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Blue Coat Systems (NASDAQ:BCSI)

Q2 2012 Earnings Call

November 17, 2011 5:00 pm ET

Executives

Jane Underwood -

Gregory S. Clark - Chief Executive Officer, President and Director

Gordon C. Brooks - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Analysts

Scott Zeller - Needham & Company, LLC, Research Division

Sanjit Singh - Wedbush Securities Inc., Research Division

Gary Spivak - Noble Financial Group, Inc., Research Division

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Blue Coat Systems Second Quarter Results Conference Call. [Operator Instructions] As a reminder, today's conference call is being recorded. I'd now like to turn the conference over to the Vice President of Investor Relations, Jane Underwood. Please go ahead.

Jane Underwood

[Audio Gap]

Blue Coat's financial results for the second quarter of fiscal 2012. With me on today's call are Greg Clark, our President and Chief Executive Officer; Gordy Brooks, our Chief Financial Officer; and Steve Daheb, our Chief Marketing Officer. Before I turn the call over to Gordy, let me remind you that during the course of this call, we will make forward-looking statements about Blue Coat Systems Inc. These include statements regarding expectations concerning market growth and business opportunities, including levels of IT spending; expectations regarding future revenues, expenses, margins, profits, tax rates and other financial metrics; plans to develop and offer new products and services and enter new markets; market trends and customer requirements; the success of our business strategy, go-to-market expectations and changes in our business model and operation; and other matters impacting Blue Coat's financial outlook and future business.

All statements other than statements with historical facts are statements that can be deemed forward-looking statements, including any statements of expectations or beliefs and any statements of assumptions underlying any of the foregoing risks, uncertainties and assumptions including the risks that are described from time to time in the reports filed by Blue Coat with the Securities and Exchange Commission, including, but not limited to the risks described in Blue Coat's annual report on Form 10-K for the year ended April 30, 2011. No assurances can be given that any of the events anticipated by the forward-looking statements will transpire or occur, or if any of them do, what impact it will have on the results of operations or financial condition of Blue Coat. Blue Coat assumes no obligation and does not intend to update these forward-looking statements except as required by applicable laws. Now I'd like to turn the call over to Gordy.

Gordon C. Brooks

Thank you, Jane. Good afternoon, everyone. I'm pleased to report that Blue Coat exceeded the second quarter financial guidance that we provided on our last conference call. Importantly, our product revenue performance is stronger than we had anticipated, which drove a solid improvement in profitability. Not only did we deliver better-than-expected results, we made progress on improving execution in key areas of our business, which Greg will discuss in a few minutes.

Now turning to the results. Net revenue for fiscal Q2 was $114 million, an increase of 4% sequentially but a decrease of 6% compared with the same period a year ago. Product revenue for fiscal Q2 was $62 million, an increase of 6% from the prior quarter but a decrease of 15% compared with the same quarter a year ago. In Q2, the sequential strength in product revenue performance came from our Web security products and our federal to vertical. Our Web security products, which currently include ProxySG, AV and Blue Coat WebFilter compose 77% of product revenue in Q2 compared with 69% in Q1 and 73% in Q2 of the prior fiscal year. Our acceleration products, which currently include PacketShaper, MACH5 and CacheFlow compose 23% of product revenue in Q2 compared with 31% in Q1 and 27% in Q2 of the prior fiscal year.

Going forward, we will be breaking out our product revenue results into 2 categories: Web security and acceleration, and we'll no longer be providing commentary on specific product revenue performance. Given the actions we are taking to improve our top line performance and the way we've realigned our organization, we believe these 2 product categories will more accurately measure the progress we are making and provide a better overall picture of our current business.

Service revenue was $52 million, which was essentially flat sequentially and increased to 8% compared with the same quarter a year ago. Similar to fiscal Q1, the dollar amount of annual renewal support contract value closed in the quarter, which was the highest we have closed in fiscal Q2.

We continue to be highly focused on this aspect of our revenue model by continuing to provide incremental value to our customers through software release upgrades. At the same time, we're also focusing on optimizing our support revenue stream by continuing to increase our service revenue contract renewal rate.

