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Executives

Renee Lyall -

Jerry M. Kennelly - Co-Founder, Executive Chairman, Chief Executive Officer and President

Randy S. Gottfried - Chief Financial Officer, Principal Accounting Officer and Executive Vice President of Business Services

Eric S. Wolford - Executive Vice President of Marketing & Business Development

Analysts

Jason Ader - William Blair & Company L.L.C., Research Division

Rod B. Hall - JP Morgan Chase & Co, Research Division

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

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

Mark Sue - RBC Capital Markets, LLC, Research Division

Scott Zeller - Needham & Company, LLC, Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

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

Vijay Bhagavath - Deutsche Bank AG, Research Division

Erik Suppiger - JMP Securities LLC, Research Division

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

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

William H. Choi - Janney Montgomery Scott LLC, Research Division

George C. Notter - Jefferies & Company, Inc., Research Division

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Riverbed Technology (RVBD) Q1 2012 Earnings Call April 19, 2012 4:30 PM ET

Operator

Good afternoon, my name is Ashley, and I will be your conference operator today. At this time, I would like to welcome everyone to the Riverbed First Quarter 2012 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to Renee Lyall, Director of Investor Relations. Ma'am, you may begin your conference.

Renee Lyall

Thank you, Ashley. And welcome to our conference call for the first quarter of 2012. The speakers today are Jerry Kennelly, President and CEO; Randy Gottfried, Chief Financial Officer; and Eric Wolford, EVP and GM of our Products Group. A press release detailing our first quarter results was distributed today at 1:05 p.m. Pacific Time over Business Wire. The press release is available on our website at riverbed.com. This conference call is being webcast live at riverbed.com/investors and will be archived on our website for the next 12 months on the quarterly earnings and events pages.

Our discussion today will include forward-looking statements, including statements regarding our products, markets, performance, strategies and financial outlook. Forward-looking statements are only predictions and involve risks and uncertainties that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that affect our results are summarized in our quarterly release and described in detail in our SEC filings.

Forward-looking statements are made as of today's date only and Riverbed disclaims any obligation to update any forward-looking statements. Unless otherwise stated, financial information reviewed on today's call is presented on a non-GAAP basis. Historical non-GAAP items are described and reconciled to GAAP results in today's press release and in a supplemental reconciliation available on the Investor Relations portion of our website. Any future products, feature or related specification that may be referenced during today's call are for informational purposes only and are not commitments to deliver any technology or enhancements. Riverbed reserves the right to modify or cancel future product plans at any time.

I'd now like to turn the call over to Riverbed's President and CEO, Jerry Kennelly.

Jerry M. Kennelly

Thank you, Renee, and good afternoon, everyone.

First quarter revenue of $183 million was slightly below consensus, but within the low end of our guidance range. Earnings of $0.20 per share was in line with consensus and at the high end of our guidance range.

As we predicted, the combination of our product transition and a seasonally weaker quarter was challenging. We had some customers pause their purchasing decision to evaluate, which Steelhead model they wanted to deploy. And in some cases, we saw our sales cycles extended further as customers decided to evaluate Granite. Also impacting the first quarter was a mixed sales environment.

We continue to feel the unavoidable growing pains associated with becoming a multiproduct company. We are working to better align our sales and marketing efforts for more immediate returns on our investments. I will talk more about this later. We are positive on our opportunity going forward and our ability to deliver above market results especially in the second half of the year. For many reasons I will turn to now.

In Q1, we brought to market what we believe is the most significant product cycle we have had since the company first introduced Steelhead more than 8 years ago. We successfully launched both the CX and the EX Steelhead appliance platforms, which includes 40 new edge appliance configurations. We also launched Granite, a cutting-edge breakthrough technology, which delivers edge virtual server infrastructure or edge VSI, and we launched the Steelhead Cloud Acceleration, our joint SaaS acceleration solution with Akamai. We also introduced new appliance models, software and virtual solutions for Cascade that extend performance monitoring in the load balance and virtualized data centers.

The new CX and EX Steelhead platforms have been well received by our customers, following their introduction mid-quarter, and we expect sales of the CX and EX to continue to ramp throughout the year.

Granite was also well received and is generating a lot of customer interest. We had our first sales in Q1 and the pipeline is impressive. The value proposition Granite offers is unmatched. By delivering an edge virtual server infrastructure, Granite reduces the operational burden on IT managers by allowing servers and storage remaining at remote sites to be consolidated to the data center. At the same time, it increases their control over the infrastructure, all at a lower total cost of ownership.

Granite also has the potential to deliver significant improvements to VDI, or virtual desktop infrastructure, because it allows the consolidated desktop resources to be hosted locally on Granite instead of at the data centers. This architectural approach improves performance and ensures uninterrupted access to the desktop environment should the WAN connection go down.

Our joint solution with Akamai, Steelhead Cloud Accelerator, was announced in March, and we are just beginning to sell into what is a large pipeline. As a subscription base offering and just getting started, Steelhead Cloud Accelerator is not expected to generate material revenue in the near term. It is, however, an immediately powerful differentiator, making Riverbed the only vendor that can offer symmetric WAN optimization from the customer site to the SaaS vendor site.

