McAfee, Inc. (MFE) Q1 2007 Earnings Call April 26, 2007 4:30 PM ET
Kelsey Doherty - Director of IR
Dave DeWalt - President & CEO
Eric Brown - COO & CFO
Bill Kerrigan - EVP
Walter Pritchard - Cowen & Co.
Daniel Ives - Friedman, Billings, Ramsey
Ed Maguire - Merrill Lynch
John DiFucci - Bear Stearns
Phil Winslow - Credit Suisse
Todd Raker - Deutsche Bank
Katherine Egbert - Jefferies & Co.
Rob Owens - Pacific Crest Securities
Kevin Buttigie - A.G. Edwards
Derek Bingham - Goldman Sachs
Philip Rueppel - Wachovia Securities
Brian Essex - Morgan Stanley
John Walsh - Citigroup
Israel Hernandez - Lehman Brothers
Good afternoon. My name is Kara, and I will be your conference operator today. At this time, I would like to welcome everyone to the McAfee Q1 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 session (Operator Instructions).
Ms. Doherty, you may begin your conference.
Thank you very much. Good afternoon and thank you for joining us. On today's call are our Chief Executive Officer and President, Dave DeWalt, and our Chief Financial Officer and Chief Operating Officer, Eric Brown. Today's conference call is being recorded and will be available for replay on McAfee's "Investor Relations" homepage, at "investor.mcafee.com."
In a moment, I will introduce you to Dave, who will reflect on his first few weeks at McAfee and his priorities for the company. Then, Dave will turn the call over to Eric, who will give details of our performance in the first quarter and discuss our guidance for the second quarter and for fiscal year 2007. Dave will then conclude our prepared remarks, and we will open the call to your questions.
You will find, in our press release and on the "Investor Relations" section of our website, a GAAP to non-GAAP reconciliation of the unaudited preliminary first quarter financial numbers discussed in this conference call. The link is "investor.mcafee.com," and our results are posted under "Quarterly Results." We will post our prepared remarks to the website following the conclusion of today's call.
This conference call, including the question-and-answer session, will contain forward-looking statements. These statements include, among others, those regarding our strategic positioning, our preliminary results for the first quarter of 2007, guidance on revenue, operating income margins, and earnings levels for the second quarter and full year 2007, the expected level and scope of security threats in future periods, expected industry growth rates of the market segments in which McAfee participates, expected new and future product introductions and the revenue opportunity associated with them, expected integrations of products from recent acquisitions with existing McAfee product lines, expectations regarding McAfee's business segments, statements regarding future partnership opportunities, specific growth initiatives and strategies outlined for 2007 in McAfee's business, the expected timing of potential executives hired by McAfee, and plans regarding future strategic acquisitions and other uses of cash by McAfee, including its future plans for the resumption of its share repurchase program.
Forward-looking statements are based on management's current expectations and are subject to risks and uncertainties, including that McAfee will make adjustments, which are not yet fully quantified to its unaudited preliminary second, third and fourth quarters of 2006 and first quarter of 2007 results, as well as to its financial results reported for prior periods as a result of its review of past stock option grants, and that McAfee will restate certain prior periods' financial statements.
In addition, McAfee may not achieve its planned revenue realization rates, succeed in its efforts to grow its business, build upon its technology leadership or capture market share, or benefit from its strategic relationships as anticipated.
McAfee customers may not respond as favorably as anticipated to the company's product or technical support offerings, and the company may not satisfactorily anticipate or meet its customer needs or expectations.
The company's products and service offerings may not continue to interoperate effectively with newly developed operating systems, including Microsoft Vista, and further risks may arise from the review of our past stock option granting practices, including, but not limited to, potential fines and penalties and disruptions to our ongoing business, and significant legal, litigation, accounting, tax and other expenses.
In addition, a number of operational and other factors from new product introductions, the mix of products and services sold, the size of deals closed in the quarter, the amount of revenue deferred in the quarter, the integration of acquired businesses, changes in senior management, the competition we face in the market to the greater macroeconomic environment, to name a few, may cause our revenue, gross margins and operating results to fluctuate significantly from period to period.
We caution listeners that actual results may vary, perhaps, materially from the forward-looking statements referenced in this call, including any forward-looking statements made during the question-and-answer session.
We encourage listeners to review the risk factors contained in today's press release as well as the company's filings with the Securities and Exchange Commission, including the company's first quarter 2006 10-Q filed May 2, 2006 for more detailed information on the risks and uncertainties related to the company and its business.
Now, it's my pleasure to introduce Dave de Walt. Dave?
Okay. Thank you, Kelsey. Good afternoon, everyone, and welcome to our 2007 Q1 earnings call. I am really pleased you could all join us today.
What an amazing first 30 days here, at McAfee. It's been very exciting. While we have lots of things to improve upon here, the combination of our award-winning products, out outstanding brand, the estimated 125 million plus users we have, the thousands of partners, and I believe the hottest technology segment in IT, and now coupled with nearly 4,000 energized employees, I believe, makes McAfee the place to be in IT.
We are the largest dedicated security company, and I think we are very well positioned. And I am convinced we have significant opportunities ahead of us. We're off to a great start in 2007, thanks to strong results we're reporting today. These results reflect all the hard work of McAfee's employees. And I appreciate their dedication despite all the challenges this company has faced.