On a geographic basis in Q2, net revenue in the Americas was $58 million and represented 51% of total net revenue. Net revenue in EMEA was $35 million and represented 31% of total net revenue. Net revenue in Asia Pacific was $21 million and represented 18% of total revenue. Net revenue in the Americas increased 20% sequentially and 1% compared with the same quarter a year ago. Net revenue in EMEA decreased 7% sequentially and 14% compared with the same quarter a year ago, and net revenue in Asia Pac decreased 10% sequentially and decreased 9% compared with the same quarter a year ago.

Our U.S. federal business represented 15% of product revenue or $9.4 million in Q2, compared with 4% of product revenue or $2.1 million in the prior quarter and 15% or $10.7 million in Q2 of fiscal 2011. In the second quarter in the Americas, we experienced an expected seasonal increase in U.S. federal vertical as the federal government completed its fiscal year. While the concerns that we expressed on our Q1 earnings call were appropriate given the uncertain state of funding in August, deal flow returned to a normal seasonal level in the month of September and our security products continue to garner priority in funding.

We continue to see volatile performance in EMEA, with specific weakness this quarter in the U.K. and Italy. In Asia Pac, we continue to experience slow recovery in Japan, which contributed to a slight decline in PacketShaper revenue, and we also saw weakness in Australia and made leadership changes in the subregions.

During the quarter, we had 4 deals worldwide whose total deal value was greater than $1 million compared with 3 deals in Q1 and 7 deals in Q2 of fiscal 2011. In addition, we saw an improvement of our volume business, which is composed of transaction plus some $50,000 in deal size. These transactions are generally driven by the channel.

Lastly, a shift in product mix to higher throughput products as well as decreased discounting help drive higher average unit prices across all product families.

Moving on to costs and expenses. Total non-GAAP gross margin was essentially flat at 77.8% in Q2 compared with 77.7% in Q1 and decreased from 79.8% in the same period a year ago. Product gross margin was 78.2% -- or service gross margin was 78.2% compared with 78.8% in Q1 and 80.9% in the same period a year ago. Service gross margin was 77.2% compared with 76.4% in Q1 and 78.2% in Q2 of fiscal 2011. Increased service revenue was essentially -- service revenue and essentially flat expense relating to our cloud security service infrastructure contributed to the sequential improvement.

Non-GAAP operating expenses increased to $75 million in Q2 compared with $73 million in Q1 and $72 million in the same period a year ago. The increase in operating expenses in the quarter was primarily related to one-time executive and employee severance payments of approximately $3 million or 4% per diluted share after tax. In Q2, sales and marketing expense was 40% of net revenue, R&D expense was 16% of net revenue, and G&A expense was 10% of net revenue. Normalized for the one-time executive severances, G&A expense would have been 8% of revenue. Total employee headcount was 1,321 as of October 31, 2011. From a bottom line perspective, non-GAAP operating margin increased sequentially to 12.4% and non-GAAP net income was $9 million or $0.20 per diluted share.

Now turning to the balance sheet. Cash, cash equivalents and restricted cash balances as of October 31 were $362 million, an increase of $20 million over the prior quarter. Operating cash flow in Q2 was $18 million. Trailing 12-month operating cash flow was $107 million compared with $119 million in the prior trailing 12 months. The reduction in trailing 12-month operating cash flow correlated with the reduction in operating profitability over the same period. CapEx was $2 million in the quarter.

Accounts receivable increased sequentially to $71 million on October 31 from $67 million on July 31, and decreased from $82 million on October 31, 2010. DSO increased to 56 days in Q2 compared to 55 days in Q1 and decreased from 61 days in the prior-year quarter.

Total deferred revenue was essentially flat sequentially at $175 million on October 31 and increased from $163 million on October 31, 2010, driven by the higher support renewal levels in the period.

Now turning to our outlook for Q3. Although we are encouraged by the improvements that we have experienced during Q2, we believe it is prudent to remain cautious given the extensive changes that we have undergone in the last 90 days and the work we have ahead of us. We currently anticipate net revenue in the range of $113 million to $120 million. Within this range, we expect service revenue which is primarily amortized from deferred revenue to be between $52 million and $54 million.

