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Websense, Inc. (WBSN)
Q1 2007 Earnings Call
April 24, 2007 4:30 pm ET
Executives
Kate Patterson - VP of IR
Doug Wride - CFO
Gene Hodges - CEO
Analysts
Samuel Wilson - JMP Securities
Daniel Ives - Friedman Billings Ramsey
Sterling Auty - J.P. Morgan
Walter Pritchard - SG Cowen
Katherine Egbert - Jeffries & Co.
Dino Diana - UBS
Phil Winslow - Credit Suisse
Matt Andrejczak - RBC Capital Markets
Jake Rossman - Pacific Crest Securities
Priya Parasuraman - Wachovia
Brian Sykes - Morgan Stanley
Garrett Bekker - Merrill Lynch
Presentation
Operator
Ladies and gentlemen, thank you for standing by. Welcome to the Websense conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions for that will be given at that time (Operator Instructions).
Also, should you disconnect from the conference and wish to rejoin, please dial 1-800-310-6649 or 719-457-2693. As a reminder, ladies and gentlemen, this conference is being recorded today.
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 and thank you for joining us to discuss first quarter results with the management of Websense. 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 list our upcoming investor events for the month of May. We will be at the Deutsche Bank 2007 Technology Conference on May 16th; at the Sixth Annual JMP Securities Research Conference on May 22nd; at the J.P. Morgan 35th Annual Technology Conference, also on May 22nd; the Merrill Lynch Small Cap Tech and Healthcare Conference on May 30th and the Cowen 35th Annual Technology Conference on May 31st. There's additional information on our website.
Before we begin a review of the financial results, let me remind you that during this conference 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 historical results or any preliminary results expressed or implied during this 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 conference 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 Generally Accepted Accounting Principles. The Company believes the non-GAAP billings measurement is useful to investors because GAAP measurements of revenue and deferred revenue in the current period include 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, as well as certain cash and non-cash expenses related to the PortAuthority acquisition, enhances investors' ability to evaluate the Company's operating results and compare current operating results with historical operating results prior to the adoption of FAS 123R and the acquisition of PortAuthority. For more information, please consult the press release that was issued this afternoon and which is also posted on the Investor Relations portion of the Company's website.
I will now turn the call over to Doug Wride.
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Doug Wride
Thank you, Kate, and thank you all for joining us today. The financial performance this quarter demonstrated a solid execution throughout our organization, which was reflected in virtually all of our performance metrics. We met or exceeded expectations in billings, revenue, non-GAAP operating income, non-GAAP net income and non-GAAP earnings per share.
As a reminder, most of my comments today will refer to these non-GAAP financial measures. The difference between our GAAP and non-GAAP presentation of results includes stock option expense and related tax effects, certain cash and non-cash expenses related to the PortAuthority acquisition, such as amortization of intangibles, retentions, bonus accruals and onetime charges related to in-process research and development. A reconciliation of the two is included with the press release and is on our website.
Gross billings for the quarter were $43.6 million, up 12% over Q1 last year. Net billings, reflecting approximately $1.1 million in marketing payments and channel rebates, were $42.5 million, near the high end of our $40 million to $43 million guidance range. On a geographic basis, we saw continued strength in Asia-Pacific, EMEA and Latin America. And on a product basis, our net billings reflected about $1 million in billings from information leak prevention with our Content Protection Suite.
We closed 62 transactions greater than $100,000 in Q1, which is up from 43 in Q1 of '06. The average annualized contract value was $7650, relatively flat with the first quarter of the last two years at $7700 and seasonally down from the $9900 in Q4.
Average contract duration this quarter was 23.4 months, up just over one month from 22.2 months in Q1 of last year, which reflects the average one-month increase we have seen in the past. Average contract length was impacted by an increase in the number of large three-year international subscriptions, which we billed in Q1, particularly in APAC and EMEA. Contract length in the U.S. was up slightly, but essentially flat over last year.
The contract lengthening had a modest negative impact on the average annualized contract value as the value absorbed a little more of the multiyear contract discounts. For those of you who keep a detailed model, the one-year contracts contributed 48% of total billings, two-year contracts contributed 9% and three-year contracts contributed the remaining 43%.
The attach rate for add-on products was approximately 62% of the seats under subscription with one or more add-on products. That was flat with Q1 of last year and down slightly from the 63% last quarter. The percent of billings that included security-related products now accounts for exactly half of all billings in the quarter, up from 36% in Q1 of last year and up from 49% in Q4.
Subscription revenue was a record $49.7 million, up 17% from Q1 of last year and slightly higher than our guidance range of $48.5 million to $49.5 million. Our first quarter revenue was net of marketing payments and rebates to channel partners of approximately $600,000.
International revenue increased to 39% of total revenue, up from 35% a year ago and 38% last quarter. Our international performance again reflected strong filtering demand outside the U.S. and continues to be a mainstay for growth in our core business.
Turning to the operating model, non-GAAP gross margin was slightly higher than expected at 92.4% of revenue as the hardware costs from the IOP shipments had a little less impact than we had forecast.
Non-GAAP operating margin was 25% at the high end of our guidance range of 23% to 25%, and down as expected from 32.5% last quarter. As you will recall, in Q1 we usually take a 1% to 2% seasonal hit from the preceding Q4 due to our expenses from the RSA Trade Show and our worldwide sales kick-off event.
