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Websense, Inc. (NASDAQ:WBSN)

Q2 2007 Earnings Call

July 24, 2007 4:30 pm ET

Executives

Kate Patterson - IR

Doug Wride - CFO

Gene Hodges - CEO

Analysts

Todd Raker - Deutsche Bank

Daniel Ives - Friedman, Billings, Ramsey

Phil Winslow - Credit Suisse

Dino Diana - UBS

Sterling Auty - JP Morgan

Rob Owens - Pacific Crest Securities

Garrett Bekker - Merrill Lynch

Samuel Wilson - JMP Securities

Priya Parasuraman - Wachovia Securities

Robert Breza - RBC Capital Markets

Alan Weinfeld - Henley & Company

TRANSCRIPT SPONSOR
Wall Street Breakfast

Operator

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

Kate Patterson

Thank you and good afternoon, everyone. Thank you for joining us to discuss our Q2 2007 results. With me on the call today are Gene Hodges, Websense CEO; Doug Wride, Chief Financial Officer and President; and Becky Wheeler, Investor Relations Manager.

Before we begin a review of the financial results, let me remind you that during this call management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties and other factors that may cause the company's actual results to be materially different from historical results, or any preliminary results expressed or implied during this call. The potential risks and uncertainties which would cause actual growth and results to differ materially include, but are not limited to, customer acceptance of the company's services, product 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 and 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.

Please also note that statements related to the proposed acquisition of SurfControl are also subject to risks and uncertainties that may be beyond Websense's ability to control or estimate precisely, such as the approval of the proposal by SurfControl shareholders or the satisfaction or waiver of any conditions to the transaction.

Our discussion also includes financial measures for billings 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 exclude stock-based compensation expense, certain cash and non-cash expenses related to the Port Authority and SurfControl acquisitions and a reserve associated with the settlement of litigation as well as the tax impact of these excluded items enhances investors ability to evaluate the company's operating results and compare current quarter operating results with historic operating results.

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'll now turn the call over to Doug.

Doug Wride

Good afternoon, everyone and thank you for joining us today. We just finished a very busy quarter, which included preparations for our pending SurfControl acquisition and Version 6 of the Websense Content Protection Suite, as well as the intense work leading up to the global launch of Websense Express for the SMB market on July 2nd, just after the quarter closed.

Even with all these activities, I'm pleased that we are able to stay focused and execute on our day-to-day business, resulting in steady progress against our stated objectives and solid financial results. As a reminder, most of my comments will refer to non-GAAP financial measures, since these are the most directly comparable to last year's results. The difference between GAAP and non-GAAP presentation of results includes stock option expense, a litigation settlement and certain cash and non-cash expenses related to the Port Authority and SurfControl acquisitions. All of these excluded items are presented on a tax affected basis. A detailed reconciliation -- and you will need it -- of these items is included in the press release and is on our website.

Looking at all the details of our results, let's talk about billings. For the quarter, net marketing payments and rebates to channel partners for the quarter reflecting the net of the marketing payments and rebates to channel partners we ended up at $54.5 million, an increase of 10% over Q2 last year and in the middle of our guidance range of $53 million to $56 million. This number again reflects strong international billings, around 23% year-over-year growth, and renewed growth in North America due to an increase in both SMB and enterprise business, which I believe is the direct result of our improved channel relationships and expanded distribution.

Proof in point. New SMB transactions in North America were up more than 20% from Q2 a year ago, and we closed 80 transactions greater than $100,000 in Q2, up from 64 a year ago and 62 last quarter. Total net billings also includes ILP billings that at approximately $800,000 were a little below our expectations; but up more than 300% from Port Authority's Q2 06 number.

The changing mix of our business impacted several of our metrics:

(1) Contract length. This quarter, average contract duration was 23.6 months compared to 23.4 months last quarter, and 22.4 months in the second quarter of last year. The increase appears to be largely due to the success of our three years for the price of two discount we were offering on business booked through Ingram Micro in the first half of this year. We have discussed this program in the past. On large transactions -- that is, over $100,000 -- the contract length did not change meaningfully from last year. We are anticipating an average contract length of around 23 months for this third quarter.

(2) The second area impacted is the average analyzed contract value. The average contract value for the quarter was $8,300; down slightly from $8,700 in Q2 last year and up from $7,650 last quarter. The year-over-year decrease was what you would expect as we book more SMB contracts.

(3) ASPs, average seat prices. Without going into the exact metric, which we usually don't do, the average price per seat was higher than it was a year ago. The changes in both of these metrics reflected increased SMB business which carries a higher price per seat but a lower overall contract value. This metric also shows that pricing, while competitive, remains relatively stable.

(4) A final factor in our billings performance was the 300,000 seat increase in our net seat count.

Subscription revenue, net of marketing payments and rebates to channel partners, was a record $50.4 million, in line with our guidance and up 15% from a year ago. International revenue increased to 40% of total revenue, up from 39% last quarter and 36% a year ago. This increase in international revenue reflects the consistent growth we have seen in international billings over the last few years and the investments we've been making in these areas.

Many of you will notice that the sequential revenue increase, after holding steady in the $1.5 million to $2 million range for several years, slowed substantially this quarter. We guided to up about $500,000 to a $1 million or 1% to 2% sequentially for Q3. This slowing of growth rate reflects the unique relationship between billings and revenue in a subscription-based business model. As billings growth has been slower over the past six quarters, revenue growth has also slowed but at a rate lagging the billings rate.