On a GAAP basis, we expect earnings per share to be in the range of $0.05 to $0.13. We expect the fully diluted share count of approximately 47.3 million shares and an annual effective tax rate of 38%. On a non-GAAP basis, we expect gross margin to be between 77% and 79% and operating margin to be between 12% and 16%. We expect earnings per share to be in the range of $0.19 to $0.26 per fully diluted share, with an expected annual effective tax rate of 30%. At our current level of profitability, we expect our tax rate to continue to be 30% throughout the rest of the fiscal year. This guidance is based on foreign currency rates effective as of today and any material changes to those rates could impact these projections. Lastly, fiscal Q3 is typically the quarter in our fiscal year where our support contract renewals are most robust and drive significant increases in deferred revenue and operating cash flow. We expect this trend to continue in this fiscal Q3.

In closing, I'd like to -- we've taken several actions in the last 90 days to improve our top line performance and believe we are improving our visibility into that performance. As Greg will discuss, the changes we've made in our sales force and the increased engagement with our channel partners has begun to provide us with a clear line of sight into opportunities in the closure of deals. We spent a significant amount of time and effort with our key distributors and resellers to better balance our direct touch model between our partners' engagement and our end-user customers. Overall, we are encouraged by the response from both our partners in the field, but there's more work that lies ahead of us.

Now before I turn the call over to Greg, I'd like to comment and provide my perspective on 2 recent developments. I'm sure you've all read in various newspapers and on the Web, we have become aware that certain Blue Coat ProxySG appliances apparently were illegally transferred to Syria after being lawfully sold to a channel distribution partner for a seemingly appropriately -- appropriate and designated end user. I want to be very clear: We do not sell our products to countries embargoed by the U.S. government and we contractually prohibit our partners from selling to embargoed countries. In addition, we require identification of the end user on every order and we reconcile every order before shipment from each of our locations worldwide to ensure that no identified resellers or end users are prohibited. We do not know who's using the appliances or exactly how they are being used. We continue to conduct an internal review and are working directly with appropriate government agencies to provide the information on this unlawful diversion.

Our review of the facts about this diversion presents solutions that enable us to better protect against future illegal and unwanted diversion of our products; we intend to take steps to implement them. If you'd like additional information, please refer to our website for a commentary on this situation.

Second development I'd like to mention is a standstill agreement with Elliott Associates, our largest shareholder. On October 25, the standstill agreement with Elliott Associates was extended to December 10, 2011, or 7 calendar days following the date in which either Elliott Associates or Blue Coat delivers written notice to end the standstill period. Please understand that this time, we do not have any additional public commentary to provide on Elliott Associates and the standstill agreement, and we are not in a position to answer any questions on this topic. Now let me turn the call over to Greg.

Gregory S. Clark

Thank you, Gordy, and good afternoon, everyone. First, I'd like to say that I'm pleased to see the company deliver improved financial results. Since our Q1 call, we have made progress in refining our strategy and improving execution in specific areas of the company. Importantly, we have been taking actions to return the company back to a growth trajectory and increased profitability. This afternoon, I'm going to share some of the changes we have made within the company, along with the opportunities I see before us.

Last quarter, we improved the focus of our R&D and sales teams by better aligning them to our markets and simplifying their organizational structure. These changes are already starting to provide faster decision-making and to improve productivity. In R&D, we have distinct teams dedicated to web security and WAN optimization. This realignment should drive stronger innovation and shorter time frames, accelerate development of product roadmaps and speed up the delivery against those roadmaps. In sales, we took steps to simplify our coverage model. Early in Q2, we went from a corporate-managed sales matrix to a geography-based organization. To provide some perspective, we have now reallocated the management of approximately half of our resources such as sales engineers and channel employees from Blue Coat headquarters to the regional level. This improvement is already creating better autonomy and accountability as ownership of closing new business is now squarely in the field. Our resources are now closely aligned to our partners and customers in the regions. These changes should drive improved visibility into our sales pipeline, enable more effective allocation of our sales resources and improve deal closure.

In the second quarter, we also promoted Marc Andrews to Senior Vice President of Worldwide Sales. Mark, who joined Blue Coat in April, has a strong track record of building and leading global teams. In addition to Mark, we now have sales leadership in place in all 3 geographies.

Focused alignment in the field is critical as it provides us with a clear line of sight. Blue Coat has strong product portfolio on both Web security and WAN optimization, and with focus and discipline, we can more effectively sell the solutions we have today by targeting the opportunities where our products are clearly differentiated. Market segmentation is key. Not only does it help improve our top line performance but it also provides greater clarity and direction and involvement of product roadmaps.

