Q4 due to lower invested cash balances. We are still in the process of calculating our expected tax rate because it will be heavily influenced by the purchase price allocations and NOLs from PortAuthority. Until we have more details on this, we are keeping the tax rate constant with 2006 at 37% and 35% for GAAP and non-GAAP respectively. The net result is an estimate of non-GAAP EPS of between $0.19 and $0.21 and GAAP EPS of $0.09 to $0.11. With that, I'll turn the call over to Gene for his discussion of the quarter.

Gene Hodges

Q4 was a solid quarter with excellent progress on most fronts of our operations which we believe will drive improved results in 2007. I know it's hard to digest the changes in both our operations and accounting in one sitting, so let me summarize the operational picture to put the numbers in better perspective.

Our first major challenge for 2006 has been to reignite growth in the filtering business that has become largely saturated in big companies in North America. While reengineering the North American business has kept us investing in both North America and continuing internationally, we have enjoyed and maintained solid growth outside the U.S.

In Q4, our strong filtering growth outside North America continued with billings growing again over 25%. This growth had a broad geographical base and it showed strength in Europe, excluding United Kingdom, Asia and South America. This 25% plus billings growth in the international business has been consistent, as you will remember, throughout the year. We believe that strong international growth in these geographies will continue into 2007 as the filtering market is still below 50% saturation in most of these locations. This growth will be buoyed by new versions of our products which support local languages and you may remember that the first non-English language version, Japanese, shipped in Q4.

North America continued to be a challenge in Q4, but important progress was made on reengineering our sales operations that are needed to resume growth. The remaining market in North America is in small and medium business and expanding our business in this segment has required a significant overhaul. Driving growth in SMB requires an efficient channel-oriented operation that recruits and supports a large number of small resellers. These resellers typically place small orders and we estimate that a typical small reseller will do between $20,000 and $40,000 a year of new business. Although this business is hard to get to, it's important to remember that it's all net new business.

To capture this new business, we move to a two tier distribution system. As Doug said, Q4 was our first quarter of volume operation with Ingram, our distribution partner. In the fourth quarter, we recruited over 150 new resellers and approximately 100 of those were recruited from programs that we ran jointly with Ingram. In our estimation, these partners will generate some where between $3 million and $6 million of billings over the next year. We did not expect to see a big immediate impact on billings from these new resellers, but in fact we did see about a $500,000 uptick in our new customer billings in Q4 in the U.S. filtering market. This program will continue through 2007 and each quarter adds more new resellers who will contribute to new business generation.

As you will hear next week at RSA, we will also ship new versions of our filtering products in 2007 which are customized for the medium and small markets, and these will also complement changes that we've made in the sales structure in our electronic support systems. The large scale changes in our sales processes were tough on our work force in Q2 and Q3 of this year, and we did see sales attrition. By Q4, however, we had passed through these challenges and the hiring of new channel-oriented sales talent in both North America and international was very aggressively done.

As Doug said, we added over 50 new people in the quarter and when we looked into the first half of January as well, we added over 40 new net sales and marketing people worldwide. This is a record number of hires and positions us for improved growth over the rest of the year. Again, to be clear, this is hiring in the filtering business and does not include hiring for data leakage or addition of our PortAuthority employees.

Competition does continue to be intense in the filtering market, but price points have stood up fairly well. The best metric to track here is the normalized annual value of our contracts, which as Doug mentioned, has increased about 10% year-to-year from $9,000 in Q4 2005 to $9,900 in 2006 Q4.

The second major initiative we've undertaken to drive growth was to expand our security product line with new offerings and emerging segments. This emerging segment target is again all net new and it will complement the security filtering upgrade business that we've enjoyed for the last few years. We focused on these newer emerging segments as we feel that buying into a more mature market with large established players isn't an area that we can win and sustain growth.

