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Check Point Software Technologies Ltd. (CHKP)

Q2 2007 Earnings Call

July 24, 2007 8:30 am ET

Executives

Jerry Ungerman - Vice Chairman

Gil Shwed - Chairman & CEO

Eyal Desdeh - EVP & CFO

Keith Meintzer - Director of Investor Relations

Analysts

Sarah Friar - Goldman Sachs

Shaul Eyal - CIBC World Markets

Sterling Auty - JPMorgan

Brian Essex - Morgan Stanley

Dino Diana - UBS

Ed Maguire - Merrill Lynch

Walter Pritchard - Cowen & Company

John Walsh - Citigroup

Phil Winslow - Credit Suisse Securities

Robert Breza - RBC Capital Markets

Katherine Egbert - Jefferies & Company

Todd Raker - Deutsche Bank Securities

Daniel Ives - Friedman, Billings, Ramsey Group

Israel Hernandez - Lehman Brothers

Rob Owens - Pacific Crest Securities

Presentation

Operator

Good morning. My name is Shauna, and I will be your conference operator today. At this time I would like to welcome everyone to the Check Point Software Technologies Quarter Two, 2007 Earnings Conference Call.

All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. (Operator Instructions) Thank you.

It is now my pleasure to turn the floor over to your host, Mr. Eyal Desdeh. Sir, you may begin your conference.

Eyal Desdeh

Good morning and afternoon, everyone. This is Eyal Desdeh, Executive Vice President and Chief Financial Officer of Check Point Software. Thank you for joining us to discuss our second quarter results.

As a reminder, this call is being webcast live from our website and is being recorded. To access the live webcast and replay information, please visit the company's website at www.checkpoint.com/ir.

The replay will be available through August 7. If you'd like to reach us after the call, please contact the Investor Relations department at 650-628-2050.

On the call with me today is Gil Shwed, Chairman and CEO, along with Jerry Ungerman, our Vice Chairman. I would also like to introduce Keith Meintzer, our new Director of Investor Relations. He joined the Company just last week, and we're very happy to have him as part of the team and joining us on the call today.

Now before we start our management presentation, I would like to read the following disclaimer. During the course of this call the Company will make certain forward-looking statements. Forward-looking statements include statements regarding Check Point's expectations regarding our financial performance and growth for the third quarter of 2007 and the full-year.

Our expectations that products and initiatives that we announced this quarter will make a positive contribution to our business in the future, our expectation that new versions of our products that are currently under development will meet the needs and requirements of our customers, our belief that our performance, execution, and portfolio of existing end plan products position us well for future growth in 2007, and the continued execution of our strategy.

Our statements, which may be made in response to questions which refer to our beliefs, plans, expectations or intentions are also forward-looking statement for purpose of the Safe Harbor provided by the Private Securities Litigation Reform Act. Because these statements pertaining to future events they are subject to various risks and uncertainties, and actual results could differ materially from Check Point's current expectations and beliefs.

Factors that could cause or contribute to such differences include but are not limited to the risks identified in our earnings press release that Check Point issues on July 24, 2007, and the risks discussed in Check Point's annual report on Form 20-F for the year ended December 31, 2006 which is on file with the Securities and Exchange Commission. Check Point assumes no obligation to update information concerning its expectations.

All right. Now I'd like to share with you the results of our great second quarter and then provide a little more color on the financials.

Our second quarter results exceeded the high-end of our projections and demonstrated good annual and sequential growth across all revenue segments. We believe these favorable results underscore the success of many initiatives we put in place over the past year.

Before I dig into the numbers, let me remind you that our second quarter GAAP financial results include the following. The inclusion of equity-based compensation expenses into P&L pursuant to SFAS 123R, and the expenses related to acquisition of Protect Data and NFR, which started to include in our 2007 results, and the ZoneAlarm acquisition expenses, which we included in the past.

In our press release, which has been posted on our website, we are presenting GAAP and non-GAAP results along with reconciliation table which highlights this data, as well as the reasons for our presentation of non-GAAP information.

Now let me share with you the financial highlights for the second quarter of 2007. In the second quarter we had revenues of $176 million, an increase of 27% compared to $139 million in the second quarter of 2006 and 7.5% sequential increase over the first quarter of 2007.

Our network security business contributed $156 million to revenues, an increase of 12% compared to the second quarter of 2006 and 6% increase sequentially. Our data security business, which includes business generated by our Pointsec product line, contributed $20 million in revenue, an increase of 17% compared to the first quarter of 2007.

Our product revenue this quarter showed a robust growth of 20.5% over the second quarter last year and 11% growth sequentially. We were pleased to see that these results were driven by healthy growth of both the core enterprise network security business as well as our new data security business.

Part of the growth in network security is attributable to the success of the new appliance initiative we announced earlier this year and system integration project. One item I would like to note is that we expanded solid demand across multiple product lines during the quarter.

GAAP net income for the second quarter of 2007 was $69 million, an increase of 6% compared to $66 million in the second quarter of 2006, an increase of 48% sequentially. GAAP net income in the second quarter of 2007 includes expenses that were not included last year in the net amount of $7.5 million for acquisition-related charges resulting from the acquisition of Protect Data and NFR.

The total gross amortization and acquisition-related expenses for the quarter were $10 million, and equity-based compensation expenses for the quarter were $9 million. Net of taxes these charges total $16 million.