During Q1, we also introduced more than 15 new Cascade appliance configurations. In addition to this new hardware, we launched the Cascade 9.5 software release, enhancing Cascade Profiler and introducing Cascade Virtual Shark. With this release, Cascade is the first and only NPM solution to provide service monitoring across ADCs and offer continuous package capture and performance analysis in virtual environments.

This integration with ADCs, which includes Riverbed Stingray Traffic Manager and F5's Local Traffic Manager, is another example of how we are combining and leveraging our different products and technologies to deliver end-to-end performance solutions to our customers.

Three of our new products, Granite, Steelhead Cloud Accelerator and Cascade Virtual Shark, have already been nominated for Best of Interop Awards. I want to thank everyone involved in bringing all of our new technology successfully to market. It is a tremendous achievement, and these products will be integral in the next leg of growth for Riverbed.

In the coming months, you will also see us introduce industry-first enhancements and improved integration within our Stingray ADC line. In the first quarter, we added new customers to Riverbed through Stingray sales and continued to leverage our Steelhead installed base to gain entry to some large enterprise customers.

After 2 full quarters of sales, our original thesis has been confirmed, that Stingray is optimally positioned for cloud opportunities, both public and private. Some of the largest purchases we have seen are from cloud service providers or enterprise buyers deploying Stingray in the public cloud, for example, Amazon EC2. We are also seeing traction with partners who are creating new platforms for cloud computing. Earlier this month, Riverbed Stingray was a featured partner in IBM's launch of its Cloud platform, PureFlex systems.

In our evolution to become a multiproduct company, we have shown strong execution in bringing products to market. Where we need to show better execution is in our ability to sell multiple products to different buyers, and then move to a solution sale from selling point products.

At the channel level, we need to better educate, better train and better recruit partners. Internally, we need to better align sales structure processes and incentives. And at the customer level, we need better targeting and marketing.

We are taking steps to address these challenges. We recently hired a Chief Marketing Officer. In the first quarter, we began our performance Summit World Tour, a global roadshow to educate partners and customers about the performance platform.

We also announced a new framework for the Riverbed Partner Network, designed to build our channel partners' competency to sell multiple products. The new framework includes improved training, better tools, more resources and well-defined incentives.

In addition to enriching our channel partner network we are very focused on expanding the breadth of the partnerships we have and adding new distribution and technology partners that will allow our products to be sold and accessed where they aren't today. We expect to make announcements regarding these new distribution partnerships in the new months.

We believe our decision to become a multiproduct company with the ability to deliver the broadest portfolio of performance solutions that provide anywhere any-application optimization is the right strategy for our long-term growth. While it won't happen overnight, we are confident in our ability to navigate this transition and achieve our long-standing goals to be a multibillion dollar company.

I will now turn the call to Randy to discuss Q1 numbers and provide guidance.

Randy S. Gottfried

Thanks, Jerry. As a reminder, unless stated otherwise, the numbers that I'll discuss are non-GAAP.

First quarter revenue was $183 million, up 12% year-over-year. First quarter product revenue was $117 million or 64% of total sales. Product revenue grew 4% over the year-ago period. Service and support revenue was $66 million in the first quarter, representing 36% of total sales. Service and support revenue grew 29% over the prior year. WAN optimization was 89% of revenue in the first quarter, NPM was 7% and ADC was 4%.

Turning to distribution. 94% of our Q1 revenue came from indirect channels and 6% was sold direct. Two partners contributed more than 10% to total revenue, with Arrow Electronics at 17%, and Avnet just over 10%. We had no 10% end-user customers in the first quarter.

We saw a year-over-year growth across all major regions. The U.S. grew 7% and was 53% of revenue. EMEA grew 31% and contributed 28% to total revenue. Rest of world grew 4% and represented 19% of revenue. We saw some improvement in Q1 within APAC but we continue to view rest of world as an area of targeted improvement.

Looking at verticals. Government, financial services, manufacturing and technology were the largest contributors in the quarter, all above 10% of revenue.

Moving to costs and expenses. Product gross margin was 79.5% in Q1, down about 100 basis points as expected compared to Q4, due to increased hard drive costs following the Thai floods. Drive prices have come down from their peaks, but are still well above pre-flood levels, so we continue to have some margin impact.

Service and support gross margin came in at 74.1% compared to 72.5% in the fourth quarter. The sequential improvement was largely driven by the completion of our project to restructure spare parts depots, which boosted costs in late 2011.

Our Q1 total gross margin was 77.5%.

Total operating expenses decreased 3% sequentially to $98 million, largely driven by lower commissions, which are seasonally highest in Q4. We added 64 employees in the first quarter and ended March with 1,674 total employees.

Operating margin for the quarter was 24%, consistent with our guidance and compared to 29% one year ago.

Net income was $33 million or $0.20 per diluted share in Q1, flat with Q1 2011.

Moving to the balance sheet and cash flows. Cash and investments increased to $615 million, an increase of $21 million over the balance at December 31. We continue to have no debt. Cash flow from operations was $15 million for Q1. Day sales outstanding were 35 days compared to 34 days in Q4.

Inventory totaled $19 million at March 31 compared to $11 million at December 31. Our December balance was abnormally low. We've rebuilt safety stocks and temporarily beefed up total inventories as we transitioned to our new hardware models.