Before Eric speaks about the financial details for the first quarter, I want to take a few minutes to share with you my initial observations and our plans for the company. My strategy in the weeks before and after joining McAfee was to build a comprehensive view of the company. Including all assets, our strengths, and our weaknesses.
I spoke with hundreds of employees, customers, partners, shareholders whose reactions have been very insightful as input for our plan. For example, on the morning of my first day at McAfee, I stood outside for four and a half hours and greeted every single person with a cup of coffee and a doughnut and said, "Welcome to McAfee."
I've also hosted town halls at all our major North American and European location, and my goal was to listen and learn. What I learned is that there is an opportunity here that people recognize. We are passionate about security and protecting our customers from the bad guys.
Our company tagline, "Protect What You Value," articulates the strategy. This is our sole focus, and this focus is reflected in the quality of our solution portfolio and our customer relationships. In fact, I had several of the largest companies in the world call me on the first day to tell me how strategically important McAfee was to them.
So, now, my goal moving forward is to maximize McAfee's potential. To accomplish this, I have created a 100-day action plan, which contains key priorities that I'd like to spend the next few minutes discussing.
My first priority is to complete our financial restatement. We are diligently working on this process, and the finance team is a 100% focused and energized. Eric will talk a little more in detail about where we're at in the process, but I'm pleased to report we're making significant progress. Our goal is to become a world-class reporting and compliance organization.
Secondly, we need to drive increased operational efficiencies. We will organize the business with a matrix approach, defined by three vectors -- by segment, by geography, and by business lines. This will enable us to drill down on the business and then cover opportunities to improve upon the model. This is an approach I've used in the past, and I know it works. Our goal is to maximize performance and drive returns.
In addition, we have now completed a strategic framework, from which we can manage this company and prioritize decisions about what we build, what we buy, who we can partner with, and how we can invest. This allows us, again, to make informed decisions about the strategic direction we take and what opportunities we should prioritize and exploit.
Our M&A strategy will remain the same. We'll focus on small to mid-sized acquisitions where we can identify technologies that can accomplish our goal of winning the security risk management market.
We are also building an internal and external communication architecture to create consistent messaging and align that messaging with the corporate strategy I just mentioned. The goal is to have all our key stakeholders understand who we are, where we're going, and, ultimately, what this means to their individual interests.
We are the leading dedicated security technology company, and we are going to build a security risk management strategy from that position of strength. For example, in the first 30 days, we launched a CEO blog. This generated more than 38,000 responses in the first four hours.
We also launched a customer and partner newsletter, and we generated now more than 1,700 press articles in the first 30 days. I've also committed to six major keynote speeches, the first of which is next month at Interop in Las Vegas. If you're around, please come and join me.
Another major component of the plan is focusing in on retaining talent and building out our executive management team. I want McAfee to be a fun and exciting place where employees feel invested in their work and enthusiastic about our opportunities.
We also have several key positions that I'd like to fill. We're identifying that talent, and I'm focused on bringing in those hires to closure and to build a world-class executive team.
And, finally, on the list of priorities of my 100-day plan is evolving our go-to-market strategy. Working with our channel and partners, we are moving our sales force from selling point products to selling solutions by enhancing training, modifying the compensation models, and allocating strategic resources.
We have also now applied increased rigor and discipline in the sales forecasting process to ensure that the executive management team is highly involved to meet dependencies and prioritize the issues we see in the pipeline.
Again, I'm really pleased with the first quarter results. I'm going to turn over the call to Eric, who will give you a little more detailed review of the quarterly performance. Eric, take it away.
Thank you, Dave, and welcome to McAfee. We are really happy to have you join us.
Our first quarter results were better than anticipated, exceeding the high end of our guidance. First quarter revenue was $314 million, up 16% from Q1 2006. Excluding divested businesses, this is the ninth consecutive record revenue quarter for McAfee.
North American revenue of $164 million accounted for 52% of first quarter 2007 revenue. This compares with North America revenue of $151 million, or 55% of first quarter 2006 revenue. North America revenue grew 9% year-over-year.
Outside North America, we continue to capture even greater market share. Internationally, we registered double-digit year-over-year gains across all geographies. Europe and the Middle East grew 24%, Japan grew 18%, Asia Pacific grew 35%, and Latin America grew 26%.
Of our total revenue during the first quarter, 84% came from the balance sheet. The sequential increase versus Q4 2006 is comparable to what we experienced last year. McAfee has a highly ratable business model, and this has created visibility into our future revenue streams.
Our overachievement of revenues compared to guidance was the result of three factors. First, we had better than anticipated sales execution across our geographies, especially international.
Second, we experienced higher in-period revenue recognition due to product mix and several large transactions, which involved our IntruShield appliances. You can you see the related effects of this in-period recognition in our deferred revenue amount on our balance sheet, which is sequentially flat when compared with the prior quarter.
Lastly, we ended the quarter having spent less market development funds than we had originally forecasted. This was in part the result of tactical decisions made in the period, and we would expect some of those funds to be spent in the coming quarter. As you know, market development funds are treated as contra-revenue, not operating expenses in our financials.
In addition, revenue was positively impacted by foreign exchange rates. This increased revenue by approximately $9 million in Q1 2007, as compared with exchange rates in Q1 2006.