Non-GAAP net income was $86 million, an increase of 13% compared to the second quarter of 2006, a 9% increase sequentially. Total GAAP operating expenses for the second quarter were $107 million.

Operating expenses on non-GAAP basis were $88 million compared to $64 million in the second quarter last year and compared to $85 million in the first quarter of 2007. The increase in expenses over the first quarter of 2007 resulted from increased sales of appliances announced recently including UTM1 and IPS-1, system integration project and our seasonally high marketing expenses related to our annual partner and customer events in the Americas.

Overall, we managed to improve our expense control demonstrated by a non-GAAP operating margin of 50%, up from 48% in the first quarter of 2007. Our effective GAAP and non-GAAP income tax rate was approximately 14%.

GAAP earnings per diluted share for the second quarter of 2007 were $0.31, an increase of 13% compared to $0.27 last year. The GAAP earnings include equity-based compensation expenses of $0.03 per share and acquisition-related charges of $0.05 per share. Net of taxes, these charges totaled $0.07.

Finally, non-GAAP earnings per diluted share for the second quarter of 2007 were $0.38 per share compared to $0.32 in the second quarter last year, an increase of 20%. Deferred revenue this quarter was $236 million, an increase of $60 million, or 34% over the second quarter of 2006.

For the second quarter our day sales outstanding, DSO, were 68 days compared to 66 days in the first quarter of 2007 as we continued to increase the number of large deals and our business continued to be back-end loaded.

In the second quarter we generated cash flow from operations of $81.5 million. Our cash and investment balance at the end of the quarter was $1.150 billion.

During the second quarter we purchased approximately 2.1 million shares for a total cost of approximately $50 million as part of our share repurchase program.

During the quarter we effectively integrated Pointsec into Check Point in all aspects. Pointsec employees in all departments joined the respective Check Point department and are now part of the Check Point team.

We made big step in educating our channel on our new data security solution. As a result, data security sales and fulfillment through the channels represented more than 80% of total data security business for this quarter. In addition, we announced a new version of our full disencryption solutions for PC.

In summary, we're very happy with the financial results we’ve posted this quarter, and pleased to see that our recent acquisition and product launches are paying off. We believe that our performance and execution have improved, and combined with our robust portfolio of existing and new products, we're well positioned for further growth in 2007.

I will now let Jerry and Gil speak more about our business and our plans. Jerry, please go ahead.

Jerry Ungerman

Thank you, Eyal and hello, everyone. Thank you for being on the call with us today. Following Eyal's comments, I would now like to focus my comments on some of our key business activities this past quarter. As you have seen, the quarter was very positive from a financial results perspective.

Many factors contributed to these results, but I'm especially pleased to see the contribution we received from initiatives we implemented in the last few months, as well as, new announcements we made recently that we expect will have a positive contribution to our business moving forward. Late in 2006, we announced our strategy to expand our unified security architecture into data security.

Earlier this year, we completed the acquisition of Pointsec, and since then we accomplished the integration efforts described by Eyal. We believe these efforts are now paying off as we're experiencing a healthy growth from our data security business.

Earlier this year, we also enhanced our network security product offering with the introduction of our UTM-1 appliances. On our last call, we told you about many sales seminars we'd held worldwide for our partners and customers. And today we are pleased to tell you that our efforts are showing results as the number of UTM-1 appliances sold this quarter grew by 50% over last quarter.

Another key accomplishment this quarter is the performance breakthrough our VPN-1 Power achieved with our Core XL acceleration technology designed specifically to leverage off the shelf multi-core processors.

Key performance statistics include 12 gigabit per second firewall inspection, and 5.3 gigabit per second intrusion prevention inspection. VPN-1 Power with Core XL is the first network security gateway to enable security administrators to gain data center level performance without compromising on deep security inspection.

This quarter we also held in the United States the first of our Check Point Experience annual partner and customer events. During the event, we trained attendees on our new offerings and received feedback regarding additional needs and requirements they have that we will seek to address with new versions of our products that are currently under development.

I believe this event was very successful and of mutual benefit. This quarter we will be doing the same in both Europe and Asia Pacific.

In April, we launched Check Point IPS-1, a dedicated intrusion prevention solution delivering accurate, real-time attack mitigation against known and unknown threats. We have also successfully integrated IPS-1 into our key security event correlation and management components marking the first phase of IPS-1 integration with our unified security architecture.

And finally, we won a number of awards during the quarter, including for our UTM and end point solutions. I am especially pleased with an award we received from CRN for our channel and partner programs, which is the fourth time in the last three years Check Point has been so recognized.

In addition, our Chairman and CEO, Gil Shwed, was inducted into the highly respected CRN Industry Hall of Fame, honored for his work as an early firewall pioneer and for recently diversifying Check Point into data security.

During the quarter, we had a nice contribution from large deals, coming from some of the largest companies in the world in many different sectors including government, financial, and technology and across all geographies.

Deals greater than $50,000 accounting for 37% of total order value. To be more specific, we had 13 deals between $500,000 and $1 million, and 11 transactions, which are greater than $1 million. In addition, we continued to grow our install base, adding over 20,000 gateways bringing the total to 596,000 security gateways.

In summary, this quarter we executed very well against competitors for both network security and data security solutions, which is demonstrated by our results. This includes winning additional business with many of our very large customers, as well as, the displacement of competitors in a number of important accounts.