Total deferred revenue was $170 million, a sequential increase of 8% and a year-on-year increase of 28%. As a reminder, our deferred revenue is largely comprised of prepaid support contracts.

Turning to guidance. We're positive about our overall business opportunity and the expected ramp of the recently introduced products. That said, the global spending environment is mixed, and given what we've seen over the last few months, we are taking a prudent approach to our guidance as follows:

Revenue in the second quarter is expected to be in the range of $193 million to $197 million; gross margins should be flat to up a few basis points; we are forecasting Q2 operating expenses to be between $103 million and $105 million; operating margin is expected to be between 24% and 25%; earnings per share for the second quarter is expected to be between $0.21 and $0.22 based on approximately 169 million shares outstanding.

With Q1 now complete and the Q2 guidance I just described, we are now estimating closer to 15% growth for the full year 2012 revenue. We're targeting accelerating growth as we go through the year, with revenue growing faster than expenses in each quarter.

I'll now turn the call back over to Jerry for his closing comments.

Jerry M. Kennelly

Thank you, Randy.

Q1 was a difficult quarter but we're looking ahead. The products we introduced are the foundation for our next leg of growth. We are focused on improved execution in how we go to market. We expect product revenue growth to accelerate in Q2 and in the second half of the year, and we expect to deliver increases of profitability and earnings every quarter.

While Riverbed is going through a transitional period as a company and the sales environment is mixed, WAN optimization remains the top networking spending priority. Our competitive position is strong and our addressable market is growing. We have tremendous opportunity ahead of us and we always aspire to overachieve.

With that, our operator, Ashley, please open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Jason Ader with William Blair.

Jason Ader - William Blair & Company L.L.C., Research Division

Jerry, Randy, Eric, on the federal side of the business, could you give a sense of, first of all, for the quarter, where you were in terms of percentage of sales? And then what your thoughts are for the year in terms of the federal business? Do you expect it to grow? What are some the dynamics there? And I know there's a lot of data center consolidation projects, does that help offset some of the budgetary pressure right now?

Randy S. Gottfried

Sure. I'll start out with this answer. In general, government was about 13% of revenue for the first quarter. That's a similar percentage it was in the first quarter of 2011, so there was no great surprise there. But government in general, Fed being a large component, tends to be in a trough in the first quarter of the year. And then be a little higher especially in that third fiscal -- federal buying quarter. As we look through the rest of the year, things are progressing. Jerry, I'm not sure if you want to add...

Jerry M. Kennelly

Yes. So we just went through the pipeline review with all the regions, with U.S. Fed, as well as the government parts of the country, and they're upbeat. There's a lot of interest at the agencies. We are already the incumbent technology in a large number of federal agencies, but there's still a tremendous amount of greenfield out there. There's a big initiative in the government to go to more centralized cloud computing, to consolidate data centers and save money, and we expect to run that trend.

Jason Ader - William Blair & Company L.L.C., Research Division

Do you have a specific thought on whether growth could be similar to where it's been? Or do you think it will actually decelerate in terms of the federal business in 2012?

Jerry M. Kennelly

I think we're looking for a relatively normal 2012. The big question mark -- we got past the Congressional meltdown of the fall, and life seems to go on as normal. I think 2013 will be a question mark for Fed, I believe. I think we're going to have the same issue with the election and the Tea Party and all those great folks. But now through September and probably through the December quarter, I think we'll see relatively normal world in Fed, I think it would be a good world for Riverbed.

Operator

Our next question comes from the line of Rod Hall with JPMorgan.

Rod B. Hall - JP Morgan Chase & Co, Research Division

I guess I've just got one, which is on the full year revenue growth. I mean you guys are guiding for 15% now, so you cut the revenue growth down from the 17% to 20% range. And I guess I just want to try to square that back against what you've been saying about the product cycle. And I can understand the product cycle with slow growth at the beginning of the year. But then you would expect that to come back to you in the second half of the year, and it doesn't sound like you are as optimistic now as you were. So just trying to get an understanding of why the reduction on that full year growth number.

Jerry M. Kennelly

Yes, Rod. This is Jerry. So we are optimistic about the second half of the year. But having just posted a 12% growth in Q1, and giving guidance that's 15% to 16% for Q2, we have to make up the Q1 number in the Q3 and Q4, number one. So there's a numerical issue there. And number two, we want to give ourselves some room to have a good second half of the year. We think we'll be through the transition issues by then, and we should be off and running, but we don't want to overset expectations at this time.

Rod B. Hall - JP Morgan Chase & Co, Research Division

I want to -- I just wanted to clarify one thing you said earlier. You said that growth would be faster than expected or something like that for future quarters. Can you clarify that? Comment as well, Jerry. I don't think it was yours...

Jerry M. Kennelly

Actually it was Randy. But what he was saying, the product revenue growth would accelerate going through the second half of the year, which we believe.

Operator

Our next question comes from the line of Ittai Kidron with Oppenheimer.

