Kelsey Doherty - Sr. Director IR
Dave DeWalt - CEO & President
Eric Brown - COO & CFO
Rob Owens - Pacific Crest
Daniel Ives - FNB
Todd Raker - Deutsche Bank
Phil Winslow - Credit Suisse
Heather Bellini - UBS
John Walsh - Citi
Sterling Auty - JP Morgan
Derek Bingham – Goldman Sachs
Israel Hernandez - Lehman Brothers
Walter Pritchard - Cowen
Matt Hidburg - RBC Capital Markets
Michael Turits - Raymond James
Good afternoon, my name is Denis and I will be your conference operator today. As this time I would like to welcome everyone to the McAfee third quarter 2007 earnings conference call. (Operator Instructions) I will now turn the call over to Miss Kelsey Doherty. Please go ahead ma’am.
Great thank you very much. Good afternoon and thank you for joining us. Today’s conference call is being recorded and will be available for replay on McAfee’s Investor Relations homepage at www.investor.macafee.com.
On today’s call our Chief Executive Officer and President Dave DeWalt and our Chief Operating Officer and Chief Financial Officer Eric Brown. In a moment Dave will kick off the call with a review of the highlights of the quarter and McAfee’s strategic priorities, then Eric will provide details of our third quarter results and discuss our guidance for the fourth quarter of 2007. Dave will then close with some additional comments on the quarter and then finally, we’ll take your questions.
You’ll find in our press release and on our investor relations section of our website a GAAP to non-GAAP reconciliation of the un-audited preliminary third quarter financial numbers discussed in this conference call. The link again is www.investor.mcafee.com and our results are posted under quarterly results. We will post our prepared remarks on 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 third quarter of 2007; guidance on revenue; operating income margins and earnings levels for the fourth quarter 2007; expectations regarding the benefits of our recently announced and pending acquisition of SafeBoot B.V.; the expected level and scope of security threats of future periods; expected industry growth rates of the market segment in which McAfee participates; expected new and future product introductions and the revenue opportunity associated with them; expected integrations of products from pending and recent acquisitions with existing McAfee product lines; expectations regarding McAfee’s business momentum, market position, business segment; statements regarding future partnership opportunities; specific group initiatives and strategies outlined for 2007 in McAfee’s business, 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 risk and uncertainties, including that McAfee will make adjustments to its un-audited preliminary financial results for the third quarter of 2007 and prior periods and restate certain prior period financial statements as a result of its review of past stock option grants.
In addition, McAfee may not achieve its planned revenue realization rates; succeed at efforts to grow its business to combat effectively the security threats of the future; build upon its technology, leadership or capture market share, or benefit from a spending acquisition or strategic relationship as anticipated. McAfee customers may not respond as favorably as anticipated to the company’s product or technical support offerings, and the company many not satisfactorily anticipate or meet its customers’ needs or expectations. The company’s product and service offerings may not continue to inter-operate effectively with the newly developed operating systems; the company may experience delays in product development or the release of previously announced products; the company may choose not to deliver previously announced product; the company may experience delays or losses in revenue resulting from outrages in the integrated systems on which it is highly dependent, and further risks may arise from a review of past stock option granting practices, including but not limited to potential fines and penalties and obstructions to our ongoing business and significant legal litigation, accounting tax and other expenses.
In addition, a number of other factors from new product interdiction; the mix of products and services sold; the size of deals closed in the quarter; the amount of revenue deferred in the quarter; integration of acquired businesses; changes in senior management; the competition we face in the market; currency fluctuations; to the greater macroeconomic environment, to name a few, may cause our revenue growth 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 conveyed 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-K 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 turn the call over to our CEO and President Dave DeWalt. Dave?