Our second quarter revenues were well diversified, with 46% of revenue in the Americas, EMEA contributing 42%, and the highest regional year-over-year growth in the Asia Pacific and Japan region contributing 12% of our revenues this quarter.

We are pleased to see the success of our recent initiatives, resulting in top line growth. In the second half of 2007, we will remain focused on continuing to execute our strategy.

Now I would like to turn the call over to Gil Shwed.

Gil Shwed

Thank you, Jerry, and hello, everyone. As you heard from Eyal and Jerry, the second quarter demonstrated very good results, I’m specifically pleased with our numbers and execution since it illustrates the results of the many efforts that we've undertaken in the past year. Our data security initiatives contributed positively to our results, our sales force in Europe and in the Americas produced good results this quarter.

Our renewed products and initiatives shared the same positive trends, and may be the most important is the fact that our enterprise network security segment was the primary driver behind our top line performance. These positive results in all our key business drivers continue to underscore the success of our strategy and execution so far this year.

Well, it may be too early to say, we believe the success illustrates that our unified security architecture, and pure focus on security, are gaining traction in the marketplace.

Now for guidance. First you can see that given our results so far, we anticipate revenues and earnings will come in at the higher end of our annual range. As such, we are narrowing the range for annual revenues and increasing the annual target for EPS.

We anticipate annual revenues of $700 million to $720 million, GAAP EPS is expected to be in the range of $1.12 to $1.22. Non-GAAP EPS for 2007 excluding the effect of stock-based compensation and acquisition-related charges, is expected to be in the range of $1.48 to $1.58.

As for the first quarter, it is always a challenging quarter given the summer seasonality and the increased risk of larger deals pushing into the fourth quarter. Our current projection for the third quarter anticipates revenues in the range of $172 million to $182 million, with GAAP EPS in the range of $0.29 to $0.33, and non-GAAP earnings per share in the range of $0.36 to $0.40, slightly higher than our original plan.

With that I'd like to wish us all good second half of the year, and open the call for your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is coming from Sara Friar with Goldman Sachs. Please go ahead.

Sarah Friar - Goldman Sachs

Good morning, guys. Can I drill into the data security area for Protect Data? Obviously, a good quarter, but when we look at year-over-year growth rates from what Protect Data was contributing back in '06 as a standalone company, it has decelerated somewhat. So, the question is, Eyal, how much is that just the M&A mechanics with deferred revenue write-down.

And do you expect as you start to get this rolled out to your sales force and to your partners more; that we should start to see an acceleration in that growth rate if we look through the end of '07 and into '08?

Eyal Desdeh

Well, first of all, without going into breaking down all the details of your question, the data security business looks on track to what we've guided originally. If you remember, we’ve guided that this would contribute to $95 million to $105 million to our revenue in 2007, and I think that the business is on track to getting there.

We mentioned earlier with the acquisition, some accounting implication of deferred revenues that come slower as a result of our acquisition accounting, and a few other details which you mentioned, but I think you are very well on-track.

Sarah Friar - Goldman Sachs

Maybe just to give us a sense for how far you are into integrating that, can you give us any comments around penetration of your install base with the Protect Data? Are you 5%, 10% penetrated because I presume you have a lot of upside there of getting that product into your current install base.

Gil Shwed

I don't know if we have specific data, but I think it's well below 5%.

Jerry Ungerman

It's very early stages, and transitioning will continue to grow. We're very pleased with it.

Gil Shwed

We did the good sign this quarter was the fact that we started seeing channels picking up and we started seeing in some regions of the world things that are driven not by the previous pipeline of Pointsec but driven by the Check Point channel. I think, again, it's too early to say how quickly it will catch up, but the signs right now are positive on that front.

Sarah Friar - Goldman Sachs

A little bit about North America because; obviously, there's broader concern’s about enterprise spending in North America, and you guys seem to have not seen that?

Gil Shwed

This quarter was very good for us in North America. Q1 was slightly behind, but Q2 showed a very nice rebound in our total North America sales especially the enterprise 1 and also the data security 1, so I think these two big segments, data security and enterprise network security were extremely successful this quarter in North America.

I can't say that we see a total rebound in the spending pattern in the marketplace or any macro changes, but at least for the second quarter for Check Point the results were very good, too.

Eyal Desdeh

If you look at the numbers, you would see that the Americas posted the biggest sequential increase from Q1 and Europe posted the biggest year-over-year increase over last year.

Operator, I appreciate it, if we everyone will limit to one question because we want to allow a lot of people on the call to ask questions.

Operator

Thank you. Our next question is coming from Shaul Eyal from CIBC World Markets. Please go ahead.

Shaul Eyal - CIBC World Markets

Thank you. Hi, guys. Congrats on a good quarter and guidance. Two quick questions on my end. Eyal, you just alluded, you mentioned on the deferred revenue that maybe some accounting mechanism could have had an impact on the $236 million this quarter. Is that correct?

Eyal Desdeh

Throughout the year the acquisition accounting always does not allow to recognize all the deferred revenue that the company had before it was acquired. It's nothing unusual and you see it in every acquisition, especially in the software space.

Shaul Eyal - CIBC World Markets

Fair enough. What are the kind of deferred revenue expectations for the third quarter?