The good news for us is that because we have a relatively high degree of visibility when we begin the quarter, we can manage our expenses accordingly. When billings growth reaccelerates as we gain traction in our ILP and Websense Express solutions and our SMB initiatives, the revenue growth will start to increase again; but again, after a certain lag.

For the next few quarters, starting with Q4, I believe the sequential growth in revenue will be more in the range of about $1 million. This amount will continue to be impacted by linearity in the quarter, particularly now that we've moved to daily revenue recognition and contract length mix.

Turning to the operating model, non-GAAP gross margin was 91.3% of revenue, in line with our guidance. Non-GAAP operating margin was 25.5%, also in line with our guidance. Looking forward, operating margins should be in the range of 25% to 26% in Q3, reflecting continued revenue growth against relatively constant operating expenses.

One area where we expect to see growth in expenses is R&D as we balance the need to invest in our business growth opportunities such as end point ILP and the content gateway with good fiscal management. In fact, of the net 36 individuals we added to headcount this quarter, 24 of them were in our Beijing engineering facility. Our total company headcount was 785 employees at quarter end.

Non-GAAP net income for the quarter was $9.9 million, or 19.7% of revenue, generating $0.22 of earnings per diluted share. There were several reconciling items to GAAP net income, so let me walk you through those.

We agreed to a settlement in a class action suit regarding the classification of engineers and other employees as exempt or non-exempt and took a reserve of approximately $3.2 million for the forthcoming settlement and associated payroll taxes.

Also, as required by GAAP, we marked to market the foreign exchange option that expires in July 2008 that we put in place related to the SurfControl acquisition. On June 30, due to the improved -- at that time -- U.S. dollar to British pound exchange rate and the reduced life of that option, we recorded a loss of just over $1 million. In Q3, we plan to sell our existing option and replace it with a new option that expires more in line with the closing of the SurfControl acquisition in Q4 of '07. In doing so, we may incur a realized gain or loss in the third quarter, but that will depend on the market pricing at the time of our sale.

Further, we will be required to mark to market our new option at the end of this third quarter, which will result in an unrealized gain or loss in the period. Note, please, that this unrealized gain or loss will not be a taxable event and will not therefore impact our tax rate for Q3 as it did in Q2.

Acquisition-related expenses included both certain cash and non-cash expenses related to the Port Authority acquisition such as accruals for retention bonuses for retained employees and amortization of intangible assets. The only cost incurred in the quarter associated with the SurfControl acquisition was the mark to market expense of the purchase price option that I just covered.

Total stock-based compensation expense was approximately $5.3 million and was spread across all expense categories. We are anticipating that the FAS 123 R expense will increase to about $5.7 million in the third quarter.

All of this resulted in GAAP net income that was approximately $7.75 million, or $0.17 per diluted share lower than non-GAAP. The effective non-GAAP tax rate was 35.7%, while the GAAP tax rate was 52.3%. The GAAP tax rate was considerably higher than non-GAAP, because of the non-deductible nature of the mark to market loss on the purchase price option, and the impact of the FAS 123 R stock-based compensation. As a reminder you can find a detailed account of these expenses on the press release we issued earlier today, as well as on our website.

Now let's turn to the balance sheet. Accounts receivable were $43.8 million at quarter end, an increase of approximately $6.9 million from the end of the first quarter, reflecting an increase in billings. As we predicted in April, DSOs based on billings also increased and were 74.6 days at the end of this quarter; a bit higher than our target range of 65 to 70 days, but within the 70 to 75 days we spoke about back in April. This was due to the quarter-over-quarter growth in billings and a few large international distributors that have been slow in paying. We did not see a deterioration in the quality of receivables and we have already begun to refocus our collection efforts similar to what we did back in 2005.

Deferred revenue, which represents the difference between billings booked and revenue recognized in the quarter increased by $4.1million at the end of the first quarter to $217.5 million.

We closed the quarter with $261.9 million in cash and investments, an increase of approximately $500,000 from the prior quarter. Of this, let's call it $262 million, approximately $216 million is restricted for the SurfControl acquisition, leaving approximately $46 million to run the business, which we believe is more than sufficient.

Cash flow from operations was $2.5 million and reflected cash tax payments of $7.4 million and cash payments of $3.7 million associated with the SurfControl acquisition. So if we normalize the cash flow from operations without the SurfControl acquisition, we'd be at about $6.2 million, or the $3.7 million plus the $2.5 million.

CapEx was about $1.5 million and depreciation was $1.1million. The spike in DSOs of course also reduced the operating cash flow metric.

We've already reviewed several of the guidance metrics, so to summarize, for our Q3 guidance we are looking for billings in the range of $56 million to $59 million and revenue between $51 million and $51.5 million, up between 1% and 2% sequentially. 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 $5.7 million, Port Authority expenses, including amortization of acquired technology, amortization of intangibles and accrual for retention bonuses are expected to be about $1.3 million, and we could expense between $500,000 and a $1 million in acquisition-related expenses for SurfControl.

GAAP gross margins are expected to be approximately 90% to 91% and non-GAAP gross margins are expected to be approximate approximately 91% to 92%. GAAP operating margin is expected to be 10% to 11% of revenue and non-GAAP operating margin is expected to be approximately 25% to 26%.

Looking at the rest of the income statement, we expect other income to decrease slightly compared to Q2 due to the shift toward shorter term maturities in advance of the SurfControl acquisition. We are forecasting both GAAP and non-GAAP tax rates of approximately 42% and 35.5% respectively. The GAAP tax rate is exclusive of any impact from the mark to market fluctuations of the foreign exchange option. This revenue and expense structure should result in GAAP earnings per diluted share of about $0.09 to $0.10 and non-GAAP earnings per diluted share of $0.22 to $0.23.