We announced our acquisition of PortAuthority in December and we closed the deal in early January. We see this as an exciting new segment, but we also have significant work to do to build this sales channel as well. PortAuthority has the best technology in the segment, but sales were just starting to ramp up. PortAuthority billings were not consolidated into our results in Q4, but for comparison they were only at a yearly run rate of about $5 million, approximately $1.2 million in the fourth quarter itself.

The integration of the companies is as going well to date. The large majority of the sales and engineering talent has stayed with us and the pipeline is ramping faster than we had expected. We'll give you a detailed briefing on the new products and technology in data leakage at the RSA conference next week, but to wet your appetite, we've already seen some interesting synergies as we scan the Internet using PortAuthority's data leakage engine attached to our existing Threat Seeker technology.

Q4 was a challenging quarter, but I believe good progress was made that can help us grow faster in 2007. As Doug has said, we expect growth to accelerate as the SMB and data leakage programs start to pay off and for margins to improve simultaneously. We've made significant investments over the last two quarters and this is always worrisome when moving from a relatively stable, high-margin business.

Our management team has kept focused well through this rapid change. With the progress made in the fourth quarter, I'm even more confident than before that we can increase our growth in filtering and add high growth improving margin security sales that we did not have before.

Now, we'll turn the call back over to the operator for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Daniel Ives - Friedman Billings Ramsey.

Daniel Ives - Friedman Billings Ramsey

Yes, thank you. Could you just talk more about margins in Q1? I think coming in at least lighter than I expected; could you just give me more granularity around the significant compression in margins?

Doug Wride

Typically in our ongoing historical business, we have a 1% to 2% compression because we have these expenses that are front end to the year as I expressed: our annual sales kickoff from around the world, RSA, we start hiring, et cetera. When you take this quarter, we have all of a sudden dropped $2 million to $2.5 million a quarter worth of expense on top of what was our ongoing business because of the acquisition.

That expense, only partially offset by revenue, because again the PortAuthority or data leakage types of sales, those are subscription too. So you start pretty much at ground zero, start with billings, peeling revenue out of those billings over of the life of the subscription, and get a pretty significant impact when you start from scratch. That's where we are at.

So as I said, that's a 6% to 7% hit in this quarter. We expect that that will decline about 1 point a quarter. We should exit this year having gained 3 to 4 points by the end of the year on that. As we had said before, we expect the PortAuthority acquisition to be breakeven middle of next year. Does that help?

Daniel Ives - Friedman, Billings, Ramsey

Yes, it does. Just a final question, when you look at billings growth in '07 for the year -- I know you are not giving guidance -- but can you maybe just directionally talk about how you view that in reverse acceleration or linearity throughout the year? Thanks.

Doug Wride

Well, what we have said in the past and I will repeat here is that we believe there is an opportunity for this business to be at a 15% to 25% growth rate. We don't believe that we achieve that for this 2007, and we've said that in the past. We think that we are looking at billings at a pretty nice year-over-year growth in Q1 and we think that we can sustain and build on that through the year.

I guess that's as far as I will go, otherwise I start giving guidance.

Daniel Ives - Friedman, Billings, Ramsey

Thanks, guys.

Operator

We will go next to Todd Raker - Deutsche Bank.

Todd Raker - Deutsche Bank

Hey, guys. Two questions for you. One, can you actually break out what PortAuthority revenue will be in Q1?

Doug Wride

Not yet. We are taking their ongoing pipeline, distilling that down, running with that as well as building our supplemental pipeline; and then, moving to our own standalone product middle of this year. So between all of that, it's not going to be a material amount in Q1, but we have already closed some business and we will give you an update at the end of the quarter. After this Q1, we will have a better sense for what Q2 will be.

Todd Raker - Deutsche Bank

Okay. And then just from a high level perspective, if I look at Q4, it basically looks like you guys invested about $1 million incrementally in the channel just for your Ingram relationship. Yet when I look at the billings growth profile of the business for Q1, it is 5% to 7% year-over-year growth. What do you think the core growth rate of just web filtering is without the upsell opportunity? How much more do you have to pump into the channel to accelerate that growth profile back to double-digits?