Turning to some second quarter highlights. In Q2, Web Pulse, our cloud-based classification and anti-malware service, reached a significant milestone by serving 1 billion Web content inquiries in a single day. This volume of requests is indicative of the increasing use of our technology in the market and the significant impact our WebPulse service has on malware prevention. WebPulse also provides deep intelligence about web patterns, user behavior and malware ecosystems. As a result, we can effectively identify and block the malware that plagues all corporate users. For those of you familiar with our products, WebPulse is a service behind our WebFilter product in the appliance.

We also had some significant customer wins in the second quarter. I have selected some examples that highlight the opportunities before us. In Q2, we closed a large deal with a leading global financial services firm that needed a more robust security solution for its consumer Internet banking sites. The customer purchased our security appliances replacement between the retail banking users and the service for its Internet site. This win is a great example of an Internet-to-corporate appliance deployment, or what is commonly called a reverse proxy, which enables secure access of internal corporate resources via the Internet. A reverse proxy deployment is an example of an underpenetrated use case of our appliances and represents an additional opportunity for us to sell our products.

In the quarter, we also saw good traction in our Blue Coat cloud security service. In particular, there were 2 deals that stood out. First, a leading national electronics retail purchased an initial 35,000 seats of our cloud security service. This deployment provides Web protection for its corporate headquarters as well as for its 6,500 retail locations. We are seeing strong interest for our cloud security service from organizations with large numbers of remote locations such as in retail and education verticals. Second, an American-based manufacturing company purchased an initial 13,000 seats of our cloud security service along with their MACH5 appliances. MACH5 appliances provide remote location acceleration for its critical corporate applications, and by connecting the MACH5 appliances to our cloud security service, the customer is also able to secure Web access in its remote locations. This combination of our optimization and security solutions differentiate us from our competitors.

These customer wins highlight Blue Coat's product leadership in its markets, and while there is more work ahead, we're capitalizing on the company's strengths and addressing its key challenges. Progress is well underway and we're beginning to see some results for improved execution. Now I'd like to turn to my view of the company.

Many of the fundamentals for Blue Coat's future success are in place today. We are well-positioned in our 2 markets. Blue Coat has an exceptionally strong brand and product portfolio in Web security and WAN optimization products that lead in addressing the unique acceleration requirements of the next-generation applications in rich media. I've always been impressed with Blue Coat's security appliances and see great potential in our hybrid strategy, which combines on-premise appliances with our cloud security service. This unique approach gives enterprise appliance customers the capability to extend the same level of protection to mobile workers and smaller branch officers where an appliance is not cost justified. And with our cloud security service, we now have the right vehicle to further penetrate in the global 10,000.

Blue Coat also has a highly differentiated WAN optimization product with performance capabilities that are aligned where I believe the market is headed. In particular, I believe we should win our fair share of deals for any quality of service, visibility, document caching, video, web or SaaS acceleration as a main driver of closing business. Blue Coat has some strong technical advantages in WAN Optimization, mainly the company's heritage in asymmetric optimization and object caching as well as the power of application and web content classification. This is impressive and hardened technology that allows us to uniquely prioritize and accelerate voice over IP, video, Web and SaaS application traffic. In addition, our policy management provides industry-leading visibility control over social networking, Web content and other issues facing our customers. These capabilities are well ahead of those of many of our competitors. In the longer term, these types of acceleration opportunities and application trends should drive the market's future direction and justify our continued focus in this investment.

Blue Coat has a healthy route to market, notably with a strong and loyal security channel, as well as an established PacketShaper channel. The company also has a premier customer base in both the Fortune 1000 and Fortune 10,000, which continued to trust Blue Coat in investing in our products. Importantly, we have highly capable employees who want to be part of a winning team.

Going forward, we are moving quickly on the following key initiatives: First, we are sharpening our focus on web security. We're expanding our technical leadership in our core products as well as providing new solutions that offer a strong value proposition in adjacent segments to the secure web gateway market. To achieve this goal, our team is developing next-generation solutions that expand our addressable market beyond the large corporate enterprise to the branch office, laptop and mobile devices.

The requirements in security are increasing beyond the corporate enterprise and larger-branch offices. With the proliferation of laptops, tablets and smartphones, the physical edge of major corporations is eroding. To capture this market opportunity, we're also focusing on the secure web access portion of the market. Importantly, the Secure Web Gateway and Secure Web Access segments are highly synergistic from both product development and go-to-market perspectives, and we see great opportunities to leverage our investments going forward.