The normal ramp-up of sales hiring adds to this and the increase of payroll taxes at the beginning of the new year as well. Also this quarter, we had the additional expenses related to the PortAuthority IOP operations, including items such as salary, marketing and rent expenses. In fact, our headcount increased by 62 individuals for a total of 749 employees at quarter end, about 50 of which are related to the support and sale of our information leak prevention product.
Operating margin this quarter was a little better than expected due to the combination of the high end of revenue, guidance and slightly slower than expected net headcount growth. Therefore, looking forward, I'm looking for operating margins to stay in the 24% to 25% range for Q2. For the remainder of the year, I'm still expecting the dilution of PortAuthority to decrease by about 1% per quarter, crossing over to breakeven some time in mid-2008.
Non-GAAP net income for the quarter was $9.6 million or 19.4% of revenue, generating $0.21 of earnings per diluted share.
Total stock-based compensation expense was approximately $5.2 million and was spread across all expense categories. PortAuthority expenses, including certain cash and non-cash expenses related to the PortAuthority acquisition, such as nonrecurring charge for in-process research and development, as well as accruals for retention bonuses for retained employees and amortization of intangible assets, totaled $2.6 million and were also spread across all expense categories.
This resulted in GAAP net income that was approximately $3.9 million or $0.09 per diluted share. The effective non-GAAP tax rate was 35.3%, while the GAAP tax rate was 45%. The GAAP tax rate was unusually high in Q1 due to the nondeductible onetime write-off of the acquired PortAuthority in-process R&D.
Turning to the balance sheet, we closed the quarter with $261.4 million in cash and investments, a decrease of just over $65 million from the prior quarter. We spent approximately $86.2 million net cash in January to acquire PortAuthority when you net the purchase price with the acquired cash and the payoff of their debt, which was offset by $21.3 million of cash generated from operations. Cash per diluted share now stands at $5.75 compared to $7.22 last quarter.
Accounts receivable were $36.9 million at quarter end, a decrease of almost $16 million from the end of the fourth quarter. DSOs based on billings has been consistent through the last year and was 66.6 days. Looking forward, however, I expect DSOs to increase moderately to 70 to 75 days due to the higher proportion of international business.
Deferred revenue, which represents the difference between billings booked and revenue recognized in the quarter, decreased by $6.9 million from the end of the fourth quarter to $213.4 million. This number also includes approximately $329,000 in deferred revenue acquired from PortAuthority. The decrease in deferred revenue this quarter is the mathematical result of revenue in the quarter exceeding billings as happens with the seasonality found in Q1.
As you may recall, this happened for the first time in Q1 of last year and I would expect this to be the case in the first quarter of each year going forward since revenue will continue to grow steadily over time and billings should continue to have sizable seasonal fluctuations.
In summary, our financial performance reflects firm improvement in executing our channel initiatives and our transition to two-tier distribution in the U.S. I'm also pleased with the early traction we have made in the information leak prevention market and our continued strength in international markets. With all of this in mind, I am optimistic that we are building the solid foundation needed to move in the next phase of growth for the Company.
Turning to our forward guidance, we're looking for billings in the range of $53 million to $56 million, representing year-over-year growth in the range of 6% to 12% and revenue between $50 million and $51 million, representing year-over-year growth of 14% to 17% in Q2. The ranges for both billings and revenue are net of anticipated channel marketing payments and rebates.
Stock-based compensation expense is expected to total approximately $5.3 million in the quarter. PortAuthority expenses, including amortization of acquired technology, amortization of intangibles and accruals for retention bonuses, are expected to be $1.4 million.
GAAP gross margins are expected to be approximately 90% to 91% and non-GAAP gross margins are expected to be approximately 91% to 92%. GAAP operating margin is expected to be 10% to 11% of revenue and non-GAAP operating margin, excluding the stock-based compensation and cash and non-cash expenses related to the PortAuthority acquisition, is expected to be approximately 24% to 25%.
We expect other income to be roughly flat with this quarter at $2.5 million. We are forecasting both GAAP and non-GAAP tax rates at 40% and 36% respectively. This revenue and expense structure should result in GAAP earnings per diluted share of about $0.10 to $0.12 and non-GAAP earnings per diluted share, excluding option expense and the related tax effects and the cash and non-cash expenses related to the PortAuthority acquisition of $0.20 to $0.22.
With that, I will turn the call over to Gene for his discussion of the quarter.
Gene Hodges
Thank you, Doug. Q1 was a solid quarter for Websense. Although we have a lot left to do, we are starting to see some return for the over 10 points of margin we've been investing to reaccelerate our growth. Our challenge is to re-ignite growth in new business.
In Q1, our new business grew 41% from the first quarter of 2006. Achieving our long-term growth goal of 15% to 25% requires much more new business, but we are starting to see what we think are the first sprouts of sustainable new business growth.
Growth in international business continued to be strong as it has been for the last 10 quarters. Billings grew over 25% again year-over-year outside of the U.S. with the highest growth rate seen in Asia and Latin America.
The investments we made here in the last year are clearly paying off. Geoff Haggart has just hired three new senior managers to help us continue this growth and David Roberts is seeing good return from continuing investments in both Latin America and Canada.