Doug Wride

I think that, let's just call it the core web filtering business, as we do further penetration of the small and medium-size customer market, we should be able to get that business growing at above 10%. That also, of course, includes our international expansion. The investments, the $1 million that you calculated, those investments were focused on principally recruiting these new VARs that Gene spoke about and training them, and getting them ramped up which is different than paying a spiff to an existing VAR to close more business. So, those really were more of an investment nature.

Todd Raker - Deutsche Bank

So is it fair to look at those Ingram Micro payments as one-time investments or are they going to be ongoing education and promotions?

Gene Hodges

They will be ongoing throughout 2007, but the payoff continues to be ongoing; meaning we hope to recruit additional small business resellers throughout the year, each quarter adding forward billings opportunity which becomes accretive, as we have said, somewhere around the middle of the year.

Todd Raker - Deutsche Bank

In your commentary, Doug, I think you highlighted you did have some large deals slip. Is there anything that's driving that and can you talk about the competitive position on large deals?

Doug Wride

I did say that and I also said that was is normal. I'm not suggesting at all that $69 million was because deals slipped. It was pretty normal. We had a number of big deals that we thought we were going to close that we didn't close. We have already closed some of those in January. But realistically, Todd, in March we will see the same thing again.

I think the competitive environment is really pretty much the same as it has been. We continue to compete against many companies: SurfControl, Secure, of course Blue Coat 2. As we go international, we see more and more competition from the local smaller products when you go into Malaysia and Taiwan and so on. There is a lot of competition out there. We continue to defend our turf as the best product and we charge a little bit of a premium.

Todd Raker - Deutsche Bank

Thanks guys.

Operator

Thank you. We will go to Dino Diana - UBS.

Dino Diana - UBS

Thanks guys. I got a little bit of late start. On the billings for the quarter, just apples-to-apples with how you guys were before, is it 2% that we should be looking at as the apples-to-apples number for year-over-year growth?

Doug Wride

Yes. That is 2%. However, maybe you go from a Golden Delicious to a McIntosh, in that we were expecting that contract length would be the same as it was a year ago and that's what we built in our guidance and that's what we have talked to you all here on this call, in October, as well as while we have been on the road. So, the half a month difference was about a $1.5 million impact. I was quite surprised to see contract points come in. You all know as you review your own models, you haven't seen that, I don't think ever before.

Dino Diana - UBS

I heard you mentioned you are not going to give guidance on from a revenue perspective on PortAuthority. Can you help us on the 5 to 7% growth in billings guidance, is that again apples-to-apples? Obviously that includes some PortAuthority. Can you give us a sense from the billings perspective at least, what you are expecting from PortAuthority there?

Doug Wride

The billings growth is apples-to-apples. We are talking about accounting for things on a daily basis, that's billings versus revenue. But we are talking about in our guidance, accounting for things on a daily basis in Q1 as compared to what's reported on a daily basis Q4. We are talking about booking the rebates and the marketing expenses on the same apples-to-apples basis.

The impact of PortAuthority and that acquisition on the first quarter is really fairly minimal and a little bit difficult for us to really quantify with any precision here, three weeks at the helm. Does that help?

Dino Diana - UBS

Not particularly, to tell you the truth. But we can catch up offline. Thank you.

Operator

Thank you. We will go next to Garrett Bekker - Merrill Lynch.

Garrett Bekker - Merrill Lynch

Gene, I wonder if you could talk a little bit about your channel strategy. I know you mentioned that you will be focusing a little bit on recruiting smaller VARs this year. As I understand it, PortAuthority is mainly more of a large enterprise sale. I was wondering if you could maybe contrast the channel strategies with those two and reconcile that a bit.

Gene Hodges

Sure. They are as I think you are observing quite different. The channel strategy for the filtering business is focusing on adding small new resellers internationally. That is outside of the U.S. as well as inside the U.S. with a lot of the growth coming from emerging markets in Asia, as well as growth that we hope to get started again in the U.S. with the resellers we talked about.