Okay, Kelsey thank you very much. Always interesting to see your script longer than mine. Sorry about that. So good afternoon everybody and welcome. The third quarter of 2007 was just a great quarter for McAfee. Momentum’s clearing building at McAfee and we’ve really become the leader as the largest dedicated security company in the world. We continue to take market share and I could not be more optimistic about the outlook for McAfee, as evidenced by a lot of personal conversations with hundreds of our customers and prospects who are projecting that security as a percentage of IT spending is increasing, and they’re looking to increase their purchases with McAfee.
As such, I’m pleased to report our eleventh consecutive record quarter, and an all time high in our quarter ending deferred revenue balance. More specifically, in the third quarter of 2007, we had double digit growth across all non-GAAP metrics. Revenue was $322 million, up 12% over the same quarter last year. Non-GAAP operating income was $79 million, up 18% over the same quarter last year. Non-GAAP net income was $72 million, up 24% over the same quarter last year, and non-GAAP diluted earnings per share was $0.44 up 22% over the same quarter last year. Operating cash flow was $119 million at the end of the quarter, up $33 million sequentially and 50% year over year.
In Q3 2007 we reported GAAP operating income of $46 million and GAAP net income of $63 million or $0.38 per share on a diluted basis. Year over year we increased our GAAP operating income by 28%, our GAAP net income by 108%, and our GAAP earnings per share by 104%. In addition, deferred revenue reached an all time high, growing to $954 million at the end of the third quarter, representing an increase of 14% year over year.
Our revenue contribution continues to be balanced across geographies. In addition, our international business income increased on a year over year basis by 25%, representing 49% of our total revenue. North America increased 2% and accounted for 51% of total revenue in the third quarter. We continue to see strong pipeline growth in North America, as evidenced by multiple multi-million dollar deals having a ready close in Q4.
In our corporate segment, we continued our momentum in the large deal category, closing eight deals over a million in the third quarter, including one deal worth more than $5 million. In short, we’re continuing our momentum as we are heading into the end of the 2007 fiscal year.
We have made considerable progress at McAfee’s since my first day six months ago. And my two main goals of continuing to increase our operating efficiencies and accelerating growth continue. At this point, I would like to take a minute to summarize the six major initiatives that reinforce these goals. I’ve consistently highlighted these initiatives that allow us to build on our successes and take McAfee to the next level.
First of all, an integral part of accomplishing these goals is building a great team. I’m proud of the employee success we’re generating here at McAfee: attrition is down, productivity is improving and momentum is building. McAfee is becoming an attractive place for world-class talent, and we’ve added more than twenty key senior management positions this quarter to areas such as sales, corporate development, legal, marketing and each of our regional theatres. These individuals bring expertise from some of the most well-known names in the industry like Oracle, EMC, Adobe, Sony, and HP to name a few.
Our second major goal is a focused product vision and strategy, centered around our four major product lines: systems protection, network protection, vulnerability risk management, and now, data protection with our newly established product business unit. During this quarter we announced three of the most important product upgrades in the company’s history. Each of these three is an organically built solution and together they add to McAfee’s security risk management leadership and give our customers, to the consumer to the enterprise, world-class protection. One of those is ePO 4.1, which represents the fourth generation of McAfee’s security management technology. This was the biggest release the company has ever done from an engineering capacity and investment perspective.
We continue to be the first to deliver a single agent, single console management for all end-point security. We’re the first to manage a broad range of security products including end-point, network, data, web and email security with one console. We’re also the first to combine security and compliance management, and the first to manage both McAfee and non-McAfee security products providing open architecture around systems security. ePO is the world’s most scalable security solution with nearly 55 million end-points under management.
Upgrades of ePO 4.0 have gone extremely well, with customers reporting seamless upgrades in just hours and days. And not requiring forklift upgrades like our major competitors. In addition, for McAfee’s consumer customers we’ve announced the security industry’s first triple play protection offering, securing consumer’s PCs, the web and mobile phones. McAfee triple play includes 2008 versions of Total Protection and Internet Security suites, as well as siteAdvisor and McAfee Virus Scan Mobile.