Eyal Desdeh

Let me say something about seasonality of deferred revenue growth. The majority of the renewal of large subscription and support agreements are done in Q4 and Q1, around the end of the year, the beginning of the year. It doesn't mean that we don't have numbers in Q2 and Q3, but seasonally they are lower, so we don't expect any major growth in deferred revenue in Q3.

We'll definitely go back and pick up in Q4. If you look at the annual rate of debt, you see 34% year-over-year gross and deferred revenue which is a very, very large number.

Shaul Eyal - CIBC World Markets

Fair enough. Jerry, just one final question. We have been talking about ASP trend also last quarter. What's the current kind of state of affairs still stability may be edging up a bit at about 5%?

Gil Shwed

Fees are going up nicely this year as a result of all of our different initiatives. Some larger enterprise deals, our UTM1 appliances, some Africa products that we're selling, so overall we've seen a nice increase in the, still don't have the actual percentages, but it's significant percentages. At least…

Shaul Eyal - CIBC World Markets

All right. Thank you very much. Good luck. Congrats.

Gil Shwed

Thank you.

Operator

Thank you. Our next question is coming from Brian Essex with Morgan Stanley. Please go ahead.

Brian Essex - Morgan Stanley

Hi. Good afternoon, guys. I just had a question on the dynamics of the large deals. It looks like you had a nice pickup in large deals this quarter, but deferred revenues declined sequentially.

I was wondering if you can talk about maybe the contribution of those large deals and where you expect that to impact given absolutely understanding that you have some seasonality in deferred revenue, just looking at where you expect the primary contribution from those deals to hit?

Gil Shwed

First I want to say that deferred revenues is way higher than our original plan and the modeling that we have for this year.

As Eyal indicated, so I'll repeat that, most big contracts are on a manual basis and that means that we have a expiration date of December 31st and January 1st, which means that the deferred revenue deals are coming either Q4 or Q1 based on those two dates, either slightly before or just on time in the quarter.

So I think in light of us having the kind of performance that we have in deferred revenues in Q3 and Q2 is actually quite good. In terms of the larger deals, the large deals are spread around.

We analyze our large deals, and all the large deals contain some portion of subscription support like we should do and all the large deals also contain new product sales. In percentages that varies between brand new contracts to new customers with a high percentage of new products to renewal and new products of large install base.

But I'm very, very pleased with that trend because there wasn't a single large contract that we had with these include new product sales this quarter, and they were spread around both the Data Security business but with the majority also coming from the Enterprise Network Security. Overall the trend on that is very positive this quarter.

Brian Essex - Morgan Stanley

Okay. Any indication, just one quick follow-up on renewal rates this year versus last, how that's trending?

Gil Shwed

I think it's going up and we actually increased the number of accounts that are covered by renewal. This quarter was specifically good on that front.

Brian Essex - Morgan Stanley

Okay. Thank you very much for taking my question.

Operator

Thank you. Our next question is coming from Sterling Auty with JPMorgan. Please go ahead.

Sterling Auty, JPMorgan

Thanks. Hi, guys. Can you give us some either qualitative or quantitative support for these sales seminars that you've been running in different geographies? Some proof as to whether they're generating new incremental business and new customers or is it still just kind of penetrating existing customers?

Gil Shwed

I don't have any data right now to share about that, but we had in the first two quarters more than 10,000 people participating in various seminars around the world. In Q1, the focus was partner education, in Q2 I think it shifted towards joint seminars with our partners to end-users.

I don't have, again, hard data to break up the specific results of that, but I think we see positive trends on selling to new accounts on the renewal rates, on the new license deals. So overall, I would say that it's trending on a positive way. I do think that it's important to note that the typical sales cycle is, even for mid-size deals, I'm not talking about the largest deals, it's three to six months, so I think the vast majority of results are expected to be around Q4 and not really before that.

Jerry Ungerman

And Sterling, I'll just reiterate a couple of my comments. One, we saw a 50% increase in UTM1 appliances which has been one of the primary focuses of the seminars, as we talked about, which I thought was a very healthy increase, and we have seen a number of new customers joining Check Point as well as upgrading our current customers, and, as I said, we've had a number of competitive displacements. So we're very pleased not only in the large deals, but in the breadth of the transactions across all geographies.

Gil Shwed

And let's remember one thing for metrics. When we look at mid-sized customers, first, we have a big focus this year on the mid-sized businesses and their results for the first two quarters are very good on that.

The percentage of mid-sized customers is increasing which means that we are adding new customers, and we are starting to see traction of those initiatives. Again, it wasn't low last year, but it's increasing in percentage.

When we do talk about high-end accounts, we're not going to see many new accounts simply for measurement purposes. 100% of the Fortune 100 are already customers, so it would be hard to say that we add more customers in that segment.

It is and we will -- we might do analysis in the future, check about customers that are significantly increasing because the fact that we have 100% of the Fortune 100 doesn't necessarily mean that all 100 are very large accounts. It means that we have some product.

So, we will do more analysis of that to see what qualifies us, you know, a constant pattern of purchases versus a change, a significant change in purchasing pattern and increase, or what you would call adding a new customers even while we have some folks.

Sterling Auty, JPMorgan

Got it. Thank you.

Operator

Thank you. Our next question is coming from Dino Diana with UBS. Please go ahead.