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

Jerry, in your prepared remarks, you talked about the transition and the changes you need to make in your sales effort. You talked about moving from a solutions sale -- I'm sorry, from a point sale to a solution sale to better align salespeople. You also talked about the marketing efforts that you need to change. I think that's all fair and understood. I guess the question is, implied in your guidance, and again, it feels like you're setting again a high bar for the second half, meaning you're looking at a sequential growth of around the 10% in the third and the fourth quarters to meet that. That new 15% level. And I guess the question that I'm asking is that these changes that you need to do in the sales effort, they don't seem to be the type of changes that really materialize in one quarter. This is not -- this is more than just tweaking commissions on certain products to get people to do certain things. It feels like you need to have some change in personnel in your sales effort and a much deeper kind of realignment. So I guess the question is why do you think that within one quarter, you can get the house in order?

Jerry M. Kennelly

That's a very fair question. So we are not starting right now. We started back at the beginning of the year, and so there are already wheels in motion. The biggest issues, particularly in Q1, were not -- our sales personnel per se, it was more -- the biggest issue was the product transition and then second to that, trying to be a multiproduct company in the way we approach things. We made a good change in Europe last year that we bore the fruit of. You saw a 31% growth in Europe. I just returned from Japan where we just made an offer to a new Japanese Country Manager that would have been our weak spot in Asia Pacific. And we have a fantastic individual on the hook that I hope to announce next week. The sort of channel enablement type work of training, et cetera, et cetera, is going full force. So we started early in the quarter. I attended the channel partner meeting in Asia back in March, and we had 300 partner people come up and get trained. We were doing the same thing all over Europe and U.S. So these things are in motion. Of course, we always look at the sales organization. In general, we are happy with the people have in our sales organization. They are professional people. There will be some opportunity to upgrade certain positions as we go from a small company to a quite large company. You go from a single product company to a multiproduct company, you bring in people with those skill sets, and we're looking at that very hard right now. But we're not starting from scratch on April 19. These things are in motion, and I think we'll have finished most of the product transition issues by the end of the second quarter. It's not something you do overnight. But by the time we get to May, June, we will have had 4 months under our belt. And we expect to go into July, August, in the second half of the year in pretty good shape there.

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

Then still why stick to a second half guidance? Why do you feel you need to comment about that? Why not just kind of see how it goes through the quarter? And this quarter, you just reported is a great example why you shouldn't really set too high of a bar or a bar at all, frankly, until you feel you've got people positioned in the right way.

Jerry M. Kennelly

Yes, I know, it's a -- many people can debate guidance, and that we do the best we can, is all I can say.

Operator

Our next question comes from the line of Jess Lubert with Wells Fargo Securities.

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

I wanted to squeeze 2 in if possible. This is the second consecutive quarter where we've seen a material deceleration in your WAN optimization sales, and year-over-year growth for this business is now in the mid-single digits. So I was hoping you can update us on how fast do you think the WAN optimization market is growing and your confidence in your ability to recapture share down the road. And then earlier on the call, you mentioned that you had seen some macro softening in your business. I was hoping you can maybe expand a little bit on what regions of the world you'd seen that and maybe where you're seeing some incremental strength that you are feeling a little bit more comfortable about.

Eric S. Wolford

Jess, this is Eric, I'll take the first part of your question with regard to the market. And as you might imagine, we spent a fair amount of time talking to our sales people and talking to our channel partners about that question. And really, there's 3 things that lead us to believe the market is actually in good shape. The 3 are that -- everyone we talk to, channels, sales team, CIO surveys, you talk directly to CIOs, and they say WAN optimization is a top 2, even the top 1 spending priority. And so that gives us confidence. Second is that most of the deployments, a vast majority of them are all greenfield. We're not really substituting or replacing anything. We're always putting a new box into a new site or a new data center. And then third, a bottoms-up analysis of the pipeline for the balance of the year looks very promising. There are some very large deployments that are scheduled. We look the customers in the eye. We know that it's a top priority for them. It's like one just came in last week, hundreds of sites, where the customer said we're going to buy as much of this as we can for the balance of the year because it's so important to our -- our internal cloud strategy. So those things lead us to believe that the market is strong, and we have to get through some of our Riverbed-specific issues that Jerry outlined, and that we will get back to accelerated product growth.

Randy S. Gottfried

On the second part of your question on, for which regions we're doing well or not. We talked about sort of the big regions, including the U.S., U.S. was up about 7% year-on-year. Outside of the U.S., there's no obvious things to point to. Emerging markets, we continue to try to do a better job. We've had somewhat inconsistent performance. Obviously, certain parts of Europe are a little bit mixed in their performance as well. But we didn't think this was a geographic story in Q1. It was more of some of the other issues we have identified.

Operator

And our next question comes from the line of Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

So when you take off $50 million from your full year forecast, I'm just trying to parse, where does the bulk that come out from? Is it maturation of the core WAN op market? And that might be so because the company's now 10 years old. Or is it just a slower uptake on the new products? Just kind of see if you could kind of parse up one versus the other. And it does sound with all the changes that you have, maybe 24% to 25% is kind of the new base level for operating margins going forward.

Jerry M. Kennelly

Mark, this is Jerry. So WAN op is 90% of our revenue. It's the horse pulling the sled here. So any decrease in full year revenue necessarily comes primarily from that bucket. The Cascade product line is being well received, but it's linked very much. It is sort of arm in arm now with the Steelhead, and the two kind of drag each other into the marketplace. And so we're just getting started with the ADC. It's getting a good response. We think ADC will show a good growth this year. So it's really kind of dealing with what's happened in the first half and then accelerate into the second half of the year is the way we look at it. And in terms of margin, we did 24%, 25% this quarter, in a quarter that is not our most stellar quarter. So I would tell you in future quarters, where we grow revenue faster than expense, that we should be able to do better on the operating margin side.