In Q1, our billings outside the U.S. constituted over 45% of our total worldwide billings. International markets tend to show less of a seasonal decrease from Q4 to Q1, so don't extrapolate this ratio to hold for all quarters. But this consistent international growth will play a large part in helping us reach our long-term growth goals.
International markets are growing more quickly than the U.S. for the web security filtering products that are the majority of our sales and they will start to approach half of our billings over the next year.
We also had very strong first quarter information leak prevention. We achieved our internal plan for IOP and we're pleased with our results, especially considering that this acquisition only closed on January 8th. Our pipeline expanded significantly throughout the quarter and this pipeline, plus our first quarter sales performance, makes us comfortable with our projection of $10 million in IOP billings for the year.
The integration of all PortAuthority functions is complete and the commitment and aggressiveness of these new teams is energizing our whole company. We have successfully retained all except two of the people that we brought over from PortAuthority. I don't remember this high a retention rate in any acquisition I have ever been involved with.
As you may remember, our strategy for IOP is totally channel focused, and this quarter showed that that decision was the right one. We have seen significant activity from several large security resellers, both with new prospects and with our existing customers.
Interest in our solution also took a big step up with the April 13th release of this year's report from the Gartner Group on this market segment. Gartner calls this segment Content Monitoring and Filtering and Data Loss Prevention.
This report positions Websense in the leader's section of the Gartner Magic Quadrant. It's a big change from where we were last year. This recognition will open doors in Q2 and beyond for our partners for many potential sales.
For example, on April 17th, we conducted a sales blitz to generate qualified leads for our partners. As a result, we've been able to set up over 200 introductory sales calls with new companies. Introductory calls are certainly not orders, but this level of receptivity is exciting.
Turning to our SMB initiative, we saw a market pickup in our sales through large direct marketing reseller partners in the U.S. in the first quarter. These are companies like CDW or Insight. These customer companies are an important part of the overall SMB value chain, which claim about 25% of share of wallet of IT sales to this segment overall.
We've really been able to get this part of our SMB channel back online and this part of our SMB investment is well on track to be accretive by Q3.
Turning to the smaller resellers focused on SMB, we've recruited over 300 new smaller partners since the initiation of this recruitment program last August. In Q1, 100 of these partners sold Websense. Our plans call for a higher level of new business transaction rate by the end of the year, so we still have a lot of work to do.
That said, we believe we can build this transaction volume from these and additional new partners through training and incentives to generate new business both in Q2 and turn this investment accretive by Q3 as well.
As you track our progress in the SMB channel this quarter, you will hear discussion about Websense Express. Websense Express is a major new product designed for organizations between 100 and 1,000 employees. We would characterize this as a medium-sized business.
Note; Websense Express will only be available for sale up to 1,000 employee subscriptions. Websense Express pulls together all the elements of an excellent SMB program, all of the things we've been working so hard on for a year. It's on track to ship in July. Websense Express will not be priced or preannounced to channel reps before then. We want to do that to keep from stalling any Q2 business.
But a good global launch process starts communication with our partner management early and that is already underway so we wanted to share it with you as well.
Websense Express is not just a scaled-down version of Websense Enterprise. It’s designed from the ground-up to show value quickly to an IT manager in a medium-sized business who is a security novice. Websense Express installs and starts delivering protection in under 30 minutes.
The value is shown immediately with easy-to-read reports that are always visible on Express's home page. There's no complex configuration and no in-depth knowledge of Web threats is required. All you have to do is hit the next button eight times and print the reports, and voila, you are a security expert.
We believe no other vendor delivers anything near this combination of effectiveness and ease-of-use for the SMB market.
Websense Express will be the first product we ship in several non-English languages. We plan to simultaneously ship it in English, German, French and Japanese in July. We're also retooling our support portal so we can support large numbers of SMB customers globally at a high level of satisfaction with low cost.
In addition to retooling every aspect of the SMB customer experience, Websense Express is being used as a function to finish the retooling of our support systems for the SMB channel. Express is supported by a new no-touch IT system that makes configuration easy and all aspects of doing business with us are handled through a new Web-based partner portal.
You don't have to call Websense anymore for your marketing funds or do registration rebates or renewal information or status about deals; it's all there on the portal.
We have really sweated the detail across the channel experience. We're delivering electronic business features like the ability to add new users in a small new business or medium business so they're all wrapped together with an existing subscription into a single larger subscription.
In channel lingo, this is called co-terminating, or co-terming, multiple subscriptions. This seems like a simple everyday task, right? A business of this size is probably growing and it's adding people all the time, but no one in the security industry does this with a subscription or a perpetual license.
If you add users three times over a three-year period, you end up with four subscriptions to manage, lots of paperwork for the end user and most of the renewals are not worth chasing by the partner. This everyday process is actually a huge challenge that takes painstaking coronation between IT, sales, engineering, marketing and our large distribution partners to deliver.
You know, we CEOs spend a lot of time talking about teamwork. To me, this is what real teamwork produces. My message here isn't just that we are hungry for operational excellence, it's that the senior management team that we rebuilt last summer has jelled and you're starting to see what we believe are shareholder value creating results.
The Websense Express solution will be available as a standard software product and also as a meet in the channel appliance. You've heard lots from us about the meet in the channel appliance and it’s all been leading up to this product.
Customers and resellers will see a single, simple part number. Our distribution partners will separate that single part number into an order from a PC supplied by one of the industry giants, and a Websense software order. We pay a few dollars to have the software installed, but never run the hardware through our books or have to pay salespeople commission on selling low-margin appliances.