The PortAuthority channel partners will be a small number overall. I think 15, 20 to 30 in terms of the number of resellers who are handling the product. They will be the largest resellers. So they are the other end of the spectrum. They will be resellers who will be concentrated very heavily in the U.S. and the UK. So it's almost the exact opposite in terms of expansion of what we are doing in SMB.

Garrett Bekker - Merrill Lynch

Thanks. And just one follow-up, I may have missed this, but did you give a target for the full year of where you are hoping to be on VAR recruitment?

Doug Wride

No, I don't think we've issued guidance on that. We generally haven't done guidance for the year on any of the major metrics.

Garrett Bekker - Merrill Lynch

Thanks.

Operator

Thank you. We will go next to Phil Winslow - Credit Suisse.

Phil Winslow - Credit Suisse

Hi guys. Obviously I saw a little skewing in the contract length this quarter. Just when you're looking at your Q1 guidance, what type of breakdown are you expecting -- one, two, or three-year contracts – that you are sort of implying in this guidance?

Doug Wride

We are expecting that Q1 '07 will be the same contract length as Q1 '06. We are not expecting that it will be less than that, but it will drop a little bit as typically happens in Q1. I have forgotten exactly offhand. Kate’s looking at me.

Kate Patterson

It was 52 one year, 11 two years --.

Doug Wride

Did you hear that Phil?

Phil Winslow - Credit Suisse

No I didn't quite hear it.

Doug Wride

52, 11, and 37.

Phil Winslow - Credit Suisse

So it was the same as last year. Okay. When you guys do look longer term here out into '08, what are your expectations for new billings? Obviously new billings were down year-over-year this year and the overall billings numbers were boosted up by renewals. When you look at '08, how do you think about the new billings growth and/or decline?

Doug Wride

Well definitely growth. Most of the things that we are doing new that we've talked about today and for the past many months have been about new business. Approaching the small and medium business market, going through two-tier distribution here in the U.S. to get to the right VARs, to the right customers, and, of course, the leak prevention business. That's all new. So we expect the new versus renewal percentages to grow.

Phil Winslow - Credit Suisse

Finally, you said it was about $700,000 to $1 million for the Q1 contra revenue? When you look over the full year, what do you think the effect of that will be? Does it diminish over time?

Doug Wride

I don't think it diminishes over time. As we look at this year I think we continue to invest in the development of these programs. We are probably somewhere $3 million or better in these kinds of programs for the year. A lot of that just has to do with how the market has changed and with the types of programs that you run. So the rebates, the training, et cetera, are a little bit different than they used to be with everyone. I mean everybody we talked to. Not just Websense.

Phil Winslow - Credit Suisse

Thanks, guys.

Operator

We will go next to Gregg Moskowitz - Susquehanna Financial Group.

Gregg Moskowitz - Susquehanna Financial Group

Thank you. I was wondering first of all if you saw any three for two promotional activity in the U.S. through Ingram in Q4. And just generally in terms of Ingram's billings contribution for the quarter, how did that fare relative to your expectations?

Doug Wride

I would say that the three for two program that we discussed in October that was through Ingram performed about as we expected, which was fairly minimal. We talked about that being a $200,000 or less impact in the quarter and I think that's accurate.

As far as what was the volume we ran through Ingram, we are going to stay away from that just because we don't want to add another metric that we have to track and report on a regular basis. I would say that we are pleased with our Ingram relationship, but both we and Ingram acknowledge there is still a lot of opportunity in front of us.

Gene Hodges

Also I think that the way we ran the three for twos in Q4 which was to focus them on being done only through Ingram was probably one of the contributors to keeping the contract length stable rather than growing, as it typically does. So we were a bit more disciplined in terms of giving that discount with no other discount which was the terms on which it was offered only on partners who were going through Ingram.