Again, non-GAAP excludes the impact of foreign exchange option related to the acquisition of SurfControl, also the stock option expense and cash and non-cash expenses related to the Port Authority and SurfControl acquisitions, all of which are tax-affected.

I'm sorry to continue to speak to those issues and repeat all of that, it's just a better legal position for these disclosures to be very complete.

Finally, we expect cash flow from operations to be in the range of $11 million to $14 million for the quarter. This amount has been decreased to reflect a $2 million estimate of SurfControl purchase accounting costs.

In summary, our financial performance reflects a company building for growth. As an eight-year veteran of Websense, these are exciting times. As a company we're moving forward on many fronts: channel, SMB, security, international expansion as well as M&A. We've more opportunities to succeed than at any time in our history and I really believe Websense is headed in the right direction. I recently attended our mid-year sales meeting where I was struck by just how much progress we've made over the past few quarters.

Now before I turn the call over to Gene for a discussion of the quarter, let me give you a quick update on the SurfControl acquisition. As you all know, we've received clearance from all regulatory authorities and the offering circular has been posted. Their shareholder vote is scheduled for August 16th and the final closing is anticipated on October 3rd. We're working with the people at SurfControl on pre-integration planning to the extent possible and remain confident in our projections. Until then, it's business as usual for both companies.

Now it's over to Gene.

Gene Hodges

Thank you, Doug. Q2 was another quarter of focused execution and steady progress on several fronts for Websense. We hit a number of major milestones earlier in the quarter and some shortly after the quarter closed. When I look at our prospects today versus a year ago, I think we're in a much better position to drive growth. While we're not always able to predict the timing of the top line impact precisely, I firmly believe we're solidly on track. Let me review in detail the progress we've made in several key areas.

First, growth in the U.S. As we discussed on the Q1 call, our U.S. filtering security billings had shrunk slightly in each of the last few quarters. We got back to growth in Q2 and this was achieved through an increase in our SMB business and through improved channel execution, which helped drive an increase in our enterprise business as well. With the launch of the Websense Express small/medium business product, we believe this growth in the U.S. security filtering business is sustainable and should accelerate.

Next, our international business continued strong performance as it has for the last 11 quarters, with billings outside the U.S. up more than 20% and again accounting for more than 40% of total billings. Our international growth in Q2 was very balanced across the globe, with the UK, continental Europe, Mideast and Africa, Asia, Latin America and Canada all delivering over 20% growth. Continental Europe was especially strong with growth over 50% in Q2.

Jeff Haggard has also hired a new leader for our Asian operations, Tim Lee. Tim has years of experience in both security solutions and critical channel contacts across the region and we believe these can help us sustain growth for years to come.

We see this international growth remaining strong, both in Q3 and beyond. We believe we'll continue to accelerate our SMB growth in Q3 and Q4 so we can start to extend many of the improvements we've made in the U.S. to our more mature international country operations as well. We've invested heavily for awhile now in SMB, and we think we are starting to see the payback.

We've talked a lot about the Ingram investment in the U.S., but our program is much broader than that. As we get to the end of the invest phase of this initiative, here's where we stand and here's what we have accomplished.

We have developed our first SMB product, Websense Express and shipped it in five languages, English, German, French, Spanish and Japanese on schedule on the 2nd of July. Express has a new user interface and installation procedure. It can be installed in less than 30 minutes, and it shows reports on the protection being provided from the time of installation, so customers can clearly see value immediately.

Express is available in two appliance versions as well; a little and a big one. These appliances are the meat in the channel appliances we've described before. The hardware comes from HP, distribution installs the software and the customers and our reseller partners see a single part number for the appliance, but the cost of goods and the inventory never touch Websense books.

Also important, we've added web-based partner training for Express. This lets small resellers get trained without sending either their sales or SEs to a formal class. We expect this seemingly small change will have a big impact over time in getting new small resellers to sell our product.

The biggest step forward with Express, however, is in pricing and in the interaction we have with our resellers. Express is less expensive than Websense Enterprise and that will allow us to compete more effectively in deals where sometimes we weren't even considered because of our price.

You may have concerns about cannibalization of our existing higher priced renewal base. We've addressed these concerns through the structure of our channel margins. Resellers can certainly convert an existing Websense Enterprise renewal to Express, but if they do so, they receive no rebates on those sales. Hence, their margins are lower, so they absorb most of the price decrease to the end-user customer and are not so motivated to make this move. In addition, Express lacks many of the high-end features that are must-have for the more technologically sophisticated customers that we sold Websense Enterprise to in medium businesses. Finally, we've limited Express orders to a maximum of 1,000 users, so there'll be no impact in our enterprise space.

For new customer sales in SMB, however, Express is much cheaper and the resellers make good margins on it at the same time. Our pricing is targeted to be even more aggressive for the smaller end of the SMB spectrum. We've been a bit more conservative with the pricing for the larger SMB customers to minimize cannibalization, but at the small end we've gotten very aggressive since we have a much smaller install base.

With Express, we've also implemented our full no-touch model in the United States. We won't give discounts on Express. It's priced competitively and distribution in reseller partners has sufficiently margin to address price competition. Hence, resellers don't have to come to us and play the game to get discounts, they can sell much more efficiently and realize higher yields from their sales force. This simplified commercial interaction in an Express sale addresses the issues that cause small resellers to complain that we've been hard to do business with in the past.