Later this year, you will see us supply this same process through our IOP product, and then later to our ThreatSeeker content blocking gateway. By this approach, Websense will have a strong appliance offering, big ones and small ones, without the margin impact or engineering diversion of owning the iron.
As I hope you see, the Express program is pretty important for us. We've changed many elements of our SMB system in the last three quarters, but this allows us to bring it all together, complete the retooling and roll it out globally. By July after a year of effort, I believe Websense will have created a best-in-class product, support and channel management system for small and medium business. It has been a long time coming and I appreciate your patience.
In Q1, the Websense team achieved both our short-term goals and did the work we needed to do to be ready to accelerate our growth in the future. We finally started seeing substantial new business growth. We successfully integrated our first acquisition. We sold IOP successfully. We were recognized as having a leading solution in this hot IOP security segment. We continued consistent international growth. We expanded our channels and we prepared for the future with products and processes to deliver our long-term growth goals. The bottom line is that our team is starting to click and I believe that bodes well for our investors.
Now, let's turn the call back to the operator for your questions.
Question-and-Answer-Session
Operator
(Operator Instructions) First we’ll hear from Samuel Wilson with JMP Securities.
Samuel Wilson - JMP Securities
Good afternoon gentlemen. Two quick questions for you; first, can you just give us -- I think you mentioned you added 300 resellers, so it's sort of a clarification, but can you just give us a sense of what the total number of resellers you have is at the end of the December quarter and then at the end of the March quarter?
And second, can you just give us an update on what the thoughts are in reference to the share buyback? I noticed you weren't buying back any shares this quarter, and I just wanted to know what you thought were there. Thank you.
Gene Hodges
Let me give you the numbers I have off the top of my head. Our K, I think reports 1450 active resellers, so I'm going to give you some apples-to-apples numbers here. We have added -- this was at the end of the calendar year, so 12/31. From approximately August through Q1, we have added 300 small reseller partners, and those partners added 100 who did business with us for the first time in the first quarter.
So I think the apples-to-apples number would be 1450 goes to 1550, and obviously we hope to get that number up towards the 1700 mark just with the number we've added so far. So when you look at percentages in those lights, it's a pretty good step-up in the total reseller base. Did that comparison make sense?
Samuel Wilson - JMP Securities
Absolutely.
Gene Hodges
All right. I will turn it over to Doug on share buyback.
Doug Wride
So, you're right, Sam, we did not repurchase any shares this quarter. There were a variety of factors that influenced that decision and kept us from purchasing within the six-week open window that we have in a quarter. That said, our program remains intact. We just have under 4 million shares remaining in the authorization. It's still an accretive purchase at this point and we expect to be active again in the future.
Samuel Wilson - JMP Securities
Great. Thank you very much, gentlemen.
Operator
Next we’ll hear from Daniel Ives with Friedman Billings Ramsey.
Daniel Ives - Friedman Billings Ramsey
Yeah, could you just talk about the competitive environment, specifically what you are seeing on the SMB market?
Gene Hodges
The SMB competitive market is fairly fragmented and there are lots of different types of competitors. It's actually a very broad competitive venue. We see competition at the low end from unified threat management vendors like SonicWALL with span, e-mail and Web filtering box suppliers like Barracuda, and as you move towards the middle business, we see competition from antivirus vendors who are expanding into that territory, like Trend, McAfee and Symantec, as well as vendors you would associate with our legacy filtering market, like SurfControl, AD6, St. Bernard.
So it's a real free for all with of course a very aggressive pricing. I think it's important to understand though that the price per user in this market is higher than it is in the enterprise world, and overall or typically a small to medium business once you have an efficient delivery infrastructure, which means a channel oriented infrastructure, it is often more profitable than enterprise business and our expectation is that is what we can achieve as well.
Daniel Ives - Friedman Billings Ramsey
Okay, thanks.
Operator
Next we’ll hear from Sterling Auty, J.P. Morgan.
Sterling Auty - J.P. Morgan
Thanks guys. Can you talk a little bit more color on Ingram Micro and maybe how much of the billings in North America went through Ingram Micro? And then a broader question on North America. Can you just give us more color on how you felt the geography did in the quarter relative to expectations and how the changes that you have made there are coming along?
Gene Hodges
Sure, Sterling. I want to reposition the whole discussion. I think you guys are focusing a bit more on just Ingram than the whole SMB investment. Ingram does constitute a large amount of the investment, but as we tried to call out in the earnings call, we are spending some significant monies -- of the same scale, by the way as we do with Ingram in the rest of our SMB programs.
So the way that we decomposed it for you to get the investment return picture is into the resellers that we're working with who are the big large direct marketeers and then the small guys. Ingram helps us with both. Ingram is a prized partner for several of the large direct marketeers. They have a close relationship and provide all of the logistics for those companies and the value for small partners is obviously, they recruit the partners and then motivate both new partners and existing partners to sell more licenses per quarter.
I don't think we want to try to break out the specific number in Q1. I think it's fair to say that in Q2, the large majority of our business in North America or at least in the U.S. would be going through Ingram.
Canada, let me separate Canada from the U.S. We have not invested heavily enough in Canada. Dave Roberts started that about two quarters ago and we already saw results in Q1. So Canada, Dave typically calibrates about 10% of the U.S. number. It's well below that for us. We have a great team up there, some really skilled guys, and I think that's another piece of international growth opportunity.