Randy S. Gottfried

I'll also add to that. In general, we still look at roughly 30% operating margin as a medium to longer-term target for us. We're most focused on growth and reigniting growth in the business, and we're very optimistic that, that can happen. And in the meantime, we're just looking to grow revenue faster than expenses until we get there.

Operator

Our next question comes from the line of Scott Zeller with Needham & Company.

Scott Zeller - Needham & Company, LLC, Research Division

Following up on the earlier question about operating margin. It sounds as if you're going to be making a more material investment both in marketing programs and other investments for partners. I still want to ask you again if the guidance for operating margin might be a bit aggressive going forward.

Randy S. Gottfried

Scott, I wouldn't say that. I think in general, everything we've talked about is embedded in the numbers that we described for Q2. And as we look forward, there's not some magic big wave of spending that's coming. It's really implied in the numbers. We've got a lot of these things that we've talked about in place. We're trying to fine-tune it, but there's not a wholesale change or reinvestment period that we have to go through.

Jerry M. Kennelly

And never forget that we have a very powerful gross margin, high 70s gross, almost a software [ph] gross margin. So any extra revenue falls right to the operating line very powerfully.

Scott Zeller - Needham & Company, LLC, Research Division

And a follow-up on the sales force. Regarding your comments about multiproduct solution strategy, do you find that you'll be changing the core WAN sales persons responsibilities? Or are you going to be adding specialists for the newer product areas? I'm just trying to get a sense of how much of a change the core sales rep will be experiencing.

Jerry M. Kennelly

Yes. So fundamentally, we want to put more emphasis on the core rep selling the core product and be less distracted by trying to have him learn all the new products. And so we're going to lean a little more heavily than we have on product specialists who support the core rep and really have him focused on what is our biggest market, our biggest product and where he's most comfortable, and then have him bring in by reference, sort of an overlay SC product specialist organization to help him close the other products.

Operator

Our next question comes from the line of Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Can you talk a little bit about how the Steelhead product transition is going in terms of what are you shipping that's of the new platform today versus the old. And if there are any sort of developments, early developments in terms of the adoption between CX and EX?

Eric S. Wolford

Sure. Kent, this is Eric. Obviously, we track that very carefully. And the light that shines through, even though it's a small number -- early, early in the process, but it does look like the ratio, the take rate of EX as a percent is greater than the percent that RSP was. So we think we're over 30% EX of the new platforms versus CX. And so our thesis that we could build a more multipurpose, multifunctioning box, we think that's making sense and that's working. It's still early though, we're out in the market with it probably for half the quarter, but it looks pretty good.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Is this one of those situations where we're thinking 70%, 80% new platform in 2Q as far as shipments go? Or is that too aggressive? Just trying to get a sense for the build there.

Eric S. Wolford

Between the new and the old, it's hard to put a specific number on it. There's the trend -- the shift is taking place. People are more moving to more CX and EX. There are big customers who have qualified and certified the 50s. And it takes them 6 months, some of them even 9 months to re-qual and recertify, go through the security tests and all of that of the new stuff. So it definitely isn't a 1 or 2 quarter thing, but definitely increasing right now.

Operator

And our next question comes from the line of Alex Kurtz with Sterne Agee.

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

I think, just to go back on some of the earlier questions about growth in the core WAN op business, I think a lot of investors who are listening in this call are trying to discern whether or not the Steelhead core business can be a mid-teen plus type grower. I know we're going through a transition phase here for this year, but I mean, you guys still have confidence that this -- ex-out [ph] the rest of the business, that the Steelhead is still sort of a high-teen growth opportunity? Or is it still sort of debatable at this point given what you're seeing in the marketplace?

Jerry M. Kennelly

It's a very fair question. In fact, we ask ourselves that question because we don't like to come at the low end of what we say either. And in fact, we're only a deal or 2 away from being much higher. But we think the horse is still running. And we look at it very hard both top-down and bottoms-up. Top-down, all the trends in IT are to -- for people to have access to their applications across the network. And whether it's VDI or data center consolidation, whatever you want to do, all the trends, every corporation, every government network, the user is farther and farther away from the data center. Cloud computing, all these things are the sweet spot for our technology, and we're seeing the demand for it. Now when we're seeing demand for it, but the first time we have the full product set to address all the different approaches people are going to take to access their applications across the network. On a bottoms-up basis, from the pipeline we have, from the reviews we do at the field salespeople, from the morale and the enthusiasm in the sales force, this is a live market with the full growth potential. If we had just simply sat here and kept selling the old models, I can tell you for certainty that in the short-term, we would have produced a bigger Q1 and probably a bigger Q2. But that's not the right thing for the company. It's not the right thing for the customers. It's not the right thing for the shareholders. On every sort of bottoms-up and tops-down, we look at it very hard because this is a key to us. The WAN optimization market is robust and will be for a longtime.

Operator

Our next question comes from the line of Brian Modoff with Deutsche Bank.