We've retooled distribution not only in the U.S. but in Europe too. You've heard a lot about the Ingram relationship in the U.S. That relationship is clearly productive now and is starting to generate new business. But there's also been significant work in Q2 on international distribution. In Q2, we put out an RFP for distributors in Europe and awarded contracts for distribution of Express to several new partners, who we believe will do more work to generate new business than some of our existing distributors.

In the U.S., the move to two-tier distribution was an investment. It cost margin over several quarters. In Europe, we will either increase growth on our same spend to distribution or cut costs as we make these moves, so, it's accretive from the beginning. As we've retooled the distribution layer, we've recorded new resellers and are starting to see a payoff from the sales of these new resellers.

In Q2 we signed up 218 new resellers in the U.S. and 336 in EMEA; almost all of these, of course, were smaller resellers. In total, since the reintroduction of our new channel program last Q3 we've signed up over 2,000 new resellers globally. 2,000 signed up is good, but we still have lots of work to do to get these people selling for us. In Q2, about 200 of the new resellers sold. We think this more efficient commercial interaction with Express and the more efficient on-boarding process we'll see with web-based training will start to get more and more of these small resellers selling our products.

In Q2, SMB transactions from existing resellers, both large and small, were also up, indicating we're getting more attention from our existing partners.

We built a new partner and customer relationship management IT system that we've talked about for awhile that's purely partner centric. In Q2, Europe came up on the final stage of this project implementation. The U.S. is switching over now and this major project will finally be complete and ready to support both Express sales and an influx of new sales people and partners as we integrate SurfControl in the fourth quarter.

Net in our SMB initiative the new product is done. The appliances are done. The new training and support mechanisms are done. The new IT systems are done in a few weeks. New pricing and rebate structures are done. New distribution partners are in place. 2,000 new partners are signed up and we're working to get them selling. We saw a step towards higher billings in Q2 and the difficult, multi-functional changes needed to be an excellent channel company are nearing completion. We believe we've laid a solid basis for growth.

The SurfControl acquisition will add new products to this SMB model, especially the exciting Black Spider on demand e-mail filtering and web security filtering offerings and the SurfControl e-mail filter, all of which we plan to sell in this no-touch model.

In contrast to our SMB initiative, Q2 was somewhat disappointing for our ILP, or data leakage initiative. We booked $800,000 and this was below our expectations. The good news is the prospect pipeline for the second half is large and the billings shortfall was predominantly because of slips, not lost deals. In Q1 we closed the Port Authority pipeline and in Q2 we started up a new Websense generated pipeline. We simply did not get enough of those new deals closed.

We've seen a significant spike in evaluations, or as we call them in ILP, proofs of concept, throughout Q2 and continuing into the third quarter. Our win/loss rate in Q2 was about what we expected, with the major competitors being start up players. At the start of the quarter we were losing more deals than we were winning as we were coming in late on many sales because the start-ups had been there sooner, having wider sales coverage. By the end of the quarter we were winning better than 50%. Demand certainly seems to be there to support a sustained growth in the ILP business.

Initially, at the beginning of the year, we thought we'd do $7 million to $10 million in ILP this year. After a strong Q1 we felt we could reach the upper end of that billings range. In Q2 its more realistic to return to the original $7 million to $10 million billings estimate and we'll be pushing to get high up in that range.

To help execution in the second half, we are shipping the next major release of our ILP product, V6 of the Content Protection Suite, early in August. This is the integrated Websense Port Authority product we promised you whether we closed the Port Authority acquisition. This product takes information about who is handling a piece of content and where it's being sent to from our Websense code base and it combines it with critical information about the content itself from the Port Authority technology.

To put this in a simple context using an example event that we know would never happen in real life, this product would tell you that Kate Patterson has sent a draft of the earnings release to one of our investors rather than a user at IP address X has sent a draft of the earnings release to IP address Y or domain Z. You can see how this product functionality differentiates us and allows clear and concise reporting that allows our users to follow-up on leak incidents better than with any other product available.

In Q2, we also started development of an ILP endpoint client which we anticipate shipping in the first half of 2008. This client will allow a company to establish a single policy to control information flow through the gateway, from desktops on the corporate network and on traveling laptops with their ubiquitous thumb drives and CD burners.

Q2 was rough on ILP, but we have a strong pipeline and an excellent team leading this business in sales, product development, product management and services enablement. We're still very bullish about ILP and hope to report improved results in Q3.

As we look forward to the first half of 2008, after the integration of SurfControl, we believe we will have one of the most powerful and coherent product offerings in the industry. With new organically developed ILP and threat to your content gateway products and the on demand capabilities and layered e-mail filtering solutions of SurfControl, we will truly be able to offer total content protection for each of the major market segments we serve, with an especially strong offering for the SMB customers where we've made such heavy channel investments.

In conclusion, we're a much stronger company today than we were a year ago. We have a strong roster of current, leading-edge products to sell. Our new product pipeline is robust and differentiated. We've regained the respect of our resellers, and expanded our distribution dramatically. We have improved our back-end processes and we've made it easy for small resellers to do business with us.

Our top line performance may take a little longer to reflect this progress than we'd like, but I'm more optimistic today than even just six months ago when we outlined this strategy to you in detail. We now have proof points the strategy is the right one, and we've executed to get the groundwork in place. I have complete confidence in the executional capabilities of the current team. They've proven it by doing both their day jobs and making the number and their night jobs of preparing for the future at the same time.