Gregg Moskowitz - Susquehanna Financial Group

Got it. Just a follow-up on the contract length. You're exiting Q4 about a half a year of a shorter length than what you did in Q4 '05; and certainly as you enter Q1 there is a seasonal effect and as you pointed out you are kind of seeing more of a shift to newer, smaller customers who buy on shorter terms.

What is your view in terms of giving you maybe a little bit of confidence in the guidance that will be able to keep the contract length for Q1 flat with where it was a year ago?

Doug Wride

Well, the crystal ball has a little bit of milk in it right now, because we have Q4 which was different than quarters in the past, so, we have one sort of outlier, if you will, in our trend graph and until we see more we are going to expect that things are stable on a year-over-year basis. That is the basis of the guidance. Similar however to Q4, if contracts were to lengthen or shorten up, we can quantify what the impact is to billings and as we as I did here today of about a $1.5 million in Q4.

One last comment. Again, if we are not running programs that stimulate behavior and as Gene said we ran a very limited program in that way in Q4, then again the contract length is always the choice of the customer. There is only so much you can do to forecast how 5,000 transactions or 5,000 customers are going to choose.

Operator

We will go next to Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

Hi. Good afternoon, gentlemen and Kate and Becky. Just a couple of small questions and I will just kind of throw them at you. CapEx for the quarter?

Gene Hodges

Good question.

Samuel Wilson - JMP Securities

It was supposed to be an easy one to start.

Doug Wride

Sam, you are killing me here. I think that I was so wrapped up in the revenue and billings calculations and explaining those to you. I think CapEx was a little more than it has been. It was probably in the million range. I will get that to you.

Samuel Wilson - JMP Securities

Would you expect any major changes with PortAuthority and Israel and those things for 2007?

Gene Hodges

What do you mean by major changes? PortAuthority in Israel is a major change for us.

Samuel Wilson - JMP Securities

But do you expect CapEx to be significantly higher than 2006?

Doug Wride

CapEx will be higher in 2007. I would say it's probably about $1.5 million higher, not really because of the Israeli operation because that's up and running and has the CapEx already spent, if you will. We acquired that CapEx. But the programs and systems that we have been putting in place to be able to handle the U.S. two-tier distribution move towards a no-touch transaction improve our sales management with a PRM system, and then the establishment of our Beijing operation will have more influence on the CapEx spend.

Samuel Wilson - JMP Securities

Got it. The total number of resellers that you exited the year with was?

Gene Hodges

Did we release that metric?

Doug Wride

We didn't.

Samuel Wilson - JMP Securities

You had 1,350, on the October quarter you said, you had 1,200 and added 150. And so I'm trying to figure out the 150 number you have added takes you to 1,500 or you are still around 1,350?

Doug Wride

We just don't have an exact number on that.

Samuel Wilson - JMP Securities

Care to ballpark?

Doug Wride

I would say that the 150 that we have added through Ingram Micro that we spoke to, that is one number. That's what we have added through Ingram Micro as opposed to that's what we added in Q4.

Samuel Wilson - JMP Securities

Got it. That is what I was looking for that clarification. Actually now comes the two harder questions. Just philosophically, what are you thinking on in terms of share buybacks in 2007? When do you expect to turn profitable on all these change in channel investments you made starting in 2006?

Doug Wride

So I think in reverse order, the channel investments that we have made to-date should be accretive in the second half of '07, but they will be continuing. So I mean, we have invested money in the second half of '06, we will continue to invest money throughout '07. We will just be building the momentum on the return, if you will, such that we cross over and I think it becomes all positive in the second half of this year.

Samuel Wilson - JMP Securities

Got it. Okay.

Doug Wride

The first part of that question related -- I'm sorry.

Samuel Wilson - JMP Securities

Just philosophically on buybacks.

Doug Wride

Stock buybacks. Our position on stock buybacks hasn't changed. We think that the current value or the current price of our stock is still an accretive acquisition and a good use of cash. We were conservative in this fourth quarter because we were in negotiations and we believed that the PortAuthority acquisition was going to take place. As an investor, if you will, or as a buyer of stock that sort of gave us insider information that didn't seem appropriate to be using that, so we stayed out of the market. That's now done and behind us and we are in a different situation in Q1.