Before I move on, I'd like to discuss a change in the metrics we report to you. Management will no longer provide data on bookings. We believe this decision will bring our reporting into line with industry practices, and it will support our goal of limiting the number of non-GAAP financial measures that we report.
In addition, after this quarter, we will no longer be reporting consumer revenue broken out between online and retail but will provide one revenue line item for the consumer segment. This reflects the changes in our consumer licensing to a subscription-based model. As a result, the distinction between online and retail sales is blurred, and become less meaningful.
Now, I would like to review our corporate and consumer businesses. Corporate revenue in the first quarter was $185 million, up 16% year-over-year. In the quarter, we closed 226 deals of more than $100,000, 15 deals over $0.5 million, and 6 deals of more than $1 million.
We had good performance in several of our businesses, especially our network protection and management businesses. We also saw momentum with out Total Protection solutions.
Mid-market execution improved year-over-year. In the medium tier, 100 to 1,000 desktops, our dedicated and global mid-market unit is now in place. And it is actively building demand for McAfee solutions and fulfilling this demand through our partners.
Our mid-market targeted secure content management appliances performed well. And we're also making steady gains with Total Protection solutions for small and medium businesses.
Turning now to the consumer side of our business. Revenue from our consumer business in the first quarter was $129 million, up 16% year-over-year. In 13 out of the last 14 quarters, we have had greater than double-digit revenue growth year-over-year in our consumer business.
Revenue for McAfee.com was $111 million for the quarter, up 14%, and continues to be a strategic area of focus for the consumer team. Growth in the quarter was driven by our online partnerships and solid performance in our international business where we had our largest addition of new subscribers ever.
From a product perspective, we are seeing growth in our two most comprehensive suites, McAfee Internet Suite and McAfee Total Protection, confirming our suite-based subscription strategy.
We are updating our net new subscriber numbers reported for Q3 and Q4 of 2006. The net new subscribers in Q3 2006 were 1.6 million and in Q4 2006 were 1.2 million. In the first quarter of 2007, we added 1.7 million net new consumer subscribers to bring the total to 25.2 million as of March 31, 2007. The net new subscriber numbers do not include any additions from retail box subscriptions.
We continue to enjoy a strong relationship with Dell. From February 2007 through April 2007, McAfee is Dell Recommended and Dell Default globally. We are pleased to announce that McAfee will, once again, have recommended status in the U.S. and APAC, both recommended and default status for Europe and Latin America for Dell's May through July 2007 quarter.
In the smaller tier of our mid-market, 100 or fewer desktops, the team is leveraging our consumer partner model into small and medium business and having good success.
Moving down the income statement. GAAP gross profit margins for the quarter were 78% compared to Q4 2006 results, which were 77.5%, and Q1 2006 results, which were 80.8%. Non-GAAP gross profit margins for the first quarter were 80.8% compared to Q4 2006 results, which were 80.1%, and Q1 2006 results, which were 82.6%.
This year-over-year decline in gross profit margins was due to a continuing shift in product mix towards hardware as well as continued growth in consumer subscriber acquisitions through channels, where McAfee pays a revenue share to a partner.
Total GAAP operating expenses were $197 million in Q1 2007, up 16% compared with $170 million in Q1 2006. Total non-GAAP operating expenses were $170 million in Q1 2007, up 11% compared with the first quarter of 2006.
GAAP sales and marketing expenses were $89 million. Non-GAAP sales and marketing expenses were $84 million, or 27% of revenue. GAAP research and development costs were $51 million. Non-GAAP research and development costs were $47 million, or 15% of revenue.
We continue to invest in our product portfolio and our strategic risk management vision. GAAP G&A expenses were $44 million. And non-GAAP G&A expenses were $39 million, or 12% of revenue.
Our GAAP operating income for Q1 was $48 million. That results in an operating margin for the period, on a GAAP basis, of 15.3% compared with a year ago operating margin of 18.5%.
On a non-GAAP basis, our operating income for Q1 was $84 million. And our non-GAAP operating margin was 26.8%, up from 26.6% a year ago. The sequential improvement in non-GAAP operating margins was due to several factors.
First, in addition to the better than expected revenue performance, we reduced total sales and marketing spending in Q1 2007 compared to last quarter. At the end of last year, we rebalanced our workforce. This action was completed in Q1 2007.
In Q4 2006, we also had a fairly aggressive SiteAdvisor and McAfee.com advertising campaign oriented towards the direct acquisition of end users. Q1 2007 spending on this program was significantly lower.
Finally, we slowed employee headcount growth versus our original expectations, adding only 29 heads in Q1 2007 compared to last quarter. Other income for the quarter was $14 million. This is up from the $13 million in Q4 2006 and $12 million in Q1 2006.
The company's GAAP tax rate for the quarter was 25.5%. This is slightly higher than our GAAP tax rate guidance of 24%. On a non-GAAP basis, our tax rate was 27% unchanged from a year ago.
In Q1 2007, we reported net income on a GAAP basis of $46 million, or $0.28 per share on a diluted basis. Year-over-year, we increased our GAAP earnings per share by 12%. Our first quarter net income on a non-GAAP basis was $72 million, or $0.44 per share on a diluted basis. Year-over-year, we increased our non-GAAP earnings per share by 19%.