One final note. I realize that many of you may be concerned about the transition in the CFO role. But I want to reassure you that we're adding bench strength rather than just piling more work on Doug. Doug will remain in his role as President and manage the SurfControl integration. I know you'll agree this is going to be critically important to shareholder value. He will also be here to provide continue continuity and guidance on all financial matters. I'm confident in our ability to recruit and hire a candidate every bit as strong as Doug for the CFO position and we'll give you a report as we make progress.

With that, I thank you for your attention and will now turn the call back to the operator for questions and answers.

Question-and-Answer Session

Operator

Your first question comes from Todd Raker - Deutsche Bank.

Todd Raker - Deutsche Bank

Gene, as you talk about the ILP business, can you talk about how much direct touch is required versus pure channel selling and how you see that kind of playing out longer term?

Gene Hodges

ILP requires a lot of direct touch at the moment, Todd. It is a sales cycle where I think the most accurate way to describe it is the partner opens the door, we go in and get the proof of concept started, and the partner works with us today to prosecute the proof of concept. The proof of concept is more central in an ILP sale than it is in other security sales, because you’re looking at how you change your business processes and monitor them, as well as the technical capability.

Over time, as we ramp our technical partner staff up, they will take on more and more of the POC, which is more than half of the total effort that’s involved in the sale. So it will be a joint sale for I think the foreseeable future, with the partner adding significant value in terms of account relationship and technical skill.

Todd Raker - Deutsche Bank

I don’t know if you can give us a sense for headcount associated with ILP. As the business missed this quarter, are there any changes to headcount plans between now and the end of the year?

Gene Hodges

We are certainly not cutting back on the expenses but we are focusing our sales model to take advantage of our in-field Websense salespeople more effectively. In Q3, we’ll be utilizing what I consider to be a little bit of excess capacity. You know, we don’t have much growth opportunity in that large enterprise filtering business, so we’re going to let these guys loose on ILP to identify new opportunities and expand that pipeline.

So we believe we can get improved productivity without adding additional headcount. We will add headcount in technical areas in ILP. The engineering team, which is one of the best I’ve ever seen in the world, has not shown attrition and will be growing. It is a dynamite team.

Todd Raker - Deutsche Bank

One last question. Just in the core business as you are starting to see some success expanding down market, can you talk about what you’re seeing in terms of the renewals or your core-installed base? What the status of that looks like?

Gene Hodges

The renewal business in SMB did not perform quite as well as the new business, but it was still fairly solid. We are under very heavy price competition at the low end, from a very low price vendors, as well as SurfControl and that’s where most of our churn from a number of customer’s perspective, where we lose renewals has come. So we think Express is definitely going to give us a stronger small business reaction at that low end. You know, when you get to a high discount point on Websense Enterprise at the low end, we’ll actually make more money selling Express.

Operator

Your next question comes from Daniel Ives - FBR.

Daniel Ives - Friedman, Billings, Ramsey

In regard to guidance, just to make sure I’m clear, I know you only give 3Q guidance, but when you are talking about the sequential increases, could you just give some sort of sense with regard to Q4? I mean should that also be up similarly sequentially? Could you just touch on that?

Gene Hodges

Q4 seasonally is strong; we don’t want to give guidance for Q4 yet. We don’t have a lot of visibility, given that obviously we expect to close SurfControl acquisition earlier in the quarter.

Daniel Ives - Friedman, Billings, Ramsey

With regard to the CFO moving around, I’m just, from a timing perspective, especially with SurfControl going on, could you just talk about that? Is this going to be a role you are going to fill sooner rather than later? I know Doug’s still on. I’m just trying to understand that from a timing perspective?

Doug Wride

As it relates to my role, I think that sooner is better. That’s certainly what we are going for. That said, it’s always an iterative process one that we are going through but when we find the right person there won’t be any hesitation to try and get them on board. There is a lot to do and as Gene said, building the bench and having more able-bodied people to deal with that is better.

I would like to go back to your first question. You were speaking about guidance and I agree with Gene. We are not in a position to give Q4 guidance as it relates to billings, but from a revenue standpoint, just to be clear, I did say that I think that our Q4 revenue number should step up about $1 million.

Daniel Ives - Friedman, Billings, Ramsey

So that was right on the revenue perspective?

Doug Wride

Yes. That’s why I wanted to go back to that.

Operator

Your next question comes from Phil Winslow - Credit Suisse.

Phil Winslow - Credit Suisse

Maybe I missed this on the call, but did you give a specific breakdown of just one, two and three year billings, what they were as a percentage of the overall billings?

Doug Wride

They were 48% one year, 7% two year and 45% three year. So the way you build your model, you’ll note the shift was mostly two years going to three years in that metric.

Phil Winslow - Credit Suisse

Exactly. And then you talked contra billings last quarter about $1.1 million; it was about similar levels this quarter as well?

Doug Wride

As we continue to move into that and focus on the channel, those numbers are going to move around. It was certainly at least that size. What we want to be cautious of is not laying the cards on what are our actual budgets are and what our spending is to the competition. You can appreciate that. But it’s certainly going to run $1 million or more as we move forward.

Gene Hodges

The billings and the revenue numbers are all net-net-net.

Doug Wride

Correct. We’re just trying to give you perspective and remind you that those numbers weren’t there a year ago.

Phil Winslow - Credit Suisse

Also, when you do look at the close of the SurfControl acquisition, I wonder if you could just give us a sense for the product lines, how you sort of envision maintaining Websense Enterprise, Websense Express, the SurfControl product and BlackSpider and what is your intention with the SurfControl base? Has it migrated over to Websense Enterprise or Express or are you trying to maintain the standalone SurfControl product?