Vijay Bhagavath - Deutsche Bank AG, Research Division

This is Vijay Bhagavath calling on behalf of Brian. Jerry, a question for you in terms of, how do you view the product adjacencies, I mean you obviously you have Granite, Cascade, Stingray et cetera, and then you have Steelhead. How would you view these adjacencies contributing to incremental revenue growth this year and next year? I'd like to get your thoughts. I mean we do understand the core business, the WAN optimization business.

Jerry M. Kennelly

Sure. Well Eric is our product maestro, so I'll toss that one to him.

Eric S. Wolford

Yes, sure. You've already seen the percent of revenue coming from other products is -- still it's above 10% now. So it's becoming significant. We do want to focus first and foremost on growth across all products that we believe, as Jerry just spent some time talking about, there's plenty of growth opportunities left in the Steelhead business, so we want to do that. In conjunction to that though, we think that we can increasingly get more of our revenue from these other adjacent products. So we want to do both, focus on Steelhead growth and get that core business accelerated, and at the same time, take advantage of these adjacent new market opportunities. One of the hardest things is to get the product lineup, get it built, get it launched, get it out there. We have the product lineup. It's pointed at multibillion dollar market opportunities. We have the trends of the industry behind us supporting that, and we feel very good about our ability to become that multiproduct company.

Jerry M. Kennelly

Yes. In addition to your question, sort of to the last question, I just spent a lot of time on the road with customers. And I talked about our technology fits trends. It's more than fitting trends. I just sat in front of a big Japanese customer who just told me, to my face, his network doesn't work anymore without the Steelhead. They can't do their work, so they are a global software developer [ph]. They can't send their development. They simply -- they can't even conceive of making -- using their network anymore without the Steelhead in it. I was in New York, sitting in front of a big global services company, a different one than the one that Eric mentioned a few minutes ago. And they need 600 more units this year. They're going to start in late spring, buying 10 to 15 a week until they deploy another 600 and they intend to do the whole 600 this year, because it's just key to everything they're trying to do. And there's a whole slew of greenfield opportunities, not only in the U.S., in different markets. We're starting to break into the retail market where the unit counts are gigantic. So this is more than just good news, this is a fundamental thing that people are doing to connect global networks.

Vijay Bhagavath - Deutsche Bank AG, Research Division

And then just a quick follow-on in terms of any color on the competitive side. Are you seeing any incremental share gains or any share loss to someone like a Cisco, for example, in your core business?

Eric S. Wolford

I think -- this is Eric again, in terms of the relationship or our competitiveness with Cisco, we, bottoms up, definitely don't see any material change. From a market share perspective, I think our gap is 27%, so it's more than 2x the Cisco share position. So it looks very strong there. And the Magic Quadrant, Gartner's Magic Quadrant recently came out, we had very favorable position there. So I think they are definitely our top competitor. I think the only thing I would note that has sort of changed just a little bit is that the competitiveness with Blue Coat has softened a little bit in the past quarter, so that's probably the only thing of note.

Randy S. Gottfried

As in we're seeing less of them.

Eric S. Wolford

As of we're seeing less of them.

Operator

[Operator Instructions] Our next question comes from the line of Erik Suppiger with JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

Just want to get some more clarity on your approach to the sales comp plan. On the one hand, it sounded as though you're going to have the sales -- the core sales force focused on selling the core product. But I don't understand how that nurtures a solution sale if you're not providing specific incentives for some of the complementary products. Can you give us a little bit more flavor?

Jerry M. Kennelly

So think of them as major account managers as opposed to sales reps, where they go into a big corporation. And they have a -- their quota includes a requirement for everything in our product line, and they get compensated in everything in our product line. And in fact [ph] we give accelerated compensation at a higher level for the other newer products, the non-Steelhead products, just to make that point. But we don't expect them to know everything. We're only human, right? And you can only know so much. And so that -- and these are complicated advanced technologies, and so what we're trying to do is we have a quota for it, the customer needs it, if you can sell, you'll sell the higher, more strategic level in the company. We'll pay you more for it. And, by the way, we have this group of big-brained, super product specialists in your region, are available to fly in at a moment's notice, as soon as you find the opportunity to help close that opportunity with the customer and support the channel partner who's trying to make that sale. And we think that will drive more revenue than trying to expect those guys to sort of sell everything. It's hard to be a masters of all -- jacks of all trades but masters of none.

Erik Suppiger - JMP Securities LLC, Research Division

So just to be clear, it sounds like there are specific quotas for the different product families, it's just a question of getting -- giving them more resources to sell all of the products, is that right?

Jerry M. Kennelly

Exactly right.

Operator

Our next question comes from the line of Alex Henderson with Miller Tabak.

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

I was hoping you could give us a little bit of clarity around the issue of the timing of these products sort of just launched. Should be starting to kick in, in terms of benefiting the top line. I mean, obviously, there's a sales cycle, there's a requalification cycle. How much of a factor do you think that, that's trimming the second quarter by? And does that create that pent-up demand, which makes that second half re-acceleration sequential growth more evident and easier to forecast? And how are you thinking about the lag that's created by the new product launches?