Sterling Auty - J.P. Morgan
Okay. And then on the contract duration, Doug, is there any sense as to any trends in contract duration by geography? In other words, is international tending to be skewing towards the longer and North America getting shorter, or is it consistent across all geographies?
Gene Hodges
First, Doug's going to answer this question, but I should preface it by saying Doug was thinking of hiring a swami to forecast contract duration in the future.
Doug Wride
Yes, either that, or I'm just going to take whatever the Street's consensus is and go with that. It is more and more difficult to trend what tens of thousands of customers are going to do and the decisions they are going to make as you have seen by the volatility within that metric. When we look at Q1, international is still a shorter subscription duration in the United States.
However, what we saw in Q1 was that there were a number of markets where -- geographic markets where the deals got a little bit bigger and a little bit longer and the contract duration in North America was essentially flat, but the international lengthening is what pulled that metric this quarter. So as we look forward into Q2, we are going to a midpoint and we are thinking in terms of about 22.8 months. That's what we're modeling on, and that's slightly more than a year ago, Q2, but it's down from Q1 of this year.
Gene Hodges
Sterling, I think it's important to understand that we are not seeing big swings for customers of a given size in a given geography. What we are seeing in Q1 that was different was enterprise, big enterprise deals started to pop up in geographies where we haven't had them before in Asia and in Canada.
We had mid-six-figure deals in both places and a larger number of high-five figure deals in Asia, and that's a pretty big deal actually in Asia. Those tend to have longer contract durations, but it is not an indication to us of a decay in the business from everything going to very long durations and we'll run out of runway or a collapse in the business because duration is going very, very short, which will crater the billings for some period of time. So the duration story was no big news. The underlying news was some pretty good enterprise deals in Asia and Canada.
Did I get all that right Doug?
Doug Wride
Yes.
Sterling Auty - JP Morgan
All right, great, thanks, guys.
Kate Patterson
Next question please.
Operator
Now, we will hear from Walter Pritchard with SG Cowen.
Walter Pritchard - SG Cowen
Hi, Doug. Not to beat a dead horse on the contract length, but if I do the math in terms of how much that was worth to you this quarter, I get about half your growth or maybe $1.5 million or so, and the billings was, just kind of using the different contract length versus the apples-to-apples from a year ago, am I doing the math about right there?
Gene Hodges
Walter, did you add that back in Q4 when it was down?
Walter Pritchard - SG Cowen
I did actually, yes.
Doug Wride
Walter, I'm sorry, did you say $1.5 million?
Walter Pritchard - SG Cowen
On the billings, yes.
Doug Wride
Yes, that's about right.
Walter Pritchard - SG Cowen
That's about right, okay. And then, Gene, could you just, on the IOP, the $10 million, could you just help us understand how that -- or maybe Doug how that goes throughout the year? Is that still more of a back-end loaded $10 million as we release the new products and get the channel all trained up, or did you see more of it this quarter and therefore less of it in the back half of the year?
Gene Hodges
No, it's heavily back-end loaded, Walter, and I think we've been pretty consistent in that. The pipeline, as I think I mentioned, looks very good. So obviously you can feel a lot better going into Q4 if you can make it less back-end loaded. But my experience and I think you've been on calls with me before with new network security acquisitions is that the first you're out of the gate, it's a Q3 and Q4 experience.
Walter Pritchard - SG Cowen
And just last question being related to that. I don't know if we can look at it this way, but what percentage of your VARs do you think will be carrying that product as we exit -- or that product line as we exit 2007?
Gene Hodges
It's going to be small. We targeted about 50 resellers. We're pretty close to that number now and we can probably take it up. But this as opposed to the small business investment is not about the number of resellers; it's really more about how well we support the resellers we have.
The people that we're dealing with here are in many cases literally hundreds of millions of dollars of revenue in their own right, so they have significant sales forces, and rather than dilute the territories, we really just want to kind of focus and support those guys because some of them could do several million dollars each.
Walter Pritchard - SG Cowen
Great. Thanks a lot.
Kate Patterson
Next question please.
Operator
Now, we will hear from Katherine Egbert with Jeffries & Co.
Katherine Egbert - Jeffries & Co.
Hi, Good afternoon. Just a question on the international side. Why are you seeing such a steady ramp there? Maybe this is the wrong question, but it seems like the legal environments overseas aren't what they are here domestically. What accounts for the ramp?
Gene Hodges
Well, Katherine, we've talked about this several times. The security filtering market really evolved very differently in international because the whole EI end stage got skipped in many geographies. They didn't worry about productivity because they did not have Internet penetration. They weren't worried about liability from pornography, so we see growth in areas that you wouldn't expect it when a market is already saturated in North America.
And I emphasize that point so hard because frankly I think the Street has been missing the point that the international market is far from saturated. It has been a consistent growth producer now for 10 quarters and we expect it to continue. Arithmetically, it does a great deal to get us towards our long-term 15% to 25% bogey.
Katherine Egbert - Jeffries & Co.
Okay. And then Doug, you mentioned, margins staying steady to maybe a little bit down next quarter. As you exit the hardware business in this back half of this year, where do you think your pro forma margin can go?