Gene Hodges

Phil, it’s Gene. We’ve laid this stuff out in the regulatory documents and want to color within those lines. Our objectives will be to maintain the SurfControl base at their current pricing on the SurfControl filtering product which constitutes about 70% of their revenue. We will enhance that product by upgrading it with our database. We expect that we can accomplish that in approximately six months after closing the transaction.

So we’ve given those customers a good, long timeframe through 2010 to move over to Websense Enterprise. We’re not going to force them. They will have a nice, smooth ride and we’ll support the product very ardently to be able to keep their business.

The layered e-mail product will be one which we hope to cross-sell into the Websense installed base; it will be well over 50,000 customers in the combined company and a bit more than half of those will be Websense customers and that e-mail product is one where we see some upside.

BlackSpider is the crown jewel, from our perspective, in the SurfControl product line. It sold very effectively in the UK and in Europe, and last quarter and the quarter before that, generated the bulk of SurfControl’s growth. That’s from their public trading updates. It’s just come to the U.S. and Asia. SurfControl has opened up network operating centers in the last six months in both of those regions and we will be looking at selling it aggressively, globally after we close the deal.

We think BlackSpider will give us both a great new offering for both e-mail and for web filtering in the small market segment, the less than 100 users. So our product lineup will be e-mail and filtering in small from BlackSpider. E-mail from Surf and filtering with Websense Express in medium, and Websense Express for security filtering in large with ILP soon complemented with the Threat Seeker content gateway and the ILP end point solution.

Phil Winslow - Credit Suisse

Doug, when you look at the debt that you will be raising for the SurfControl acquisition, what sort of interest rate should we expect on that?

Doug Wride

The rate will be set at close of the debt offering. The margin over LIBOR is disclosed in the public documents.

Operator

Your next question comes from Dino Diana - UBS.

Dino Diana - UBS

On the cash flow from ops, did you say it was 6.2 if you add back all the one-time SurfControl acquisition costs?

Doug Wride

If you add back the $3.7 million worth of what I will call deal costs related to SurfControl, you would be at $6.2 million. The stated number if you do the formula as laid out is $2.5 million, but one of those numbers is the SurfControl-related costs, which we wouldn’t normally be incurring when you look at year to year.

Dino Diana - UBS

Okay. If we were to net that and add back $2 million to the guidance, I guess cash flows are still down just under 30%. Can you talk about why that is? When do you expect cash flow from ops to stabilize and then start to grow again?

Doug Wride

Well, the delta between billings and revenue has long been the real cash flow engine, right? You take that plus a whole bunch of profitability and it drives the bottom cash flow. So we need acceleration in the top line, the billings number. We need to improve our DSOs, and we need to bring the profit margins, the operating margins back over 30%. When we do those three things, you’ll see cash flows back to where we’ve been more historically.

Dino Diana - UBS

Any guess on when that will be?

Doug Wride

No. If I gave you a number or a timeframe now, it just wouldn’t have good visibility through the SurfControl acquisition and so we’d been talking about a hypothetical number that we won’t be able to measure in the future.

Dino Diana - UBS

One last question on duration. Last quarter you mentioned 22.8 months; came in at 23.6. I guess you mentioned it was the Ingram billing more of the three years for two. When does that program end? Do you expect next quarter are you looking at maybe flat sequentially? What is your implied duration for next quarter?

Gene Hodges

The three for two program is over. It was one -- everybody take your pencils out, a lot of detail here. It was run for deals through Ingram that were sold at risk. Generally, if you swap out an install-based customer, if you do a three for two on an install-based customer, it’s not sustainable and it somewhat inflates the picture of billings. We don’t believe this contract duration does that for two reasons. First, some of it is new customers and if we sell new customers at 60 months it is really new business.

Doug Wride

We didn’t do 60 months.

Gene Hodges

Yes, right. That is a hypothetical corner case. In addition, we effectively just displaced existing discounting we were doing with a clean three for two that was a warm-up for Websense Express. We were testing the business process. So we believe that the duration adjusted growth rate was fairly near the 10% growth rate.

Doug Wride

Dino, as Gene said, that program ended June 30. It’s a viable program that’s been used in the space by us and others when you want to stimulate customer behavior and it was effective. We wanted to drive people through the Ingram distribution engine so that we can see economies downstream. We’ll probably use that again here and there to stimulate different kinds of behavior.

Dino Diana - UBS

Is the thought that duration net after all, what you think you will and won’t use for Q3? Do you think it is going to be flat from here? Or up or down?

Doug Wride

I think about 23 months is where we’ll be in Q3 when we look at programs in place and what’s up for renewal and everything else. But as is always the case, the last say in that decision is driven by the customer and what their appetite is when they’re making their purchase.

Operator

Your next question comes from Sterling Auty - JP Morgan.

Sterling Auty - JP Morgan

Hi, guys. Given the length of time that it’s taken to get the SurfControl deal closed, has it caused any disruption in the marketplace in the areas where the two companies competed? Meaning, have you seen customers delaying decisions or turning to competitors or anything else that may be caused by the deal process itself?

Gene Hodges

Q2 was amazingly business as usual. We did not see disruptive action by Surf. But they stayed a very tough competitor in most of the countries where we operate. Customer reaction has generally been fairly positive on the SurfControl side of the house where we talked to them. We probably had more interaction with SurfControl resellers where I think we can say that it’s been fairly positive. But all of that is at the level of how do you feel? We are obviously not engaging at all on an operational discussion at this point.