Dino Diana - UBS

Hi. Thanks, guys. Was UTM1 more than $5 million in the quarter? And kind of more qualitatively, are the companies buying, that are buying the UTM box, more in the small and medium businesses that you're targeting or are you seeing success in the larger, existing enterprise customers, maybe by putting boxes in their branch offices, because it could be controlled with the one management console?

Gil Shwed

We don't bring the specific product contribution, but the answer is probably still, yes to your question. And in terms of where it was installed, again, we don't have right now the accurate analysis of which customers it went through, but as I indicated in the previous answer, we do see an increase of sales to mid-sized businesses and UTM-1 was targeted there.

I do think that we see UTM-1 selling to both larger enterprises and mid-sized, and again, there is some correlation between the overall business results we've increased on the portion of offering mid range customers.

Dino Diana - UBS

Okay. And I know you don't give -- I'm sorry?

Gil Shwed

Go ahead.

Dino Diana - UBS

I know you don't give Pointsec license revs, but is it fair to conclude that the core business, when we back that out, was actually up very slightly year-on-year, in terms of license revenues only?

Gil Shwed

Yes.

Dino Diana - UBS

Okay. And lastly, Asia-Pac, I don't think Pointsec had much business in this area, so it's fair to assume that the rebound Asia-Pac is due entirely to the core business and if so, why? And that's good for me.

Gil Shwed

Actually, we did see in Asia Pacific, we did see the biggest increase coming from data security, and that's what I referred without saying it specifically in my comments to earlier. But with Pointsec was actually gaining traction through the Check Point channel in Asia, coming from, again, the Check Point sales force, the Check Point channel and eventually, the very significant increase in business, several million dollars of Pointsec business coming from Asia. And that's a very good sign that I hope will repeat itself in the rest of the world.

Dino Diana - UBS

Great. Thank you.

Operator

Thank you. Our next question is coming from Ed Maguire with Merrill Lynch. Please go ahead.

Ed Maguire - Merrill Lynch

Yes. Good afternoon. Could you talk about the mix of the UTM products versus the FireWall-1 products in the -- among your legacy customers and whether you're actually seeing existing customers switch out some of their old licenses to upgrade to UTM?

Gil Shwed

So far, it's not a significant portion what was done. And again, it's not UTM-1, it's VPN-1, because since 1999 our main product, our only product is VPN-1. But this quarter, I think that all sales of the UTM-1 appliances were new sales and not replacements of old licenses.

Ed Maguire - Merrill Lynch

And just a quick follow-up on the consumer business. How's that been tracking and any impact from the rollout of Vista?

Gil Shwed

Consumer business wasn't performing well this second quarter. And we did introduce our Vista product in stores at the end of the quarter, and we are glad to say that this is the first product in its category to really work according to the new Vista APIs in conjunction with Microsoft, and we hope that it will produce better results in the second half of the year.

Ed Maguire - Merrill Lynch

Thank you.

Operator

Thank you. Our next question is coming from Walter Pritchard with Cowen. Please go ahead.

Walter Pritchard, Cowen & Company

Hi. A couple of just quick financial questions. Eyal, I noted that G&A expense looked like it was down quite a bit sequentially. I’m just wondering if you could give us a bit more detail behind that.

And then also on the cash flow, second quarter in a row that it was down year-over-year, and I'm just wondering if you expect that to reverse in the second half and see some year-over-year growth in operating cash flow?

Eyal Desdeh

Well, first on G&A, part of that what you see is an efficiency of integration of acquisition. G&A is the first thing that is being duplicated. G&A is the first thing, because of that, being eliminated. Trying to be as efficient as we can as a company, it’s in our culture.

Regarding cash flow, it was a little light this quarter. I do expect better collection in the second half of the year.

Walter Pritchard, Cowen & Company

Great. Thank you.

Operator

Thank you. Our next question is coming from John Walsh with Citi. Please go ahead.

John Walsh - Citigroup

Good morning. Just two questions. The first is foreign exchange impact in the quarter on revenue, and the second would be deal sizes for the Protect Data product. Could you help us out if they're trending up or what the average deal size is on that part of the business? Thanks.

Eyal Desdeh

Okay. Foreign exchange has very little impact on revenues, because most of our sales throughout the world are in U.S. dollar. We sell in Japanese yen in Japan, but it's not the largest part of our business. It does have some impact on expenses, because we do have spending in Israel and the exchange rate of these vary the second the dollar is trended up and down has become a little volatile.

So we did have a little impact on increased expenses in Q1 and it reversed itself in Q2 and it reversed itself completely since then. Same things in our expenses in Europe, which are mostly in euro and European currency, so there's some impact on expenses, very little on the revenue side. What was the second question?

John Walsh - Citigroup

Around Protect Data?

Eyal Desdeh

Again, we don't break down average deal sizes all for data security. It is higher than for network security. I don't think that we've seen any major changes in the average deal sizes, but I could say I think, and this is really satisfying, that we are seeing a larger number of mid-sized deals coming from the channel. It is beginning to develop.

And definitely, one of the keys of really growing this business is adding mid-sized and many, many small deals with mid-sized companies and small companies, and not just landing their high-end accounts, which we'll, of course, continue to do. And I think, this is something that we're beginning to see, we've seen that this quarter, and it definitely will add to solidify the growth of the business.

John Walsh - Citigroup

And one follow-up. Any margin effect of fulfilling through the channel in the Protect Data side?