Today, we offer mobile Web security through our hybrid model that combines on-premise applications with our cloud security service. Longer term, we are developing a comprehensive mobile Web security strategy and product roadmap to better capture this market opportunity and deliver the best solutions for our customers. This is a significant adjacency within our installed base and leverages our current reps to market.

Secondly, turning to WAN optimization. We're working on enhancing our MACH5 and PacketShaper appliances, including extending our video technologies to optimizing encrypted Adobe Flash, delivering unified performance reporting across our products and providing a powerful cloud-based network application assessment service, which helps our customers understand exactly what is running on their networks and what strategy to undertake to optimize performance and contain costs. We also have integrated our malware protection features of WebPulse into our PacketShaper appliances, which differentiates us from the competitors by adding important security capabilities to the customer's branch office. Not only do we provide traffic prioritization, we now disable connections to known malware endpoints within the Internet. This is something that only Blue Coat provides.

Third, we are placing greater emphasis on strengthening and leveraging our security channel by better educating and training our partners on the solutions that we have to solve today, and we are reinforcing and communicating our future product plans along with jointly driving awareness and demand generation campaigns. In addition, we continue to identify global partners that have the expertise needed to sell next-generation WAN Optimization. We're also engaging PacketShaper resellers and have committed additional engineering resources to the product line. WAN Optimization including PacketShaper represents a sizable and strategic piece of our revenue which we intended not only to protect but to grow.

Finally, as I mentioned earlier, we are making further improvements to our sales coverage model, ensuring that we have the right balance of resources, focused on supporting our distributors and channel partners.

Longer term, I'm still in the process of reviewing all of the elements of our business. In particular, I'm focusing on our operational model and cost structure and benchmarking them against best-in-breed financial metrics. Nothing will be taken for granted in this process. From a financial perspective, our objective is to drive both revenue growth and profitability. And while we remain focused on both of that markets, I believe Web security represents a stronger near-term opportunity for product revenue growth.

In closing, with progress already underway, we are identifying our focus and accelerating our pace. We are reinforcing our strengths in the Web security and WAN Optimization market, along with solidifying our relationships in the channel and optimizing our sales coverage model. At the same time, we are focusing on gaining additional operational efficiencies and are continuing to analyze the company's cost structure. These efforts and changes are focused on retaining and achieving market leadership and focused on driving shareholder value.

We look forward to updating you on our progress in the next call, and now I'd like to turn the call back over to Jane.

Jane Underwood

Thank you, Greg. That concludes today's [indiscernible]. While we open up the call to Q&A, [Operator Instructions] Operator, we would now like to open up the call to analysts' questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Rohit Chopra from Wedbush Securities.

Sanjit Singh - Wedbush Securities Inc., Research Division

This is Sanjit Singh with Wedbush Securities for Rohit Chopra. I was wondering if you could break out, Gordy, the service revenue component of the Web security and the Web acceleration business?

Gordon C. Brooks

We don't have that broken out as of yet but we will be working on that for future conference calls in the same categories we broke out the product revenue.

Sanjit Singh - Wedbush Securities Inc., Research Division

Great, okay. So then maybe a question on the competition. Last quarter, there's some competitive pricing pressures, particularly at the high end. Can you just give us an update on what's happening on the competitive environment?

Gregory S. Clark

So in terms of competitive pressure, we are very focused on competitive analysis in the company as you can imagine with the change of senior management. At this stage, I am really focusing the company in on where our strengths are, the segmentation that we are doing to make sure that we are targeting our channels and sales force at places where our technology does have a substantial leadership position. Focusing our energy there is where we are right now. I think we are, again, continuing to refine our product roadmaps to, again, as I mentioned, significantly differentiate us from that competition. One final remark, I think that we did have some very good improvement in the quarter on less discounting in the channel, which I think also lends itself to some of that already starting to work.

Operator

Next, we have a question from the line of Jess Lubert from Wells Fargo Securities.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

So I've got a question and I've got a follow-up. A question on the guidance. Generally, the federal business declined sequentially in the January period. Europe looks like it's still weak. Your nonfederal business, looks like it declined about 20% sequentially here. So can you talk a little bit more about your current pipeline, the close rates, what you're hearing from customers during the first few weeks of November that gives you confidence that you could hit the midpoint of your upcoming quarter guidance which appears doing bad [ph], modest sequential growth?