Samuel Wilson - JMP Securities

Perfect. Thank you very much, everyone.

Operator

We will go next to Walter Pritchard - SG Cowen Securities.

Walter Pritchard - SG Cowen Securities

Hi. A couple questions from my end. Doug, just to be clear on the $750,000 to $1 million impact from Ingram, is that to billing or to revenue?

Doug Wride

Both.

Walter Pritchard - SG Cowen Securities

Because you talked about something on the order of $2 million, I think, when you gave guidance last quarter. Is that apples-to-apples?

Doug Wride

No. What we talked about last quarter was discounts. Discounts are different than what we have been talking about. So I don't know, maybe that's broccoli. But if we give the VAR 30% discount and Ingram gets say 8% discount, we were taking that 8%, rolling it up to about $2 million and saying that we were accounting for not seeing that $2 million in our billings.

Walter Pritchard - SG Cowen Securities

So you saw the $2 million plus the additional?

Doug Wride

Right. So we saw the discounts. They are marketing expenses in my mind, you pay ABC training company to go to Chicago and run a VAR training, that's a marketing expense. You pay Ingram to go to Chicago and run a training of VARs, that is a contra revenue. I don't understand it but that's what the accounting literature says. We viewed that as it would be marketing expense when we gave guidance. The proof point, if you will, that those amounts in total were what we expected is that operating margin is what we guided to. So whether it came out of revenue or it came down as an additional expense, the impact on operating margin would be the same.

On the rebates where that caught us a little bit by surprise, frankly, is we thought rebates would be only against billings and therefore the revenue impact would be over the estimated life of the billing. But it also has to go against revenue all at once.

Walter Pritchard - SG Cowen Securities

That makes sense. Doug, could you give us visibility -- I know you don't give full year guidance -- but just your more strategic thoughts of hiring plans in '07? It sounds like you are investing more substantially here in Q1. Do you expect those rates outside of the people you are adding through PortAuthority to continue throughout '07 or do you think it is a front-end loaded year?

Doug Wride

We have traditionally, even last year, we start out hiring as many of the sales people as we can at the beginning so they can be here for our mid-January global kickoff and can start working on a quota at the very beginning of the year. We did that again this year. We've now added the PortAuthority people here in Q1 and I think what we will see through the rest of the year that will be the most significant impact, Walter, is building out our R&D facility in China. I think we could have 40 plus people in China by the end of this year. Although those are lower-cost individuals, they will not be in exchange for or in place of San Diego-based engineers or Israeli-based engineers. They will just be additive.

Walter Pritchard - SG Cowen Securities

Gene, just on the end point, I didn't hear you talk much about it. I know PortAuthority had a budding product on the end point side. Any update you could derive for us on just sort of what you saw in demand for your own end point product or strategy going forward there?

Gene Hodges

I think end point is going to be a mandatory requirement for deployment in 2008, but we don't see customers who are saying I want to deploy end point data leakage in 2007. In fact, the message is exactly the opposite. It's rollout something at the gateway in 2007. So we are developing that technology, looking at options for putting together the Threat Seeker end point capability with the PortAuthority Precise ID technology in a single product for 2008.

Walter Pritchard - SG Cowen Securities

Thanks a lot.

Operator

We will go next to Katherine Egbert - Jefferies.

Katherine Egbert - Jefferies

Hi, thanks. Can you talk about pricing on your core Websense enterprise product? How did that hold up in the quarter?

Gene Hodges

Pricing held. The contract value, annual contract value is demonstration that pricing did not deteriorate. So pricing isn't increasing dramatically. It's more gaining market share in this SMB space for us.

Katherine Egbert - Jefferies

So there was pricing in integrity, beyond just upselling add-ons?

Gene Hodges

Yes. There seem to be, although the environment remains intense and the price aggressors, if you will, are still pretty much the same players as before.