Our net accounts receivable balance at the end of Q1 2007 was $147 million. DSOs remained within their target range. They were 42 days for Q1 2007 compared with 41 days in the first quarter of the last year.
Deferred revenue was $894 million at the end of Q1 2007, up 15% on a year-over-year basis. Deferred revenue was flat sequentially, reflecting the higher in-period revenue recognition, which I have already discussed. Quarter-over-quarter, short-term deferred revenue was down $6 million to end the quarter at $697 million, and long-term deferred revenue was up $5 million to end the quarter at $197 million.
As we mentioned earlier, we will no longer be reporting bookings as a metric in an effort to bring reporting in line with industry practices. Management believes that revenue plus the change in deferred revenues serves as a reasonable alternative for estimating net bookings.
The reconciling items between gross bookings and net bookings, which translate to either GAAP revenue or change in deferred balances, consists principally of in-period contra-revenue plus smaller changes in other items, such as backlog, foreign currency changes or reserves.
Q1 2007 contra-revenue spending, which is the primary reconciling item between gross and net bookings, was consistent with the last four quarters. Contra-revenue spending has been weighted more towards the consumer business historically.
The composition of our deferred revenue balance as of the end of Q1 2007 was 58% corporate and 42% consumer compared to 59% corporate and 41% consumer at the end of Q4 2006.
We ended the first quarter with cash, cash equivalents and investments of $1.34 billion. This represented an increase over the fourth quarter of 8%. There were several notable changes reflected in the preliminary Q1 2007 balance sheet.
In conjunction with our adoption of FASB Interpretation Number 48, also referred to as FIN 48, we recognized a net decrease of $125 million in the liability for unrecognized tax benefits, of which $101 million was accounted for as an increase to APIC and $24 million was accounted for as an increase to the opening January 1, 2007 retained earnings balance.
Deferred tax asset balances increased by approximately $120 million in Q1 2007 as a result of changes to deferred tax assets related to acquisitions in previous years. This resulted in an increase to APIC of $120 million.
We also provided supplemental disclosures on a number of other items not directly related to the stock option restatement that will be posted in prior periods when we re-file. The impact on the closing 12/31/2006 balance sheet is shown in a table attached to our press release.
In the quarter, we generated a total of $102 million in GAAP operating cash flow, up 18% from the $86 million we reported in Q4 2006. The cash flow summary for the quarter is as follows.
Starting with GAAP net income of $46 million. We had $20 million of depreciation and amortization. We had over $15 million of non-cash adjustments to reconcile the net income, including stock compensation and other. We had $6 million for deferred taxes. And we had over $15 million for changes in working capital, deferred revenue and other items.
Operating cash flow this quarter was positively impacted as compared to Q4 2006 by lower SEC and compliance costs, a decrease in revenue share payments to our partners, and improved accounts receivable collection during the first quarter of 2007. During the quarter, we spent approximately $10 million in capital expenditures, consistent with prior periods.
Before I move to guidance, I would like to update you on the status of our financial restatement. As you know, we concluded the first or qualitative stage of our process in the fourth quarter of 2006, and we have since been moving as quickly as possible to the second or quantitative stage.
At this point, we are approaching a milestone in the quantitative process, which is worth noting. During the second quarter, we expect to submit a pre-clearance letter to the SEC, summarizing the accounting matters and subjective issues involved in the restatement process. We will continue to keep you updated throughout this process.
I would now like to provide you with our second quarter and full year 2007 guidance. The following updated guidance replaces and supercedes any previous guidance with respect to future periods and is valid as of today only.
I would like to remind listeners that guidance is based upon management's current expectations and that actual results may vary, perhaps, materially from those results anticipated in this guidance.
Consistent with our preliminary results, this guidance excludes any impact from any non-cash charges that could result from our internal review of stock option grant practices. Please see the footnotes in our press release for further details.
For the second quarter of 2007, we expect revenue of between $295 million and $310 million. We expect our GAAP operating income margin to be 10% to 13%. We expect our operating income margin on a non-GAAP basis to be 22 to 24%. We assume a GAAP tax rate for the second quarter of 24% and a non-GAAP tax rate of 27%.
Also, for the second quarter of 2007, we expect GAAP EPS between $0.18 and $0.23 per share. On a non-GAAP basis, we expect EPS between $0.33 and $0.38 per share on a diluted basis.
For the full year 2007, we expect revenue between $1.22 billion and $1.295 billion. We expect our GAAP operating income margin to be 13.5 to 17.5%. We expect non-GAAP operating income margin to be 22 to 26%. We assume a GAAP tax rate of 24% and a non-GAAP tax rate of 27% for the full year 2007.
Also, for the full year 2007, we expect full year 207 GAAP EPS between $1.07 and $1.27 per share. On a non-GAAP basis for the full year, we expect EPS between $1.55 and $1.65 per share on a diluted basis.
I will now turn the call back over to Dave.
Okay. Thank you, Eric. Eric, we appreciate all your efforts. And by the way, if you didn't know this, Eric was actually named one of the top three CFOs in the software sector by Institutional Investor magazine for the second year in a row. Congratulations, Eric. Pretty cool.