Eyal Desdeh

Not much. Not much. I think the channel adds the leverage. They do have some discount, because this is our model, but I don't think that the impact -- by and large, that the impact is not very high, and it's a positive one overall for the total results.

John Walsh - Citigroup

Okay. Thanks.

Operator

Thank you. Our next question is coming from Phil Winslow with Credit Suisse.

Phil Winslow - Credit Suisse Securities

Hi, guys. Wonder if you can spend a minute on the Pointsec and just on the Protect Data side and looking at just end market verticals. Wondering if you could discuss just where you see sort of the most opportunity over the next year or 18 months here. We've heard a lot of rumblings about the government vertical, wondering if you just give us a sense for what you're seeing.

Gil Shwed

Well first, I think that the biggest potential is not in a specific vertical, but taking this product to the world market. In Check Point, we have tens of thousands of accounts with our spread around all verticals in all business sizes, and that's going to be the real leverage that we can provide to the Pointsec business taking it all over the market.

In terms of the specific government vertical, we keep winning nice government deals. Last quarter we had several government agencies sign up nice deals with us. We just had a press release last week about --

Eyal Desdeh

That's our first initiative of the U.S. government…

Gil Shwed

…just about for the U.S. government, and we see many of these deals in the U.S. right now primarily, but also in other parts of the world. But as I said, again, the key thing for us would be to take that business and spread this around our entire install base and create a true leverage.

It's going to take some time, but we're starting to see the first few signs. As I indicated, one good example in this quarter or one example of its stand out is starting to see a penetration in Asia.

Phil Winslow - Credit Suisse Securities

And then, I guess, just looking at the product road map here on the data protection, data leakage side, anything in the road map when you look at 2008 to think of a network-based data leakage, data protection project to complement the FireWall?

Gil Shwed

I think we have outlined that we have some long-term vision around data security, on both the end point and on the network side. So without revealing too much road map and competitive information, I would say that we are still committed to the vision of having data security in different parts of the network and having an entirely Europe data security, that's provided by Check Point.

Phil Winslow - Credit Suisse Securities

Great. Thanks, guys. Good quarter.

Gil Shwed

Thank you.

Operator

Thank you. Our next question is coming from Robert Breza with RBC Capital Markets. Please go ahead.

Robert Breza - RBC Capital Markets

Good morning. Quickly, I was wondering, Eyal, if you could kind of touch on gross margins and how we should think about gross margins trending, maybe in the back half of '07 and more importantly, I guess, as we look at '08.

Eyal Desdeh

If you look at -- if you analyze the gross margin, and I admit it's a little complicated, because the cost of sales on a GAAP basis includes some of the amortization expenses, but in all, GAAP gross margins were 93% this quarter. I think that’s pretty good, given the fact that we are adding some appliances, some system integration projects, which are tracking very nicely, and these things cost money.

It's a little hard to analyze because it depends on the mix of sales, but assuming similar mix, then this more or less going to be our gross margin levels for the second half of the year, but as I said, it's mix sensitive and predicting the mix is a little difficult.

Gil Shwed

Okay. I would just to reiterate what our goal. Our goal is to increase the revenues, increase the profits. So what I'm looking at on every deal is its contribution rather than its margin.

I think we enjoy very healthy margin, even if we have different kind of changes in mix we will still enjoy a very healthy margin, so my focus on analyzing whether a deal is a good deal or not is not if it increases our gross margin or operating margin, but whether it increases these next contributions to our bottom line. And I think on that front we're doing very, very well because the new products and new deals make us not only more competitive but also increase the per deal contribution.

Robert Breza - RBC Capital Markets

Maybe just as a quick follow-up. I know, Jerry, you talked about some of the throughput rates that you're seeing relative to the competition. Maybe just touching on the competitive landscape. Have you seen much of a change either other competitors getting more aggressive or less competitive at this point?

Jerry Ungerman

General feeling is and maybe we're just bullish with our performance. We continue to do very well vis-à-vis competitors both on functionality, the features, the performance, across the board with what we're bringing to market.

We continue to improve every quarter, and I think it's showing in our results, and we're very pleased with where we stand. There's no new competitors, no new tactics, and I think we're distancing ourselves in many respects.

I think you see in the large account market when you analyze the 24 deals greater than $500,000, if you look at the financial sector, governments, it's just a positive picture right now, it's still a challenge we've got to continue to execute. We don't take any competitor lightly, but we continue to focus on the customer, their needs, their requirements, and I think if we do that we will continue to be successful. So that's our focus and I'm pleased with where we stand and what we're doing.

Gil Shwed

But let's understand. We are talking about a very competitive marketplace so we take it very seriously, we're not complacent and it will continue to be a competitive marketplace. So let's not ignore that as well.

Robert Breza - RBC Capital Markets

Thank you.

Operator

Thank you. Our next question is coming from Katherine Egbert with Jeffries. Please go ahead.

Katherine Egbert - Jefferies & Company

Hi. Good afternoon. A couple quick questions. Can you talk about your pro forma operating margin? Has it stabilized here around 50% and how much fungibility are there in the operating expenses?

Eyal Desdeh

Maybe I'll just repeat what Gil said before. The focus here is not on the margin. Yes, we're happy that the operating margin improved from 48% where it was after the first consolidation of Pointsec to the 50% level, but let's not be confused on what's important.