Katherine Egbert - Jefferies

Okay, thanks Gene. I have to admit being bit of confused on these contra revenue and contra billings accounts. Can you tell me is the change in revenue recognition going to affect billings or cash flow in '07?

Doug Wride

Not cash flow, but it does impact billings and revenue. The marketing expense, the way we have to book it is contra revenue as it goes on a dollar for dollar basis against both billings and revenue. If it only went against revenue then we would have a reconciliation problem with deferred revenue. So it goes against both.

Gene Hodges

Let's take it a step at a time here. As a rookie financial guy, it was kind of hard for me to get straight. There are two changes. One of them moves what used to be classified as an expense to classification as contra revenue and contra billings. That is the change in the handling of channel-oriented marketing programs. The second one is a change in revenue recognition policy going from monthly to daily. That obviously does have impact on revenue and works its way through cash flow.

Doug Wride

But no impact on billings.

Gene Hodges

Right.

Katherine Egbert - Jefferies

So the change in daily revenue recognition does impact revenue and it does impact cash flow?

Doug Wride

As Gene said, he is a rookie finance guy -- it does impact revenue. It doesn't impact cash.

Katherine Egbert - Jefferies

Does not impact cash.

Doug Wride

Cash is related to billings. You bill it, they pay you. It's cash.

Katherine Egbert - Jefferies

I think I got it. Thanks guys.

Doug Wride

All right, I will follow up, Katherine if you need.

Katherine Egbert - Jefferies

Yes.

Doug Wride

It's not straightforward and I'm sorry.

Operator

We will go next to Brian Essex - Morgan Stanley.

Brian Essex - Morgan Stanley

Hi, good evening. I had a quick question around renewals. Just looking at billings up a couple of hundred basis points over the same period last year but with higher annualized contract values and increased attach rate. Noticing that your renewal rate based on number of customers seems to be in a consistent range. Can you talk a little bit about renewals from an absolute dollar amount and any competitive pressure there?

Doug Wride

Well, there was a lot in that. Renewals, the metric that we always speak to is customer renewals. Customer renewal rates were constant. They were in our 75% to 80% range. The upsell capability continued whereby if you look at it on a dollar basis the customers that renewed bought more. So, the dollar renewal basis was again higher than that customer renewal base. But we don't get into that on a specific basis on a quarter-to-quarter basis.

Brian Essex - Morgan Stanley

Any perceived flatness relative to previous years due to the shift based on changing contract lengths and whatever other metrics depending on what numbers come up for renewal?

Doug Wride

The one impact is that if contract lengths are expanding, then that expansion is a part of the upsell, if you will. So somebody is a one-year contract for $10,000 and they renew for two years at a 15% discount at $17,000. That $7,000 delta is part of the upsell. As contract lengths are stable, that component comes out of your dollar upsell capability per calculation.

Brian Essex - Morgan Stanley

On the competitive front, we are hearing more about other vendors experiencing pressure from OEMs, I know you talked a little bit about OEM margins. Any other dynamics that you can speak to regarding any installment plans or any other competitive angles you are looking for in the market to maintain share?

Gene Hodges

Well, one of the things that has remained simple and constant is that we haven't pushed the products through OEM or other fairly low yield billing channels. The competition is pretty intense in the filtering space across all the geographies, but it is still sales to end users to our partners.

Brian Essex - Morgan Stanley

Okay, great. Thank you very much.

Operator

We will go to Robert Breza - RBC Capital Markets.

Robert Breza - RBC Capital Markets

Hi, good afternoon. Looking at the three-year deals, you guys saw slowdown in three-year deals. Your nearest competitor who reported this morning also noted a slowdown in the three-year mix. I guess just as an observation, that seems to curtail the growth from a billings perspective when you look over it in totality. I know, Doug, you talked about it going back to the March '06 mix, but shouldn't we be thinking more like the March '05 timeframe from mix because it seems like there is a reluctancy here by customers to take on multi-year deals and obviously your shift to the small-to-medium sized business probably tells us that mix changes to a lower percentage. What are your thoughts on that?