As I mentioned, this was a good quarter, our ninth consecutive quarter of record revenue. We had strong cash flow from operations, exceeding $100 million, significant international revenue growth of 24% year-over-year, as well as balanced revenue growth of 16% in both corporate and consumer.
I want to give you a little bit more color on the quarter, and I wanted to comment on three major trends I'm seeing. The first trend is the movement of customers buying from point products to best-of-breed solutions.
This plays perfectly into McAfee's security risk management strategy of a suite-based solution, like our TOPS for consumer, our TOPS for small business, our TOPS for enterprise, our McAfee Internet Suite, and our Gateway Suites.
This supports our strategy of a single-agent, single-management console as a security framework for all customers, from consumers to the enterprise. In fact, we obtained six new patents in the quarter, bringing our total to over 250 patents issued. We also have another 250-plus patents in process.
In Q1, customers like Tenet Healthcare, the nation's largest publicly traded hospital company, have already begun responding. Tenet made a major purchase of our high profile suite, Total Protection Enterprise Advanced, TOPS Enterprise, and McAfee IntruShield.
In addition, we displaced a competitor in an important deal with Interline Brands, a $1 billion New Jersey-based supplier to commercial property management entities. They chose TOPS Enterprise Advanced as well for its superior protection and world-class enterprise management. We also closed a deal with Citrix, which invested in McAfee because of our SRN vision.
The second important trend is that our customers are facing immediate business risk as a result of important data loss. I am sure you all have seen the headlines of high profile businesses losing information, like consumer credit cards, tax information, laptops and BlackBerries.
To respond to this need, McAfee has the most comprehensive solution in the Data Loss Prevention, or what's called DLP market. This is an important component of the security risk management market.
McAfee's DLP solution is offered as either host-based or gateway-based, which was just announced this past week, or software-based solutions. All these technologies can be managed by our ePolicy Orchestrator, our integrated management console.
Moving on to the third trend we're seeing. Security is constantly evolving. And we need to address the next generation threats on platforms like web, mobile, voice-over-IP, instant messaging, peer-to-peer -- an example. For example, on the web, we're aggressively distributing McAfee SiteAdvisor, the world's first safe search technology, both directly and through our partners.
During the first quarter, we expanded our global reach by launching SiteAdvisor Plus in 13 additional languages. Since its launch less than a year ago, there have been over 50 million downloads. This is a pretty impressive validation that our safe search solution is resonating with customers and gives us important new areas of growth potential.
For mobile, McAfee made two first quarter introductions. We launched our Mobile Security Risk Management platform for mobile operators and manufacturers. And we introduced McAfee OK, the industry's first and only mobile content safety initiative, designed specifically for mobile content aggregators and operators. Our technology is shipped on over 45 million devices worldwide, now.
As I mentioned earlier, a key component to our strategy is driving partnerships and strategic relationships to deliver McAfee's SRM solutions to our customers. In Q1, McAfee and the Hewlett-Packard Company have recently executed a master teaming agreement. This agreement will allow McAfee and HP to cooperate in responding to enterprise business customer requests.
Also in the quarter, we entered into a new agreement with AOL where our relationship is moving into its fifth year. This agreement extends our relationship, and we look forward to many more years of working together.
And finally, we announced that the consumer team signed or extended 21 agreements and launched 62 new or enhanced online partners during the first quarter.
With Q1 behind us, our focus is now on execution, and we look to build on our momentum. We will drive Q2 to a successful completion by focusing on SRM and closing significant opportunities we see in the pipeline. I look forward to meeting many of you in the coming months and at analyst day in June.
And, with that, I'll turn the call over to Kelsey for questions. Kelsey?
Thank you, Dave. Before the operator polls for questions, I would like to inform you that McAfee will be presenting at the JPMorgan conference in Boston on Tuesday, May 22, and the Wachovia Conference on Nantucket on Wednesday, June 27.
I would also like to remind you that McAfee will be hosting Analyst Day 2007 on the morning of Tuesday, June 12, in New York City. This event is by invitation-only, and registration is required. A live webcast and replay of the event will be available on the "Investor Relations" homepage. Please mark your calendars.
Operator, you may now poll for questions. And at this time, please limit yourself to one question per person. Thank you.
(Operator Instructions) We will pause for just a moment to compile the Q&A roster.
Your first question is from Walter Pritchard with Cowen.
Walter Pritchard - Cowen & Co.
Hi. Eric, just wondering on the MDF you talked about being lower this quarter than you expected. Could you talk about in what specific areas? And I guess I'm just trying to figure out how if it's lower this quarter. It sounds like you expect it to almost catch up later in the year. And, therefore, that's why you're not raising to pull your guidance more than you are, just having the upside roll through.
Yeah. Thanks. I think that our view, kind of, coming into the year was that we were just coming off of a, kind of, a reshaping of the sales and marketing organization, which we executed or initiated as of Q4 and finished in Q1 2007.
And while we were in the midst of that, we were a bit more, kind of, tempered in terms of our MDF expenditures. Having now, kind of, moved through that transformation, we think that we'll be back to more normalized rates of MDF spend in the corporate side of the business.
Next question, please?
Your next question comes from Daniel Ives with Friedman, Billings.
Daniel Ives - Friedman, Billings, Ramsey
Yeah. Could you specifically talk about, on the enterprise side, what sort of demand you're seeing for the IPS solution and maybe touch on pricing?