Gordon C. Brooks

Jess, this is Gordy. I'll go ahead and answer that. I think there are a couple of elements. As you know, from a seasonal standpoint, even though there is volatile performance in Europe, we generally see sequential growth in Europe going into our Q3 as a significant number of our distributors and resellers in Europe have their calendar quarter end, so we work very closely with them to understand the visibility within that pipeline for the calendar year end. In federal, we've certainly gone through the same type of scrutiny of deals that are opportunities within the quarter, and given some of the activity over the federal period through the end of their fiscal year, we also see that there is still opportunities here for us in this quarter. Lastly, we do see opportunities within our strategic accounts, also in the Americas primarily driven by that end of calendar year. So with the new sales administration and with the channel, we've done a much deeper dive this year for this fiscal period, especially given some of the volatility that we've seen in the geographies to gain comfort in that range that we provided.

Operator

Next, we go to the line of Scott Zeller with Needham & Company.

Scott Zeller - Needham & Company, LLC, Research Division

The first question is on large deals. Could you tell us if there were any 10% customers or what was the largest deal in the quarter?

Gordon C. Brooks

There were no 10% end users, so I assume you mean end users, not channel partners at this point in time. And the large deal composition was relatively similar to prior periods as far as the overall percentage. No deals over $5 million in that mix.

Scott Zeller - Needham & Company, LLC, Research Division

And on the balance sheet, could you give us some color around the deferred which was flattish? Was there a change in the license component? Did it go down or up?

Gordon C. Brooks

We relatively have a nominal amount -- generally have a nominal amount of license components. It didn't change significantly quarter-over-quarter, I think what we've seen in deferred revenue is that improvement in product revenue means that the support attached to that product revenue is more robust. It's period-over-period, allowing that deferred revenue to stabilize as opposed to the sequential decline that we saw last quarter.

Operator

Next, we go to the line of Gary Spivak from Noble Financial Group.

Gary Spivak - Noble Financial Group, Inc., Research Division

Greg, you mentioned the near-term opportunities are more on the security side. What do you think is -- have you had time to look at what do you think the appropriate mix is going out a couple years or more?

Gregory S. Clark

I'm not prepared to comment on that at this time, no. The market in general, I think we like the supporting evidence from all of the third-party analysts from the growth in the security market. We do like the recession-proof nature of the security market which has been proven in previous recent downturns. So we'd like that over the longer-term horizon and we also are confident that the WAN optimization space is coming our way as there is more rich content and heavier use of content than what I've mentioned about the asymmetric elements of WAN optimization really driving the market into the direction we have substantial technology advantages. And I would just like to comment on the difficult nature of that kind of technology. That is not something someone can put together in a short period of time. And we have proven and hardened products in the market, they have been doing that for a long time, so we do have a substantial advantage from where we feel the market is heading over that longer period.

Gary Spivak - Noble Financial Group, Inc., Research Division

Okay. And if I could ask a follow-up relative to the same 2 pillars there, the sales force composition, are you -- and where is that sound? Did you see attrition in the quarter? Are you hiring? And are you hiring more with a focus on one side versus the other?

Gregory S. Clark

I think what we are focused in on in Q2 is really just making sure we had the right alignment to the opportunity as we see it. We did a lot of realignment of our current sales force. We have [indiscernible] begin to stabilizing that team, and where we are -- the segmentation comments I made are very important in the top of -- we have been working hard to making sure that our channel and our direct sales force are going after stuff where we know we can win and shaping our energy into that part of the market. In terms of the next step, we are still analyzing the sub-geographies, subregional level, the ability of us to really deliver some of those solutions in each geography. And we will be continuing to sharpen our focus towards making sure we had partners in the right places for the optimization and acceleration technologies because it's more than just our direct sales force. We need the channel partners in region to be able to deliver it, so we're working hard on both of those efforts.

Operator

Next, we'll go to the line of Alex Kurtz from Sterne Agee.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

A question and a follow-up. This is the first quarter in a really long time that you outperformed on the guidance. Is there something about the forecasting process or just sort of the pipeline data that you're getting back from the field that you guys sort of feel like you have a better feel for, Gordy [ph], than in the prior quarters?