Eric S. Wolford

Sure. Alex, it's Eric. I would categorize our new stuff in 2 categories. There are brand-new products like Granite, like Steelhead Cloud Accelerator. And then there are new models, with -- basically like the old Steelhead but new, with new hardware platforms and new specs. And so there's a different dynamic to each one of those 2. There's a natural new product adoption curve that takes place on like the Granite and the Steelhead Cloud Accelerator, and pipelines are building, funnels are building. For those to be material, I think we said for the Steelhead Cloud Accelerator, because that's a subscription-based service, we don't expect anything material this year. Granite, we mentioned we'd already made in Q1 some sales of Granite. And that one seems to be -- those are not subscription sales, those are full product sales, those seem to be ramping very nicely. We don't -- at this point, it's still early. We want to get some experience under our belt before we say when we think our revenue will be material. But we're very encouraged by what we're seeing with regard to Granite. It's a great product, has a big impact and has the potential to be a big game changer. With regard to our transition to new models and new hardware platform, well, that, as we've mentioned before, it takes a couple -- 2, 3 quarters. There's a tail on it. Bigger customers sometimes take longer than smaller customers to make the transition. But that's one where we'll feel it. I mean we'll have a substantial amount of new model business next quarter for sure, or this quarter for sure.

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

If I could follow-up, so do you have a much larger pipeline of large ticket transactions that have been delayed as a result of that, that will take another couple, 2, 3 months to work through the pipe? Or is the pipeline of larger transactions, which would be held up with those qualifications, still normal and on the standard track?

Eric S. Wolford

Yes. I understand your question now. First of all, everything is baked into our guidance, that's for sure. But there's no question, we had business push because of the transition, right? We had large customers. And some large deals where the customer wanted to rethink, did he want the 50s or did he want the 55s or the 60s, and what about this Granite thing. We did these regional reviews and we heard it, a reasonable amount of time where we could point to customers and deals that pushed. Those will work their way through in the next quarter or 2, and we'll be through that product or that model transition, the big product transition in that time frame.

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

So just to clarify, in 2Q, there are still pushouts from 2Q to 3Q as a result of that transition still being baked through?

Eric S. Wolford

We can't, I can't tell.

Jerry M. Kennelly

We can’t be that specific.

Eric S. Wolford

I can't be that specific, Alex. It could be, might not be, just depends on the customer's decision making.

Jerry M. Kennelly

Yes. It should be mostly worked out this quarter.

Eric S. Wolford

Should be mostly worked out, I think is fair.

Operator

[Operator Instructions] Our next question comes from the line of Ryan Hutchinson with Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Okay, so I guess most of my questions has been answered. The key one being what the core WAN optimization market grows at, which I think is still unanswered. But be that as it may, maybe we can talk a little bit about market expansion. And what's different this time around? Maybe help us understand why or what you mean when you provided some commentary in the prepared remarks? And is it different than 2-tiered distribution? And how is it going to help improve the top line?

Jerry M. Kennelly

Well, yes. This is Jerry. Yes, so what I remarked is that we actually -- Riverbed is seen as an integral part of the technology industrial complex, and so we are engaged with some large tech companies interested in the distribution of our products. And over the course of the year, I'm looking forward to announcing some new incremental distribution partnerships with large tech partners.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

So they're different than the 2-tier distribution of -- I guess large strategic partners different than what you've had with HP and others in the past? Or is there not a difference?

Jerry M. Kennelly

Slightly different, but along those lines.

Operator

Our next question comes from the line of Bill Choi with Janney.

William H. Choi - Janney Montgomery Scott LLC, Research Division

So I guess I wanted to confirm when you talked about some complexity, assessing new products, particularly within CX, EX and Granite. The larger deals are the ones that are taking longer, that the average deal sizes here in Q1 took a hit versus Q4, and what are you thinking about deal sizes recovering with the next 1 or 2 quarters?

Randy S. Gottfried

The deal size is always been a little bit tricky. The vast majority of our transactions remain under $100,000, and that really hasn't changed. At the margin, there's slight changes on a quarter-on-quarter. The bigger thing is sort of overall rollout, frequency and rollout timing, and I think that's -- we saw some elongation in the sales cycle during this product transition, some of the issues that we described as we evolve to be a multiproduct company, we think that improves. So it's the transaction volume, not necessarily transaction size that improves as we go through the year.

William H. Choi - Janney Montgomery Scott LLC, Research Division

But that doesn't necessarily fit with where the delays are occurring right? I mean they would tend to bigger-sized deals, you didn't notice any deal size, actually on average basis go down this quarter?

Randy S. Gottfried

There's a nuance, I think. Maybe I'm overly precise in how I answer. But in general, even the biggest customers often buy in small denominations. So big customers are a big deal, and we see big customers who have paused as they go through the qualification, they may not come back with an instant multimillion dollar deal. There may be some of those, but just as often there are big customers who are buying frequently but in small chunks.

Jerry M. Kennelly

15 per week.

William H. Choi - Janney Montgomery Scott LLC, Research Division

Right, so you have expectations when these larger companies make the assessment that they give the orders in big chunks after holding it back for a while? Or do they stream it out regularly? What's built into your expectations when you gave the second half guidance?

Randy S. Gottfried

It's a mix of everything. I think what we're seeing is -- at the end of the day, I'm less concerned what denominations someone buys in, so much as we get big customers who start that flow of orders coming as they flesh out their network with our product. And so that's what we're looking for. There's a variety of deal sizes that get baked in those as we think about the growth through both the second quarter and through the rest of this year.