Okay. Daniel, this is Eric. The -- first of all, IntruShield continues to perform exceedingly well. And we noted that we had a couple large IntruShield transactions that occurred at the very tail end of the quarter.
In terms of pricing trends across corporate, both IntruShield, the management lines and the systems line, we saw continued stability in pricing. And so no net change versus what we've seen over the past several quarters.
Next question, please?
Your next question comes from Ed Maguire with Merrill Lynch.
Ed Maguire - Merrill Lynch
Hi. A question for Dave. Since you've joined McAfee, what have you identified or what have you been able to see in terms of any process improvements or organizational changes that you think you can affect over the next few months?
Yes, thanks Ed. You know, I got a chance now to get my arms around this a little bit, but still only 30 days into it. I talked a little bit about these kind of six, seven key actions that I was looking at.
Probably the biggest areas is a lot of things the company is doing well, it is just trying to improve upon what they are already doing, but go-to-market models is an area I know pretty well coming from EMC and having managed a pretty big business there.
Some of the rigor and discipline I talked about in the forecasting model really trying to come up with measurements on how we can drive enterprise type transactions, compliment the consumer in the small to medium business markets.
Just operating management efficiencies that's an area that I know pretty well. And of course the company has done a good job of from the results here, but there is always room for improvement every company has it and I am going to look to try to lead that and take it to the next step.
Next call, please?
Your next question comes from John DiFucci with Bear Stearns.
John DiFucci - Bear Stearns
Eric you had mentioned a change in some of the balance sheet and how you, it's been about a $125 million liability having to do with unrecognized tax. Can you sort of explain that a little more detailed, because it looks like the operating cash flow benefited from some difference there in deferred taxes, and I am assuming there is some relation to what you are talking about there?
No, there would be no correlation between the kind of the FIN 48 related adjustments and the operating cash flow. The other side that the tax related entries that I mentioned were going to the balance sheet to additional paid in capital.
And so, if you do the lock ford on the balance sheet from 12/31/06 to 3/31/07, you will see those entries there in the APIC section, but they do not impact the $102 million of operating cash flow.
Next question, please.
Your next question comes from Phil Winslow with Credit Suisse.
Phil Winslow - Credit Suisse
Hi guys. Good quarter. Dave, I have a question for you, as far as the sales force goes. Obviously, you have a lot of experience and when I am working with enterprise sales forces, when you'd look at I guess your channel structure and your direct sales model. How do you plan to balance that going-forward and just sort of the commitment between those two?
Good question. It is tough for a company sometimes to do both channels and direct. I really don't have a strategy to change what this Company is doing, the goal here is to leverage our channel partners, and we get a lot more leverage, we do 100% of our business in channels today.
I don't want to repeat that. This is an incredibly leveragable model when you have got thousands of partners, thousands of distributors, multi-tiered models. We want to keep doing that, but what we want to do in addition to that, is get a higher touch model as well and continue to drive to enterprise accounts, we see a lot of opportunity.
I mentioned a couple of largest customers in the world calling me on the first few days I mean these are recognized top handful of companies who came in and said, this is very strategic to us, but we would like to see more of you.
And that doesn't mean we are going to change our model for how we deliver or fulfill our technologies, but it gives us an opportunity to become more of a trusted advisor to these larger companies and really compliment the model that we have already have in place.
And the more I have seen in the security marketplace from both my EMC lenses over the last couple years, as well as now for McAfee. There is really no major company here who has the Trusted Advisor kind of code encode status with many of the big companies. What an opportunity for us to get that.
And as I look at the IntruShield product lines, that Eric talked about, the E-policy orchestrater products, and the whole framework there. You look at our AV suite that moves up to the enterprise there is a lot of rich and fertile areas for us to go.
And not to take anything away from the other segments, just to say it looked pretty obvious to me, that we could do a lot more to improve across a number of segments from commercial and mid market up enterprise and keep doing what we're doing on consumer and keep driving that.
Next question, please.
Your next question comes from Todd Raker with Deutsche Bank.
Todd Raker - Deutsche Bank
Hey guys nice quarter. I wonder if you could just comment more generally on the competitive landscape and you cited a competitive displacement. What is it that's driving share toward you guys and do you think you are picking up share more broadly?
And as part of this discussion there has been some rumblings around pricing on the enterprise AV market. Can you talk about pricing trends, and have you seen any price increases across the competitive landscape?
Yes Todd, this is Dave, thanks. I will answer the first part and I will ask Eric, to comment. The biggest thing I saw quickly I dove into as many transactions, as I could. Really reviewed the go forward pipeline, but also the past transactions to build a bit of a profile on what was working.
The biggest thing we talked about was the suite approach. This is really resonating. And when you look at leading indicators for a marketplace, the movement from kind of Best-of-breed, point solutions to a Best-of-breed stack or a suite.
We are getting right into that mode and customers I think more and more are looking for a suite, a trusted advisor, then when you couple that with a SRM, we are doing a pretty good job of evangelizing or getting an advantage with a customer competitively.
And I noticed that a lot on one-off data review that I did, and what was working for us and telling a more consolidated story of SRM coupled with a suite approach.