Doug Wride

Well, typically customers renew for what their previous expiring subscription was. What we were seeing for '04 and in '05 were large customers, the percentage of customers extending their subscription was not changing that much. It was rather the dollars involved were being influenced by the large one-year customers going to three-year. So what we have seen is that those three-year customers are staying, those large three-year customers are staying at three years and there aren't additional participants extending basically. When you look at the new business, the new business to the extent that it's the smaller customer in North America, they are sticking closer to the one-year deals.

Gene Hodges

I would not characterize this as a reluctance among the larger customers. I would characterize it as us not reaching as hard for the billing with a focus on discounting for the three-year deal, possibly showing a little more discounting which leaves a little more business in the market to take in the future. So in many ways this is an investment. You can always perform a little bit better on the billings line, although it doesn't hit revenue, by trying to be more aggressive in contract length extension.

Robert Breza - RBC Capital Markets

I guess as a follow-up to that Gene, it also came up that your competitors are not looking to be aggressive in pricing the three-year deals. They feel that they are giving value away. Normally we see Websense increase price in January. I don't think we have heard that or seen that from you yet this quarter. What are your thoughts about pulling the three for two promotion that you put in place last quarter? It seems like your competitors are pulling that. How are you really reviewing that against the whole pricing promotion strategy going forward?

Gene Hodges

Rob, I think we want to try to keep things simple. We will not raise list price in Q1. But it is a fairly complicated calculation. Raising list price does not actually change pricing further down, if you raise list price and street price doesn't move. It really doesn't make any difference. We don't see significant increases in street price for customers at a given size. We think we can raise our average pricing or the average pricing will tend to go up a bit as we move the mix. But we don't see the street price for a given customer going up, and hopefully not down either.

Robert Breza - RBC Capital Markets

If you look back, I think in Q2 you hired 40 sales reps or so to attack the SMB market and then move to the two-tier distribution, I think if I heard you correctly in your remarks you talked about hiring additional 40 net new sales/marketing people in Q4, and I think they are more channel-oriented people. How do we compare what happened in Q2 that didn't pan out to kind of what you are doing now in Q4? How are they different from the strategic perspective?

Gene Hodges

I think it was actually Q1 and Q4 of '05 that we did most of that hiring. That was to build a direct sales organization for SMB, and we refocused that group to start doing channel support in late Q2 and types of people that we brought on in Q4 and this year are both in field channel-friendly sales people as well as classic channel account managers.

Robert Breza - RBC Capital Markets

Thank you.

Doug Wride

Rob, let me also add to the clarity there. We have, for years, hired an increase of sales people in Q1 at the very beginning of the quarter. Our discussions in interviewing and so on have taken place in Q4, so that we can get back that ramp rolling right away in January. Last year '06, we again did that but the focus on the nature of people we are hiring were the group that Gene spoke to, the direct telesales group, to approach the SMB market. Our headcount then decreased in Q2 and Q3 because, we were changing our direction to the two-tier distribution and now that that's in place, the nature of the people domestically that we are hiring are with more of a channel focus. The international folks that we've hired continue to be the same as they have been in the past. So '06, Q1, was really the outlier where we hired people and then decided that their responsibilities needed to change.

Robert Breza - RBC Capital Markets

Maybe as just a final wrap-up question, if you look at the sales force churn in the quarter, where was it relative to your expectations and how do you stem sales force churns going forward?

Gene Hodges

We don't forecast sales force churn, but it was certainly lower than we experienced in Q2 and Q3. I'd characterize the North American and international sales force as stable and executing on the channel-oriented strategy.

Operator

With no further questions at this time, I would like to turn the conference back over for any additional or closing remarks.

Kate Patterson

Thank you all for joining us. We will be available for follow-up calls and hope to see you at the analyst meeting next Wednesday, February 7. Thank you.

Operator

That does conclude today's conference.

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