Doug Wride
I think we get back to the 93% gross margins we were. There's not a lot there. We were 93 last year, so we're down a point or so on a non-GAPP basis. I don't think that changes a lot.
Katherine Egbert - Jeffries & Co.
And what about on an operating basis?
Doug Wride
I'm sorry?
Katherine Egbert - Jeffries & Co.
On an operating margin basis?
Doug Wride
On an operating margin basis, I think we exit this year consistent with what our expectations were. We're somewhere in the high 20s. We thought we would gain about 1 point per quarter. We actually came out a little faster than I thought we would in Q1. So Q1 was a little bit of an outperform. We'll be 24%, 25% here in Q2, and overall for the first half, we'll be ahead of what I actually expected and then that will continue to step up. I don't know we'll be 27% or 28% operating margin at Q4.
Katherine Egbert - Jeffries & Co.
Okay, thank you. And then last question if I may. What was the effect of the change in the revenue recognition in the quarter? Was there any?
Doug Wride
The change in what conditions?
Katherine Egbert - Jeffries & Co.
The revenue recognition from -- you know the daily impact?
Doug Wride
Well, nothing changed this quarter, thank goodness. The impact of daily was something between $100,000 and $200,000.
Kate Patterson
It's an apples-to-apples comparison, though…
Doug Wride
Right. What we reported in Q4 was on a daily basis, so what we reported in Q1 is also daily if we grossed up -- and a year ago as well, Q1. So if we grossed everything up and went back to the old way, it would have been a couple of hundred thousand dollars higher, maybe $100,000, but then you would have to undo the last five quarters, so you wouldn't want to do that.
Katherine Egbert - Jeffries & Co.
Okay, I just wanted to check on that. Thank you.
Kate Patterson
Next question please.
Operator
Next, we will hear from Dino Diana with UBS.
Dino Diana - UBS
Hi, Thank you. We have heard from a few companies that enterprise in the Americas was strong in January and February, but it fell off in March. I know your results don't necessarily suggest that, but can you comment around the macro -- what you have seen so far in the macro from the U.S.?
Gene Hodges
Dino, its Gene. I don't think we saw a fall-off in March. For us, it was probably a little more of a battle in the front of the quarter than many may have experienced and maybe a little less of a battle towards the end of the quarter, although it's always highly competitive in enterprise. So we didn't see any fading towards the end of the quarter.
Dino Diana - UBS
Okay. And so inherent in your guidance expectations for 2Q, the macro stays kind of flat? There was no change in the macro?
Gene Hodges
Right. I think we said a couple of times we were not going to do macro forecasting and you guys probably won't try to build security products. Macro forecasting globally and with the percentage of billings that's international, that is an important factor is just well beyond our expertise. So we will tend to be followers of wiser people, and right now we don't see a clear signal that says horns in or get bullish.
Dino Diana - UBS
Okay, thank you.
Kate Patterson
Next question, please.
Operator
Now, we will hear from Phil Winslow with Credit Suisse.
Phil Winslow - Credit Suisse
Hi, guys. I just have a couple of incremental questions here. When you look at your -- I guess the contra revenue or the contra billings for Q2, what are you expecting there?
Doug Wride
The contra billings number we are expecting to be in the $1 million to $1.2 million range, pretty similar to Q1, which was $1.1 million. When you look at contra revenue, that is probably $600,000-$700,000 in Q2 as opposed to $600,000 in Q1.
Phil Winslow - Credit Suisse
All right. And then, when I guess you do look at your SMB business right now and with the launch of Express coming in July, what programs do you have in place right now to sort of ensure that you don't have a pause out in your business during Q2? And sort of what have you baked in for any sort of potential effect there in your guidance?
Gene Hodges
Phil, an SMB channel transition is a lot different than an enterprise transition where you have a direct sales force touching the customer. The sales cycles tend to be fairly long and the sales people tend to be pretty much immediate results-focused.
We brief the management teams on our partners, but they don't pass the information on to their reps until the day we do the announcement, and then you go out and have a big incentive event with the large resellers on their floors.
So the bottom line is, we don’t see any stalling of the business. Its not the type of thing where a small reseller would say, hey just wait, you can buy Express. And resellers don't tend to bring business forward in any case. If a subscription's up in July, they look at Express, and if it's up in June, they'll probably just renew it.
Phil Winslow - Credit Suisse
Okay, thank you guys.
Kate Patterson
Next question, please.
Operator
We will move on to Robert Breza with RBC Capital Markets.
Matt Andrejczak - RBC Capital Markets
Hello, this is Matt Andrejczak for Rob. A question on the sales force. Was the churn any more than what your expectations were?
Gene Hodges
No, not in Q1. As you remember, we had quite a lot of chop in Q2 and Q3 of last year, but I would say that international morale was excellent and U.S. morale was pretty strong. And people had a reasonably good fourth quarter and salespeople generally feel pretty good when they make more money.
So the sales force from a talent perspective is solid and we're not looking at any upheavals for the rest of the year, we're just building out the infrastructure internationally and the channel infrastructure here to try to go after this new growth.
Matt Andrejczak - RBC Capital Markets
And I know on the Q4 call you talked about sales force expansions in general. I guess what are your headcount plans, I guess specifically into Q2 and then I guess for the rest of the fiscal year?