It works and it is a pretty clear advantage that we have over these point companies and point products, I think that is a good opportunity for us to lever.
Eric, you want to comment on that?
Yes. In response to the second half of your question again back to pricing and discounting overall. Again, we track your price points and your net discounting from our net-based price list fairly carefully.
And again, in this past quarter, Q1 '07 there was no change versus what we have seen in the past 3 to 4 quarters there, so again, I would emphasize the notion of pricing stability. I think what we are seeing is that we have a differentiated approach versus other vendors we are building off of the SRM framework, which is powered by ePO
Our integrated management council and framework. And I think that that's important messaging, and so we have been able to maintain the price points across the product lines, be it systems, a network, or management.
Thanks a lot. Next question, please.
Your next question comes from Jordan Roberts with Jefferies & Company.
Katherine Egbert - Jefferies & Co.
Hi, this is Katharine Egbert with Jefferies. Just if I may, it looks like the results that we are seeing some software companies are somewhat mixed. Can you talk about, you guys had a really nice quarter, can you talk about the macro-environment for spending?
What you saw in Q1, and then what you think about Q2 since you are upping guidance a little bit?
I will answer the first part. This is Dave. I don't know that the IT spending has changed all that much year-over-year. I certainly haven't seen that. It's incrementally stepping up over the last couple years, we have seen some modest improvements, certainly security risk management pretty top of mind for a lot of companies, a lot of consumers right now.
You look at what I mentioned on the data leakage, data loss prevention areas a lot of companies are getting sensationalized in the headlines right now about issues they've had in that regard and we are seeing a lot of initiatives there I think that's a little bit greater growth than maybe you see in other areas, but generally, it's a challenge to see an expansion of the IT spend, but having said that, it is a continued steady climb. Eric?
I would also note that we had really good balanced performance reporting 16% year-over-year growth in both corporate and consumer and I think, again the international geographies did very well. In particular, we saw very nice gains in all the international geographies for the consumer business, as we continue to push the online model outside of North America.
I believe it's one of the strength the company has. I took an assessment, you look at the elasticity of the model here, and you got a nice balance of growth, both consumer-up through the corporate segment but then you have got elasticity of the model geographically as well.
And the Company has got a nice blend between it's North American segment and it's international segment, and when you start to look at geo and by product line and by kind of market segment, you see a lot of balance here and a lot of opportunity to continue to grow where some markets might be weaker, and some markets might be stronger we can be respond to that.
Great, thanks. Next question, please.
Your next question comes from Rob Owens with Pacific Crest.
Rob Owens - Pacific Crest Securities
Yes, good afternoon. Could you give us some color on TOPS and just the ramp you are seeing in the marketplace, I think it's been out almost a year now with the lack of competitive solution out there. Are you seeing market share gain? And what kind of traction do you think you will see going-forward?
Good question, I'll answer the first part, maybe Eric can add on too. We mentioned earlier we have the TOPS suite, and we did this by segment as well, so we talked a little bit about the TOPS suite for the consumer, TOPS suite for SMB and then, TOPS suite for the enterprise, and then we have a TOPS suite enterprise Advanced, as well kind of the whole enchilada for our product line.
And, when you look at Gartner and certainly I have and look at some of the analysts, they are ranking us as kind of filling out each of the key areas of the suite. And it creates a nice competitive positioning for us, and again we want to continue to be able to fill that suite out, do it as a package, make it integrated, that single agent, single console kind of style, is a real advantage for us right now technically.
Yeah, last quarter, we talked about the results in TOPS, and this quarter as well, we saw TOPS grow well over a 2X composite year-over-year corporate growth rate. So it's continuing to really accelerate in the marketplace.
We also note in our earnings release the number of awards that the company won for its products, as you can see, there have been a lot of very prominent mentions for the TOPS solution set.
Thanks. Next question.
Your next question comes from Kevin Buttigieg with A.G. Edwards.
Kevin Buttigie - A.G. Edwards
Thank you. Just back to the MDF for a second, could you quantify what that impact was, and it sounded like it was concentrated on the enterprise side, was there any impact on the consumer side of that business? Or was it completely enterprise?
Yeah, I won't quantify it specifically. It's in the single-digit millions of dollars, where again, kind of entering the year going through kind of a reallocation of our resources we have, we're a bit more kind of circumspect in releasing certain types of funds. MDF is somewhat generally discretionary.
Now, that we have the kind of confidence of having kind of moved through that we expect to be back at normalized MDF spending levels. One other comment, I would make on expected spending. We expect to see operating expenses go up a bit in Q2 across the board, once a year; we reassess the workforce, give base salary increases. And so given that holding headcount constant we'll have a step-up in operating expense across all of our GAAP line items, cost of revenue, R&D, G&A, and sales and marketing.
Next question please.
Your next question comes from Sarah Friar with Goldman Sachs.
Derek Bingham - Goldman Sachs
Hi, it's Derek Bingham for Sarah. You pointed a few of a benefit from a higher end period realization rates, can you talk about any expectation on how end period realization rates might trend going forward, and what is driving that, and also if you could comment on any change to D-Links in the quarter?
Sure, it's kind of interesting. Looking at the Q1 2007 results, it's a bit of the kind of the inverse to what we saw in the fourth quarter of 2005, where we had bookings and activity, but lower than expected revenue realization rates and that was a function of mix.