Gregory S. Clark

I guess I'll just take a first crack at that. When you have a senior management change like we had here, you of course dig in and scrub everything in that part of the world. And Marc, Gordy and myself and all of the senior team have been crawling all over, making sure that we have that process improving, and we will continue to improve it going forward.

Gordon C. Brooks

Yes, I think maybe one question, Alex, in regards to the current quarter when we set guidance in August, certainly especially related to the federal government, there couldn't have been a more uncertain time in the federal funding to have done that. We used the same methodology in August as we had in prior quarters and had just seen a weakness in the pipeline and concerned about closure in such big exposure in federal. And they come in here into Q3, again as Greg noted, a real different discipline over the sales force, really trying to have all of us as executive management focused on what those opportunities are to be as crisp with guidance as possible and have a confidence ratio that we can continue to perform against.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

And Gordy, just my follow-up here, is it right to understand that you're not going to be breaking out PacketShaper anymore?

Gordon C. Brooks

That is correct. So I think that with the information that we provided on the percentages and the percentages against prior periods, you can get a good feel for what the relative values were in the current period, so we try to give the best information to keep that consistent to translate the models.

Operator

[Operator Instructions] We'll go to the line of Jess Lubert from Wells Fargo Securities.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

I wanted to follow up on Europe. In your response to my first question, you seemed to suggest that Europe would be up sequentially next quarter, and I guess I wanted to understand better what was giving you that confidence. It seems like some of the macro forces in the region that had previously hurt you had gotten worse rather than better. So if you could dig in a little bit more on Europe, I think that would be helpful.

Gordon C. Brooks

Sure. I think a couple of things. I think in the last year, we've seen, with the initial weaknesses that we had in Europe that we believe were significantly driven by some of our execution challenges, we've seen a relative level of stability granted, than volatile from quarter-to-quarter. But I guess for this particular quarter, we certainly look down at the pipeline at a regional level, work with our channel partners to understand what those opportunities were, looked at the larger deals cadence as well as the smaller volume base deals that we've talked about. They're kind of the foundation of any given quarter. So I think that looking at that and looking at the performance of the countries, as well as realized that Europe also includes the Middle East, we do have a robust business in the Middle East with certain key strategic telcos. So across that whole landscape and understand those deals is what gave us the confidence to set the guidance where we have.

Operator

Next, we have a question from the line of Alex Henderson from Miller Tabak.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

So I just wanted to get a couple of data points correct because you broke up a little bit when you were giving the percentages earlier. You said that Web security was 77% of product sales and acceleration, 23%. Is that correct?

Gordon C. Brooks

That is correct.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

And the year ago was 27% in acceleration?

Gordon C. Brooks

Yes.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

Okay. Just want to make sure I had the numbers right. And did you give a book-to-bill or a headcount number?

Gordon C. Brooks

We gave a headcount number, 1,321, and we don't give a book-to-bill metric.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

My question is on the operating expense lines going forward. [Technical Difficulty] The question I was trying to ask was the operating expenses. Can you talk a little bit about where you are in terms of the cost-cutting exercise, how much of that is completed, how much more should we be expecting to run through the OpEx line and how should we think about the investments you need to make to rebuild, particularly in the European theater around the distribution reach? Obviously, some of this is discretionary and therefore it's hard to model externally.

Gordon C. Brooks

I think that the guidance gives you our best view of the current period, and we will provide a longer-term outlook on those operating expenses as we continue to determine what the right steps are in each of the organizational areas. I would say that our expectations for our investments in R&D have not materially changed. We generally run 15% to 16% of revenue in R&D and I don't see that as being significantly different in the near term. For the other areas, we gave the same area of guidance that we generally do from a profitability standpoint, but within that, we are still working on the different changes that we may make and assessment of each area of the business. So there's really not a cadence to provide as of yet. Just to go ahead and clarify on one area, as far as the engagement or reengagement that we have made with our channel partners, we don't believe that this is a significant cost investment but really more of a change of the engagement model between our sales force and the channel. So we again do not believe that that's necessarily a burden to our operating expenses but more a way of doing business for the company.

Operator

And we have a question from Scott Zeller with Needham & Company.