Important is growing top line and bottom line, the EPS and I think if you can do that while improving operating margins, fine, if we do that without improving operating margins, this is fine, too. Our focus is on growing the business.

Katherine Egbert - Jefferies & Company

Okay. And then quickly, the two last acquisitions you've made have done very, very nicely for you so far. What's your propensity to do other acquisitions now?

Eyal Desdeh

You know, traditionally we've always been communicating acquisition after we sign them, and I don't think we're going to change, but let's not forget Check Point is putting a lot of effort in also internal development, bringing new products to market which are developed internally.

We have a very large, one of the largest R&D force in the field of security and look at what we've done this quarter. It's a very nice mix of business that was driven by internal development as well as by the acquisition.

Gil Shwed

If we look moving forward, I think with our focus is not there on growth by acquisition but growth through an expanding of the strategy. Now, we have a much broader product mix today and product line, so that opens up more opportunities to expand ever the existing product line for acquisition or even adding more product line, so I think we will see more acquisitions in the next five years than we saw maybe in the last ten years.

At the same time I think that a lot of focus is coming on what we do internally, and I think as I said in my comments, the most pleasing thing about this quarter that the biggest driver in the performance and the exceeding our range of projection actually came from the enterprise network security business while having the acquisitions perform quite well.

Katherine Egbert - Jefferies & Company

Okay. Thanks, Gil.

Operator

Thank you. Our next question is coming from Todd Raker with Deutsche Bank. Please go ahead.

Todd Raker - Deutsche Bank Securities

Hey, guys. Two questions for your first, on the core business it's accelerated very nicely the first half of this year, you know, 10% growth in the first quarter, 12% this quarter. Can you give us a little bit of insight in terms of how much of that growth you really attribute to expanding the product portfolio into the UTM segment versus are you seeing any kind of refresh cycle around VPN-1 or is there anything in the kind of the more mature side of the business that's changed in the last six months?

Gil Shwed

I think the main thing that we've seen this quarter is very balanced execution. There wasn't any one type of product or one type of deal that generated the results. It's spread around all the different initiatives.

So two good things around that. First, we can expect that sometime in the future we will, we may see some products that make a big breakthrough and that accelerate performance even more, and second, that means that the initiatives that we've undertaken are the right ones and they all contribute to the results, and that's the things that we're focusing on. We're not talking about initiatives that include the new products.

It includes giving the sales force the right focus on increasing deal sizes, and not deal sizes, but increasing the percentage of product sales. All these things have good contribution and execution, especially in the two large markets, Americas and Europe are doing quite well on that.

Todd Raker - Deutsche Bank Securities

Do you feel the core business can maintain this growth trajectory into the back half of the year? When you gave guidance you were expecting this performance to continue?

Gil Shwed

I think you heard the guidance, and I think we are standing behind it. There's always a high level of uncertainty about the future. Our people are more optimistic now than they were before, and not that they weren't positive.

It was very positive entering into the into the year, they're more positive now, but I think it's important to note that projecting into the future is always difficult, and we always have to be careful about that. As you see, we have the right thing that we've I think, upped some of our guidance numbers and the increased the ranges, so that shows that we're making headway, I think.

Todd Raker - Deutsche Bank Securities

And then just one question on large deals. Very nice performance. Can you guys quantify that the largest deal in the quarter for us?

Eyal Desdeh

Without revealing names of customers, I think our biggest deal this quarter was a $2.3 million deal with a service provider. That included both renewal, new (inaudible) support and a nice components of new product sales.

Todd Raker - Deutsche Bank Securities

Okay.

Gil Shwed

And one last thing about our business model that's also important. Unlike many enterprise software companies and even the enterprise hardware companies, our deals tend to be longer-term deals.

I mean we generally, again, don't force customers to preorder a big part, a big pile of products ahead of time, so many of the large deals are actually multi-stage deals, and what we see, then if we see a half $0.5 million deals and $1 million and even more invested in many cases it's only one step in the multi-quarter, multi-year purchase which I think, again, balances our business over time.

Todd Raker - Deutsche Bank Securities

Okay. Thanks, guys.

Operator

Thank you. Our next question is coming from Daniel Ives with Friedman, Billings, Ramsey. Please go ahead.

Daniel Ives - Friedman, Billings, Ramsey Group

Yes. Thanks. A question on taxes. Your tax rate was a little lower than expected this quarter. By going forward where do you see that? Is it going to be like 15% or below in the pro forma tax?

Eyal Desdeh

Oh, I don't intend to give a long lecture on how the Israeli tax code works.

Daniel Ives - Friedman, Billings, Ramsey Group

Come on, you want to give it. You can give it.

Eyal Desdeh

Not too long, but we benefit from a (inaudible) as you know, and the way it works is that the more revenue growth you have, the more efficient the utilization of the benefit programs are. This is what we've seen.

Growth coming from our enterprise network security product is applied to approve enterprise programs and reduces the effective tax rate and as long as we'll continue to grow we could look at smallest level of tax rate.

Daniel Ives - Friedman, Billings, Ramsey Group

Okay and just a final question on Pointsec. Guidance $100 million for the year, the first half you guys have done about, let's say, $40 million.

So it looks like the second half there's going to be a significant ramp on the Pointsec. I mean is that, and you say to date it's pretty in line with expectations in regards to the contribution. Is that the best way to characterize it?