Here we saw the opposite kind of expected levels of activity or slightly better than expected levels of selling activity with the mix toward product lines, which yield a higher revenue realization. So, for example, IntruShield appliances, majority of the revenues booked up front versus in the fourth quarter of the year.
You will do a lot of enterprise permit into renewal contracts, which has zero end period realization. So, the mix worked quite favorably to our advantage here in the first quarter of 2007. We don't comment on expected realization rates as part of our guidance.
Next question, please.
Your next question comes from Philip Rueppel with Wachovia Securities.
Philip Rueppel - Wachovia Securities
Great, thank you. You talked about pricing on the enterprise side, how about on the consumer front. Has there been any change especially as you rolled out the Vista capable products in your OEM or service provider pricing?
And then for the end user has there been any pricing strategy changes after Symantec has rolled out its 360 products?
Thanks Phil, this is Dave. Maybe it's a good time to introduce Bill Kerrigan here who runs our Consumer Business. Bill, do you want to comment on the pricing in consumer?
Sure, no pricing changes at all within our OEM channel, or the ISP channel. Where we saw some differences is the promotional activity was certainly very competitive in the retail channel in North America. At this point, we're not announcing any business models, subscription pricing changes, or licensing changes going forward for this product.
Great, thanks. We have time for two more questions.
Your next question comes from Brian Essex with Morgan Stanley.
Brian Essex - Morgan Stanley
Hi, good afternoon. I was wondering if you could comment, it looks like you had a great result on the operating margin line for Q1, maybe you could talk a little bit about, it looks with the Q2 guidance going forward, do you expect it to dip a little bit?
I don't know if you can talk about maybe some of the dynamics that play there, and how we can expect margins to fluctuate for the remainder of the year?
Okay. This is Eric. Again first thing to notice, we're coming off a good realization quarter. So keep that in mind, I think also last year, if you go back, you look at what happened, Q1 versus Q2 of '06.you would have seen our non-GAAP operating margins drop by more than four percentage points, and so there is a bit of seasonality here.
Part of it is that, again our operating expenses, again holding everything else constant, holding headcount constant, will increase automatically in Q2 versus Q1, because that's when we put through our annualized base salary increases, as part of our focal review process.
The other things we touched upon earlier is that it's a bit more visibility. We'll feel better about releasing marketing funds such as MDF, and other advertising dollars, and so that's what's factored into our thinking in regards to the Q2 '07 guidance.
Next question, please?
Your next question comes from John Walsh with Citigroup.
John Walsh - Citigroup
Okay. On the enterprise side, could you talk about ePolicy Orchestrator, or any kind of color as far as the adoption? Or how that effects large deals? And then, maybe just overall large deal metrics in the quarter?
I'll comment on the, maybe the second half of that question. I mean, the large deal metrics year-over-year were actually pretty good, we reported six transactions in excess of $1 million this quarter, compared to only one transaction in excess of $1 million last quarter. So it was an unexpectedly strong finish the last several days of the quarter there.
As regards to ePO and its importance in regards to very large-scale enterprises, I'll let Dave comment on that.
Yeah, I mean, John that was a good question. We, obviously, are seeing ePO as a pretty strategic tool for an enterprise. I'd mentioned that we have a number of customers call me and talk to me, I mean, most of them are calling about how strategic of an infrastructure, ePO really is to them, you know, hundreds of thousands of desktops being managed by this tool, creating a policy.
And remember our strategy here has been not only to manage the McAfee product lines, but really any type of security product line as well agnostic to our own tools, at this point we have more than 40 million nodes being managed, 40 million nodes being managed by ePO, is pretty impressive number.
We're building agents out across our product lines, so we can manage all of our own architecture, and use it as a delivery tool for just about everything that we do. So it's become a pretty interesting tool. And of course, this came from an acquisition, and it really shows it does work, and we're pretty pleased. And this is a good area for us to keep driving strategically, as it does drive large deals for us as well.
This will be our last question.
Your last question comes from Israel Hernandez with Lehman Brothers.
Israel Hernandez - Lehman Brothers
Hi, good afternoon everyone and congratulations. My questions were just asked, but I have one follow-up just on the margin question. Gross margin came in a little higher than we were expecting.
Can you comment on the trend line going forward, and is there any potential to move that higher over the course of the year or is this kind of where, the level where we should expect that today?
Yeah, I think that in any given quarter, the gross profit margin is going to be principally a function of really two driving factors the amount of rev share related business we do with consumer partners, and the mix of pure software were ePO versus the hardware products.
Now, one of the things we have actively been doing, and will actively continue to do is as we reengineer the product lines, we're looking to build them more efficiently, and hence increase even the existing attractive gross profit margins on the hardware line. Beyond that though again it's difficult for us to guide the gross profit margins, given the mix question. So we can't give you any additional granularity.
Okay. Israel, thank you. And thanks, everybody for the questions here. I am going to wrap up here, and thank everybody for joining the call. I can't tell you how excited I am to be here at this company. Great management team, great people, great opportunity, and it's the exciting times. We're really looking forward to driving our agenda, and winning this market place.
So that does conclude the call. Thank you so much. Look forward to meeting you all.
This concludes today's conference call. You may now disconnect.
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