Operator

Our next question comes from the line of George Notter with Jefferies.

George C. Notter - Jefferies & Company, Inc., Research Division

I wanted to challenge your assertion earlier that the vast majority of deals are greenfield and certainly you guys have unique perspective here. But intuitively, it seems counterintuitive, right? This market is 8 years old. We know the return on invested capital on WAN optimization is in the hundreds of percents, payback periods tend to be 3 to 12 months, if you talk to the customers. I guess I'm -- that would suggest that the market ought to be somewhat more penetrated than you guys are asserting. So what am I missing here?

Jerry M. Kennelly

No, it's 8 years since we started selling, but probably 80% of our life-to-date sales have taken place in just the last 3 years. And so the early sales are to the guys who are the innovatives, the early adopters. And so I've seen some reports talking about -- is the low hanging fruit gone. Well no, the early adopters have done their early adopting, but there's a gigantic, I don't know what to call it, following majority or whatever the hell is, of people who are just coming to understand this. It's a relatively new technology in the scheme of the world. And there are a lot of big companies who need to do big branch office deployments, data center consolidation, use VDI, do cloud computing. And probably everyone together in this market has sold 300,000 to 400,00 units into what is potentially a 4 million to 6 million unit market, and so it's not saturated, the low hanging fruit is not gone. It's not -- it's still early days, and we have a big run in front of us.

George C. Notter - Jefferies & Company, Inc., Research Division

And do you think the issue then is just education, that customers by and large aren't fully aware of WAN optimization? Is that the issue then?

Randy S. Gottfried

Yes, in part, there's no question that's the issue. Because what happens is, whether it's in the form of an education program or it's our salesperson knocking on the door to explain to them how they can apply WAN optimization to achieve their cloud objective, to achieve their consolidation objective, how they can use this to achieve those objectives, it doesn't just come into the fax machine, you do have to actually go out and talk to them and sell it. But in terms of it being new, putting the box where there wasn't one before, George, I have to tell you, I mean that is the vast majority. The vast majority is it's time we put a box in, we're not replacing anything. This anecdotal story from this week was a customer who, brand-new, will be a brand-new buyer, and they're excited to put them in hundreds of locations because they've just completed doing all of the math and the research and the testing. And they've -- so like where were they 4 years ago? I don't know. But it took us that long to get to them via marketing and via sales and then get to, now, that their convinced and they're excited. Well it's now a top spending priority for them. So I know the more weight the industry puts on this space, the more sales result. If Cisco, Riverbed, Blue Coat, we all put a ton of sales effort into this. The market would grow, much, much faster, there's no question. Because it's not a share shifting, pork-belly-type fixed market. It is -- you're reaching new customers with -- and new sites with this new type of solution.

Operator

The final question comes from the line of Jayson Noland with Robert Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Just a follow-up to the previous topic. Eric, is it fair to assume that the older 20 series of product has a decent percentage of the installed base and is ripe for replacement with the newer 55 and 60s?

Eric S. Wolford

Yes. It's a great question, Jayson. I would think that's the case. But we have new features, new capabilities that attract them to come on to the new products. And I think we have to attract them to do that. Those xx20s don't go off of support until beginning of 2000 or early 2014. So they're compelled to make a change in a couple of years. Prior to that, we now have to incent them by saying, "If you want any of the new capabilities, features, functionalities, then you have to go to the new stuff." So there's no question it's a sales and marketing challenge to go pitch them trade ups and loyalty promotions and here's what you can get by -- give them some credit, we have to do all of those, those things. And they should be -- are old targets for us, and that's part of becoming a bigger company, you have to hunt and farm at the same time.

Randy S. Gottfried

The good news is actually we think that's a largely untapped potential as we go through that, 18, 24 months, we think there's still a lot of upgrade possibility. On top of what we think is still a very strong market.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Okay. My question is on product mix. And are you still seeing sales of the 50 series and then what do you expect to see between 55, the newer 55 and 60s, what type of split there?

Eric S. Wolford

Sure. So this past quarter we definitely sold more 50s as we had expected than the 55s and the 60s, although there was a pretty good take-up of the 55s and 60s for the remote office boxes, and there will be more this coming quarter. In terms of the relationship of the new between the EX, the 60s and the CX, the 55s, I think I had mentioned that, that relationship is that about over 30% of the new models are the EX version. So it's greater than the 20% that we had, had with RSP, so it's very encouraging.

Renee Lyall

Thank you, everyone, for joining us today. If you have any questions, please direct them to Investor Relations.

During the second quarter, Riverbed will be presenting at the JPMorgan, Barclays and Sterne Agee conferences in May. We will also participate in the Stephens, Needham and William Blair investor events in June.

Our second quarter earnings conference call is tentatively scheduled for Thursday, July 19 of this year. Beginning in Q2, we will be making some changes to how we discuss revenue to be more consistent with industry standards. We will report our geographies as Americas, EMEA and APJ. We will also report all revenue detail as a percentage of total revenue versus product revenue. Available on our website now is data presented in both formats for Q1 '12 and the previous 8 quarters. Thank you.

Operator

Thank you, ladies and gentlemen. This does conclude today's Riverbed First Quarter 2012 Earnings Conference Call. You may now disconnect.

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