Doug Wride
This is Doug. We'll probably net grow in Q2 20 people, and I would say in the second half of the year, probably another 20 to 40 people. So a lot of the growth that we are experiencing in this second quarter has to do with gearing up our Beijing development center.
So as we exit this year, we'll probably have somewhere between 40 and 60 people based in Beijing, and that's from I think one at January 1. So that will be a good-sized piece of our growth combined with the acquisition of PortAuthority. That is roughly 100 people right there.
Gene Hodges
The headcount that we'll add in Beijing and outside Tel Aviv in the Israeli engineering center will throw off the cost per head in your models because the more aggressive labor rates in those areas.
And we are going to expand in Beijing just as fast as we can find good talent. Our plans for this year are focused on engineering, but eventually we will have marketing people there doing competitive analysis and market intelligence work.
We'll have FP&A people there getting to the analysis of all of those performance indicators that we just don't have enough arms and legs to do. It's going to be a big facility some time.
Matt Andrejczak - RBC Capital Markets
Great. And then one final question for Doug. What was CapEx in the quarter?
Doug Wride
I know the answer to that. It was a think it was like $800,000, and a lot of that was software. I would say $800,000 to $1 million, which is a little higher than normal for a Q1.
You have got some software systems that we have not talked about today but we did talk about in January. There was a back end for the frictionless, processing for SMB and two-tier channel, and then there's a little bit of CapEx related to the Beijing office, the build out and the furniture and computers etcetera. Anyway, Kate is giving me a harder number. Okay, so I was wrong -- $1.7 million.
Matt Andrejczak - RBC Capital Markets
Great, thank you very much.
Doug Wride
Okay. Thanks.
Kate Patterson
Next question, please.
Operator
Next from Pacific Crest Securities, we will hear from Rob Owens.
Jake Rossman - Pacific Crest Securities
Good afternoon, guys. It's Jake Rossman for Rob. A couple of quick questions. You had announced a partnership this morning with SafeEnd for delivering ILP to the desktop and endpoint.
Just wondering if there's anything to that, if this is something similar to the initial PortAuthority partnership that you announced, or if there's any revenue opportunities for you here?
Gene Hodges
This is a continuation of the partnership that PortAuthority had established with SafeEnd. It's a great little company. They have some interesting technology on the endpoint and we are seeing some customers who have interest in both product lines.
And that's something that we want to continue. We have not planned anything deeper than that beyond that type of partnership.
Jake Rossman - Pacific Crest Securities
And, lastly, you discussed somewhat at your analyst day back in February around a security as a service model you will be potential launching later this year. Just wondering is there has been any progress with that?
Doug Wride
There has been so no progress on security as a service. I don't believe that we committed to launch by the end of this year. We said that is a delivery or a distribution mechanism that seems to have a good market opportunity.
Jake Rossman - Pacific Crest Securities
Okay. And lastly one quick question on linearity. Just wondering if you can give us any sense to a monthly number, even though you guys have moved a daily rev rack, but just give us a sense of what linearity was in the quarter?
Doug Wride
Well, on day one, we had -- you're right, Jake, the monthly is a little out of whack these days when you look at daily revenue recognition. We did about 55% in the quarter in March, and I think January is probably something around 20, 25, 55. Q2 would typically be similar. That seems to be sort of the Q1, Q2 and Q3 linearity these days. Q4 gets a little bit more back ended.
Jake Rossman - Pacific Crest Securities
Okay, thanks.
Kate Patterson
Next question, please.
Operator
Now, we will hear from Phil Rueppel of Wachovia.
Priya Parasuraman - Wachovia
Hi. This is actually Priya Parasuraman for Phil. Just a quick one, going back to the international markets, I was wondering what are some of the key areas where you're seeing good growth, and are you looking at expanding into other regions or adding more resellers and sales forces…
Gene Hodges
I'm sorry, we couldn't hear very well. Would you repeat the question please?
Priya Parasuraman - Wachovia
Okay. Can you hear me better now?
Gene Hodges
Yes.
Priya Parasuraman - Wachovia
Okay. Sorry about that. In the international markets area, what are some of the key international markets where you're seeing growth, and are you looking at adding additional regions, additional resellers or more sales people to expand there?
Gene Hodges
I think our expansion in international markets is probably broader than the usual candidates because we're seeing good opportunities in Southern Europe, which is still fairly under penetrated in security filtering, as well as the Middle East, India, China, Japan, Australia, Mexico.
In fact, I think all of Latin America and as I mentioned before Canada, the Nordics for IOP and IOP in the U.K. and there is very good interest for IOP in Japan. We saw orders in the first quarter out of the Ukraine for IOP and that is kind of an indication that this market is probably going to be broader globally than we would have expected.
Priya Parasuraman - Wachovia
On the SMB product, I guess that is also the new thing where you expect good revenues, is that a fair statement to say?
Gene Hodges
I'm sorry; we're still having sound problems with our speaker’s overhead. One more time.
Priya Parasuraman - Wachovia
Okay. I hope this is better. The ThreatSeeker product, and also the Websense Express, what about growth in those in the international area?
Gene Hodges
I think that Websense Express is focused to achieve a lot of its growth internationally. We showed before that we see about $0.75 billion per year in subscription billing incremental opportunity globally in the SMB market, and that is almost all outside the U.S., I think about 80%-85% outside the U.S.