Eyal Desdeh

That's the arithmetic, yes.

Daniel Ives - Friedman, Billings, Ramsey Group

Okay. Thanks.

Operator

Thank you. Our next question is coming from Avalina Navarre (ph) with Lehman Brothers. Please go ahead.

Israel Hernandez - Lehman Brothers

Hi. It's actually Israel Hernandez here at Lehman. Good morning, everyone. Can you provide a little bit of color, additional color on the Defense Department and Data Security Initiative and any announcement last week? How meaningful an opportunity is this for you? How much visibility do you have there in terms of the eventual revenue opportunity? Can you try to scope it out a little for us? Thanks.

Eyal Desdeh

I will be very careful on that, and you saw the press release definitely did not provide any guidance or numbers. It depends on so many factors. First and foremost on the government itself, how much they buy, what they protect, but I just want to reiterate this is not our first sales to the government.

We've been selling data security and of course our network security product to the U.S. government for many, many years, and on the data security products the U.S. government is a very large customer of Check Point in many of its department, so this is not the first introduction, of course.

And Jerry mentioned we signed a few nice large deals with the U.S. government this quarter alone, so I would not start to forecast and predict now how much it's going to deliver and what is the future contribution of this initiative, probably be more than zero. The high-end of the size, hard to predict. I don't want to.

Jerry Ungerman

Israel, let me add just a little bit more. And it's not just the U.S. government, this is government. I think government is a very important sector for data security. Gil talked about across all of our sectors and I agree with that and I hear it from every customer I talk to.

With the government, state, local, federal, not only U.S. but all governments around the world are very good customer of ours and they're very good prospects for what we're doing.

I think we have the right level of technologies and data security happens to be one of them that's most importance across the Board. But I think it's much bigger than us just talking about what are we doing with the U.S. government because we're talking many governments at many different levels around the world and I think it is an excellent opportunity and I think we're very well positioned as some of the indicator's already shown we're going to continue to pursue and execute on that strategy around the world.

Gil Shwed

And maybe one more just, I mean, in terms of sectors that we sell to. Government is probably the third largest sector in the different customer types that we have in Check Point.

Israel Hernandez - Lehman Brothers

Great. Thank you and good job, everyone.

Jerry Ungerman

Thanks, Israel.

Operator

Thank you. Our final question is coming from Rob Owens with Pacific Crest Securities. Please go ahead.

Rob Owens - Pacific Crest Securities

Yeah. Good morning, everyone.

Jerry Ungerman

Hi, Rob.

Rob Owens - Pacific Crest Securities

You mentioned in your comments the pressure on gross margin was being driven by some integration projects. Was wondering if you could go into a little more detail on that fronts, exactly what you guys are doing, types of customers, etcetera?

Gil Shwed

First, I don't think we have pressure on gross margins. We have very, very healthy gross margin, especially given the fact that we've grown the number of products that we sell on an integrated basis including both hardware and software.

I think all the projects that we've done and pretty much all the deals that I'm aware of contributed very positively to our bottom line, and the fact that we've actually added more companies into that increased both revenues and contribution, so I think overall that's a good sign, and the more we can do on that front in a healthy contributing way we will.

Rob Owens - Pacific Crest Securities

Okay. But gross margin did show 70 basis point decline sequentially, and I think Eyal commented on some integration projects that may have weighed on that. So I was just curious for a little more color there.

Gil Shwed

So again, we've introduced different products lines on the different segments. We introduced the UTM-1 appliances, which include hardware and software. We are serving some of our largest customers with fully integrated systems.

I mean we call it system integration is the keyword, but I think it's more like fully integrated systems across the different product lines. We have low-end appliances that are selling for a few years, but keep increasing some of our numbers, so overall when you look into that, I think we've seen very nice increases on that.

One thing that is also important when you analyze the gross margin is that we also increased the percentage of services that we sell and that also, on one hand, it increases the revenues on the service line. And services, by the way, we mean it's primarily support services, at least through cost centers and through service programs, it's not so much professional services which is very small portion of our business.

But we also increased nicely the investment in customer service, the head count on our call center, and the specifically the people who are addressing our largest customers is growing very fast, and this is, again, all good signs because it's coupling growth in revenues with growth in expense. We have a much, we have a higher growth in profit. So all in all I think these are all very positive signs in the overall business.

Eyal Desdeh

I will add one thing which is very important to understand. Almost with no exception, almost with no exception all these appliance-based deal or system integration which include hardware are incremental to our topline and our bottom line, as compared to selling this software only.

So what you see is that there’s line of business that, on every deal where we're adding more, but not just to the topline but also to the bottom line. That's very important to understand, and I think part of the results that you're seeing is coming from there. Not all of that but some parts of what we have reported in the first half of 2007 is a result of this strategy.

Rob Owens - Pacific Crest Securities

Great. Thanks for your comments.

Eyal Desdeh

You're welcome. Okay. Well, I'd like to thank everyone for your participation, for your kind and eye-opening questions. If you want to speak to management or to Investor Relations following this call, please call our Investor Relations department at area code 650-628-2050, and we'll be very happy to take your call.

Thank you very much and we'll talk to you next quarter.

Jerry Ungerman

Thank you, everyone.

Operator

Thank you. This does conclude today's Check Point Software Technologies Q2 2007 Earnings Call. You may all disconnect and have a great day.

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