Scott Zeller - Needham & Company, LLC, Research Division

Could you remind us again about the channel revenue recognition policy? Is everyone worldwide recognized on a sell-through basis or do you have sell-into revenue recognition for anyone?

Gordon C. Brooks

We have and you can read it in our public filings on rev rec. We are a sell to model, we sell into the channel, and so we go through. But the channel has, unlike several years ago, we were a sell-through model when we allowed stocking rights for the channels. One of those [ph] stocking rights channel does not hold inventory, and contractually, they're not allowed to hold inventory, so the channel, the distributor, and/or the reseller depending on the type of transaction has an identified end user and an identified commitment from the end user, and we do not again allow the channels to hold inventory. We do not allow any refunds on any sales into the channel. So it is a sell-in model with a identification of an end user.

Scott Zeller - Needham & Company, LLC, Research Division

And just to clarify, that's worldwide?

Gordon C. Brooks

Yes, that is worldwide.

Scott Zeller - Needham & Company, LLC, Research Division

Okay. And then the next question is, can you just help us with understanding, I guess broadly speaking, the outperformance in the quarter, especially around EMEA when we'd heard about pretty material disruption in the field due to leadership changes and just a general macro pressure, how is it that -- and also the sales model change, with people -- I mean, it sounds like you went from a named account model to a geographic coverage model, and how did all those happen in one quarter and you outperformed, if you could help us?

Gregory S. Clark

A couple of comments on that. Prior to management changes that were made there was a reasonable understanding within the board and management to move the company from the matrix organization that it was to a direct geo model. So we didn't move. We pushed the responsibility for the resources closer to the point of sale executable in the geography, removed any excuses around accountability, forgetting those outcomes that were being forecasted achieved, and removed a lot of complexity from the organization. That was done early in Q2. That was not done towards the end. And we quickly made the leadership changes in place to stabilize our internal sales force right away and got back to work. And so I think that we have that structural change behind us. In addition to that, we had some pretty strong engagement with the senior leadership of our channel partners and checked in on how things were going there and started to -- programs to work more efficiently with them. So that were the changes that we've made. They were pretty special changes. They are behind us as per the comments we made in the remarks before, and we are continuing now to review any additional work that we have to do in that area of the company. We're 2.5, 3 months in, and we have more work to do. And we look forward to checking in with you on that in the future.

Gordon C. Brooks

And Scott, just to clarify on one element. For Q2 itself, really I would say that the overperformance was in the Americas. I think if you look at the revenue year-over-year and sequentially that the Americas is primarily driven again by federal and by -- parts of our strategic accounts were really the strength. Actually Europe was down sequentially so it wasn't overperformance in Europe. And that might be related to a discussion around Q3, where we do see an uptick in our guidance in Europe because it is the seasonal end of calendar year in Europe. And just to go ahead and talking about those strategic accounts, year-over-year I think, as most of you remember, last Q2 of FY '11 was our strongest-ever period from a federal standpoint, so we're relatively flat year-over-year in the Americas, just slightly less than federal which meant that the strategic accounts made up the rest. So again the overperformance I really think is the federal, and that's why I reference back to having set guidance back in August where federal could not have been at a more uncertain time and the concerns that we've demonstrated in the guidance range that we've provided given our exposure into the federal budget year end.

Operator

[Operator Instructions] We go to the line of Alex Kurtz from Sterne Agee.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

I look back at the Riverbed call from last quarter, guys, and they put out a statement that in the last quarter they saw, like maybe 50% of the deals are sort of uncontested, no competition in them. How do we sort of square that? Or sort of how should we think about that versus what you're seeing in the field and sort of how that relates to new initiatives? Is that sort of how you're seeing it, or do you feel like you had taken your foot off the pedal?

Gregory S. Clark

I think the comments that I made before, we have a very strong security channel. We have work to do in our WAN Optimization channel and we're working hard on that and we expect to come back to you with some improvements on that in the future.

Operator

And at this time we'll now turn the conference back to Ms. Underwood for closing comments.

Jane Underwood

I would like to thank you for joining us today. A replay of today's call will be made available at (800) 475-6701 beginning November 17, 2011 at 5:00 p.m. Pacific Standard Time. An audio archive will also be available on our website. We look forward to speaking to you again soon. Thank you.

Operator

Ladies and gentlemen, that does conclude your conference for today. Thank you for using AT&T Executive Teleconference Service. You may now disconnect.

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