We would love to be able to ship in 10 languages. We're going to start with just the three but we will follow up. Obviously, Spanish needs to be on that list and there are several other Asian languages where we can probably get a good return.
ThreatSeeker is going to be pretty tightly tied to our IOP solution and that I think will probably have more of a North America/Western Europe/Australia/Japan type of footprint.
Priya Parasuraman - Wachovia
Great, thank you.
Operator
And now we’ll hear from Brian Sykes with Morgan Stanley.
Brian Sykes - Morgan Stanley
In light of recognizing that you're still in the process of digesting PortAuthority, I was wondering if you could speak your appetite for acquisitions going forward. Are you still maintaining a robust pipeline for deals that you're looking at? And if so, what areas might you look for fill-ins to your current platform?
Gene Hodges
We've invested fairly heavily both in acquisitions and in organic growth, so we're going to be pretty cautious about making any dilutive acquisitions in the near future. There is good opportunity in organic growth and we don't need to make dilutive acquisitions.
Brian Sykes - Morgan Stanley
Okay. Can you comment a little bit on your average annualized contract? I noticed it looks like a seasonal trend down in Q1. How much of that was seasonal versus product mix, recognizing that you had a good result for higher security-related product in the Q? And how much is market order comparative pressures?
Doug Wride
Brian, most of it is Websense. Historically, we have seen that contract value drives by add-on products, and as we are now at roughly a 60% attach rate, there aren't additional security filtering add-on products that we're selling. Our expansion and how do we sell more products into the existing customer has focused on the IOP market today.
So you don't have that factor driving that. Also, when you look at this quarter, there was a slight negative impact on that contract value with the lengthening of subscriptions. We had a little bit more multi-year discount involved in that metric. But generally, I think we're going to see that contract value stay relatively flat through Q2 and Q3, in the high 7000 figure range, and then we'll see a pop in Q4 as deals get bigger.
Brian Sykes - Morgan Stanley
Okay. Great. Thank you.
Operator
(Operator Instructions) We’ll now take a follow up from Sterling Auty with J.P. Morgan.
Sterling Auty - J.P. Morgan
I wanted to revisit, so Doug you mentioned kind of the average contract duration that you are thinking for second quarter is the 22.8 months. Granted, I don't think you had in mind a specific number for each with through the year, but just in general, as you think about that for June, what kind of impact did that have on your billings guidance for the June quarter?
Gene Hodges
The international markets we expect to stay strong, and hopefully we'll see a continuation of the enterprise business that we saw that probably lengthened it a bit. One swing factor is that government buys and school buys tend to be going as a vertical towards longer, and so the school districts that have a June 30 fiscal might swing it up a little bit, but we still should still be doing a little more SMB that swings it down a little bit. And the bottom end, Sterling, or the bottom line is, Doug's got the swami in the corner and we really don't expect consistent trends one way or the other. Things are going to be volatile, but that doesn't portend a fundamental change in the business.
Doug Wride
And Sterling, I would just add on to that just to give you a couple of metrics which you probably have in front of you in your model anyway, but Q2 of '05, the average contract length was 22.2 months. Q2 last year, it was 22.3 months.
So it was pretty consistent. So our model this quarter is at 22.8, so roughly a half a year more than it was a year ago but down a little more than a half a month from what we saw in Q1. So all we can do is tell you what metric is within our model and then you build yours accordingly.
Sterling Auty - J.P. Morgan
Okay. Thank you.
Operator
We do have one question remaining. It comes from Garrett Bekker with Merrill Lynch.
Garrett Bekker - Merrill Lynch
Hi, Good Afternoon. Gene, I may have talked to you about this with either you or Doug in the past but just want to revisit it. I understand one of your competitors has experimented with a perpetual licensing offering and I just wanted to get an update if you're hearing any feedback on that or if that's getting any sort of traction in the field?
Gene Hodges
We have seen that from a competitor in the enterprise space, and fundamentally those customers do a TCO competitive calculation to determine total cost of they're smart guys like you, they know how to do a cost of money calculation. In general, if we are thinking about the same competitor, they're priced pretty far below us in any case.
Doug Wride
And I would just add, Garrett, we started on a subscription basis only and the whole marketplace has struggled to get to that point and adapt. So it seems unlikely that, that market is going to turnaround and do an about-face.
Gene Hodges
Just to give you some data that we've captured over the last six months, Garrett, one of the things we were concerned about was with the small-business market as we try to expand the footprint, the medium business market being as receptive to subscription. And obviously, we've been doing a lot of market research to try to get understanding there.
And it seems the simple annual two-year, three-year subscription choice is by far their preferred subscription mechanism. And by the way, we found out that we had pretty strong brand preference even at the low-end and we didn't expect that.
Garrett Bekker - Merrill Lynch
So the short answer is, we shouldn't expect to see that from you anytime soon in any of the product lines or segments?
Gene Hodges
Correct.
Doug Wride
That's what we should have said.
Gene Hodges
That is one of the reasons we do this appliance deal, right, and -- you will see no perpetuals.
Garrett Bekker - Merrill Lynch
Great. That's all I have. Thanks.
Kate Patterson
Operator, is there any more questions, otherwise we will close the call.
Operator
We're standing by with no further questions.
Kate Patterson
Okay, thank you all for joining us this afternoon. Talk to you soon.
Operator
Again, ladies and gentlemen, we do thank you for your participation. That does conclude today's conference.
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