Sterling Auty - JP Morgan

On the Ingram Micro side it was talk about for several quarters that once you hit about the July timeframe you would expect the expanded reach in distribution to offset the increased discount that you needed to get to bring them in to the distribution chain. Is that still the case? Or is that kind of crossover point going to be a little bit later than July?

Gene Hodges

I don’t know if we set July as a month. I think we said Q3 as a quarter and we think we are on track to do that.

Sterling Auty - JP Morgan

Last question in terms of competition, you mentioned some very price competitive competitors in especially the low end. Are they private competitors or public competitors?

Gene Hodges

Well, I think probably the two months notable are AD6 and St. Bernard and I think AD6 is still private and St. Bernard is public.

Operator

Your next question comes from Rob Owens - Pacific Crest Securities.

Rob Owens - Pacific Crest Securities

Doug, what was the linearity in the quarter?

Doug Wride

It was light in April, a little under 20%, which is pretty light. I think Kate’s looking at the number for me. But I think we were in the low 50s in June.

Rob Owens - Pacific Crest Securities

Gene, at the analyst day you talked about reaccelerating growth and hopefully achieving I think it was a 15% billings growth rate for the company. First two quarters of this year have been 9 to 10%. You are giving us guidance in that same range. Is that goal or that vision, is that pushed into ‘08 at this point or is that something that is still achievable in ‘07 even though you are not giving guidance?

Gene Hodges

I think if we were a standalone company it would definitely be achievable. Some of our Q3 guidance assumes that we will see disruption through the SurfControl integration of our own business. Not huge, a couple of percent. But rather than assume everything will go like clockwork we assume that we will have a lot of activity taking some of our sales management’s time in September as we lead up to the acquisition.

In Q4, given that we’re going to close the acquisition now, we just don’t have visibility yet since we don’t know exactly what product lines we’re going to sell through what sales forces. But the basic drivers to that growth in SMB, especially which was the big carrier, I think is on track to deliver its portion. We obviously stumbled a bit in ILP in Q2, but I think that we can still deliver some pretty significant growth in the second half of the year.

Rob Owens - Pacific Crest Securities

Great, and on the international front, what was the growth rate? Was it 23% you said year over year?

Gene Hodges

That’s correct, in billings.

Rob Owens - Pacific Crest Securities

In billings. I think you were targeting more than 25% growth for the year when Doug and you laid out what billings could look like in ‘07 at the analyst’s day. So given its Q2 and you are below that target, is there something going on? Are you reaching any saturation overseas? Is it distraction? Can you give us some color?

Gene Hodges

No I think the international operations performed well against quarter end plan in the quarter.

Doug Wride

Your, 25% is correct, Rob. That is a number that we’ve talked about. I don’t think 25% versus 23% is a change in what our expectations are. The number continues to get bigger, the base when you do the math. But I don’t think there is any negative change in the business in Q2.

Operator

Your next question comes from Garrett Bekker - Merrill Lynch.

Garrett Bekker - Merrill Lynch

Going back to the PortAuthority a bit, I wonder if you could talk a little bit at a high-level about the market. If you have seen any changes there and who you may see as your bigger competitors?

Gene Hodges

Competitively we run into Vontu, Reconnex and Vertisys probably in that order. Outside the US, we are starting to see McAfee; they are really not in deals inside the US at this point. It is still predominantly a startup player market. Does that answer your question?

Garrett Bekker - Merrill Lynch

On the competitive side, I wonder, have you seen any changes in terms of overall market demand? It seems like interest levels have been pretty hot for a while. Is that still holding true?

Gene Hodges

Very definitely, the U.S. clearly has a very high level of interest. I characterized the UK as being a little cooler than we expected and continental Europe as being a little hotter than expected with spot demand in areas where you wouldn’t expect demand. In the Ukraine, in Columbia, where there are some fairly large deals that we have either closed or we have in pipeline. So the demand reach is wider and I think it also reaches further down when we look at our pipeline, it is heavily medium/large companies as opposed to 100,000 to 200,000 employee companies.

Garrett Bekker - Merrill Lynch

I know there is not a lot of overlap at this point but I was wondering if you had any thoughts on the potential impact on the market of Google acquiring Postini?

Gene Hodges

I think we’ll be much more impacted as we get going with BlackSpider. Postini is a very good company. Google obviously has more money than God, but there is no impact in the purview of our current product line.

Operator

Your next question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

Good afternoon, just a couple of small questions. First, this is for Doug. Do you plan on having a conference call on the closure of the deal to update guidance? Or do you just plan on waiting for the regular October month conference call, reference sort of post SurfControl?

Second question is more for Gene. Gene, it’s been six quarters now that you have been investing in this U.S. channel initiative. Not quantitatively but qualitatively, is it your sense the pipeline and the sales momentum has turned the corner and is improving in that initiative? Thank you.

Doug Wride

Assuming we closed this as we expect on October 3rd, there won’t necessarily be an earnings call like this that day. We will, however, as we pull the information together, as we close the debt offering and so on we’ll do a briefing and we’ll bring you all up to speed. An interesting thing about this acquisition is as this is the case whenever you have a competitor acquiring a competitor, there is just not a lot of information of specificity that we can obtain from SurfControl while we still go head-to-head in the market. So we’re not going to know a great deal of visibility on day of close. We’ll pull it all together. We have an attack plan but it’s going to take a few weeks before we can really give you valuable perspective.

Gene Hodges

With regard to the SMB investment over the last six quarters, the first two quarters of ‘06 were playing out and then discarding a failed strategy of a direct telesales operation. We started these investments in the third quarter of last year, with obviously very little return in Q3 and in Q4. We got some nice press out of the channel who realized that we were starting to be serious and it’s been a slow, but I think generally positive, move since then.

When you do a channel turnaround, there are many more pieces of the transition that you have to put in place and I think we see all the lights as green at this point.

Doug Wride

I would just like to take a second there on that point. When you think about Q2 a year ago, we came out of there saying we need to change our strategy to the channel. We changed the strategy, we engaged Ingram. We launched Ingram. We built all the back-end processes. We convinced the channel globally that we were committed to them and have gotten their buy-in. We built products specifically for the SMB space. We’ve done an acquisition of a new emerging technology and we are about to close an acquisition of a large competitor. Wow. I mean, we’re moving. We’re hauling. We’re getting stuff done. So if Gene doesn’t think it was fast, I do. We’ve accomplished a lot.

Samuel Wilson - JMP Securities

No, I delightfully grant that. I guess my question is more along the lines in terms of overall business momentum. I was thinking the channel initiative, in particular if you feel like it has turned the corner now from an investing stage to start getting to harvesting and the backlog building and those sorts of events starting to occur?

Gene Hodges

Absolutely. You know, we are coming out of transition in SMB. We’ve built the highway. We are driving our first truck down it with Express and hopefully, we’ll be able to leverage that same investment with BlackSpider and with the Surf e-mail products, which by the way, was always part of the plan.

Doug Wride

The participation at our sales meetings in early July that I was speaking to a moment ago, right immediately following that we had our mid-year conference for partners and unanimously the partners that I spoke to were very positive about all the changes in our momentum in their space and their level of commitment to the product offerings.

Operator

Your next question comes from Phil Rueppel - Wachovia.

Priya Parasuraman - Wachovia

When do you expect the Express product to start ramping up? Though it is a little early, how has the launch been received so far by the channel?

Gene Hodges

The launch went pretty well. It was Websense’s first global launch. We have had 400 downloads or so of the product so far. We obviously do expect some contribution this quarter. Don’t know if we’ll break that out, it will be in the mix but we do expect positive contribution this quarter.

Doug Wride

And the response has been positive to the product from our target audience both the channel target as well as the end user target.

Priya Parasuraman - Wachovia

On the ILP products, do you see customers taking longer to decide on implementing these solutions now? Has it lengthened from say couple of quarters ago or are they taking longer, how do you see it?

Gene Hodges

No, I don’t think so. I think that we had a good pipeline coming into the year from PortAuthority and we closed that in Q1; started opening up new sales cycles which have tended to be in the six to 12 month range and that kind of is a function of the size of the company. So we aren’t seeing an extension of the selling cycle. We were in late in many of the sales cycles, we open in Q1 and didn’t win them and towards the end of the quarter I think we started to see stronger performance. We have a good pipeline for the second half of the year.

Operator

Your next question comes from Robert Breza - RBC Capital Markets.

Robert Breza - RBC Capital Markets

Just one housekeeping item. Doug, I think at the analyst’s day you talked or maybe on the most recent conference call talked about operating margins exiting at about 27%. SurfControl maybe considering it as a stand alone company, do you still think that is achievable?

Doug Wride

I think that if we can keep perspective on the stand alone Websense business, yes, I think we’re 25% to 26% here in Q3. You clip that up a point and there’s good reach to 27% in Q4. It’s going to be challenging for us to carve that out and present it in a comprehensible fashion and for you to, as Gene said a moment ago, sharpen your pencil. But we’ll do our best to give you that visibility because I think it’s important to see how is this base business turning out?

Operator

Your next question comes from Alan Weinfeld - Henley & Company .

Alan Weinfeld - Henley & Company

I was just curious about some of the initiatives that were real popular before you made the acquisitions like the NAC project which has been big in security land and what happened with the wireless initiative which sounded so good at the past analyst meetings?

Gene Hodges

Let’s start with wireless where we are hoping for our first contract awards in Q3 and until we see contract awards we’ll just keep our mouths shut and the first initiative was the ecosystem with the network access control. The ecosystem is basically part and parcel of what we do for the large enterprise product. It’s been less of a focus in SMB. One of the big things that the Express product to last is integration into those ecosystem partners. Technologically, it’s an inline product that does not integrate with any of those partners and that’s probably why you’ve heard us talk less about that. But it would be pretty impossible for us to sell in the large enterprise players. And the growth in large enterprise outside the U.S. is very healthy.

Alan Weinfeld - Henley & Company

You addressed that. Are the security products as popular overseas as they are in the U.S. for you?

Gene Hodges

They are most popular in the U.S. They are very popular in Europe and they are gaining popularity in Asia. So, you can see that in the increasing number of customers who bought more than one product but the penetration of those products are heavier as you go to the more mature markets.

Doug Wride

I think that’s the key there, Alan, is that as the market matures it runs from web filtering and productivity value propositions toward the security emphasis and we see that consistently as we open up new market places in about two to three years we start seeing the security emphasis.

Alan Weinfeld - Henley & Company

With 12% GDP growth in most of Asia, are you putting as many people there as possible?

Gene Hodges

Yes, both in sales and now in engineering and support. I think we mentioned our hiring in Beijing, it’s pretty important to have a local research presence so that you have a good perspective of the Asian web, as well as a local sales presence. I think our total is up to about 40 people in Beijing at this point.

Operator

With no further questions, I’d like to turn the conference back over to Ms. Kate Patterson for any additional or closing remarks.

Kate Patterson

Thanks very much. We will all be available for additional calls if you have any questions. We’ll talk to you soon. Good bye.

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Source: Websense Q2 2007 Earnings Call Transcript

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