And coming soon to our network business, we plan to deliver a major new platform for IntruShield, the first and only network intrusion prevention appliance to deliver the highest ten Gig port density in the industry, and we will offer secure content management appliances to a virtual appliance delivery model. McAfee is the clear leader in virtualization with eight products already shifting in support of VMware. Virtual delivery is the perfect complement to McAfee’s current hardware delivery model and will save customers time and money.
Our third major strategy is the M&A. We continue to focus on high growth, high shareholder value and creative product acquisitions. Our planned acquisition of SafeBoot is a great example of a scalable business that complements McAfee’s security risk management strategy. SafeBoot’s endpoint encryption coupled with McAfee’s data loss prevention is a compelling addition to McAfee, and we expect to leverage their highly acclaimed product lines, four thousand four hundred plus customers, and five million nodes under management, capitalizing our opportunities to up-sell and cross-sell solutions to both of our customer bases. We fully expect this acquisition when completed will place McAfee squarely in a leadership role in the data protection industry. Currently SafeBoot also has a preexisting relationship with Hewlett Packard; their full-disk encryption is pre-installed on business class HP notebooks and laptops sold to SMB and Fortune 1000 corporations. This represents a huge opportunity for McAfee and we’re excited about many similar type opportunities we can build with our other large partners around SafeBoot solutions.
As our fourth major initiative, we’re working to propel McAfee’s brand and image as the leader in worldwide security technology. The marketing teams have been working hard at raising the company’s visibility and supporting our sales force and go-to market strategy through new brand and marketing campaigns reflecting a very fresh and creative approach.
Our fifth major initiative’s transforming our go-to market strategy and driving accountability on three major market segments: the consumer, mid-market and enterprise, while leveraging and expanding our channels for our business. We’re increasing our sales capacity and productivity worldwide with additional focuses on high growth emerging markets. I personally reached out to most of our major customers and partners, listening closely to their needs from a strategic and product standpoint, while emphasizing to them that we recognize that our customers and partners are key to our success here at McAfee.
As part of this effort to get closer to our customers and partners, last week we hosted McAfee’s first ever executive security summit, bringing together a select group of customers including some of the largest accounts worldwide. The outcome of the summit confirmed our strategy and our view of the security industry trends.
So we intend to stay focused on SRM, building through organic product development and M&A, and we look forward to 2008 when we’ll host our first ever user conference worldwide in October. And finally our highest priority is completing the financial restatement. We continue to be in the final review and acceptance phase of our process and once completed we will submit a pre-clearance letter to the FCC. Our expectation remains that the restatement is likely to result in an aggregate option related non-cash charge in the range of $100 million to $150 million and we’re pushing the filing of the restated financials as quickly as we can.
So I’m really pleased with our third quarter results and with the progress we’re making on all our corporate initiatives. I’m now going to turn over the call to Eric who’ll give you more detailed review of our quarterly performance. Then I’ll come back to add some brief color on the quarter and then we’ll take some questions. Take it away Eric.
Okay thank you Dave. Good afternoon everyone. North American revenue was $165 million in the quarter. This accounted for 51% of third quarter 2007 revenue; this compares with North American revenue of $162 million or 56% of revenue in last year’s third quarter. This shift in the percentage of our revenue reflects a very strong growth in our international business. International revenue third quarter was $157 million, up 25% year over year. In fact we registered double digit year over year revenue gains across all geographies: Europe, the Middle East and Africa grew 17%; Japan grew 41%; Asia-Pacific grew 38% and Latin America grew 72%. Outside of North America we believe we are capturing market share.
Corporate revenue in the third quarter was $186 million, up 11% year over year. Growth of corporate revenue was due to our strong performance in our systems business, including total protection solutions for enterprises and small and medium businesses, as well as strength in our network solutions sales. During the quarter we recorded numerous transactions in the consumer and mid-market space. In addition, in enterprise during Q3 we closed 271 deals of more than $100 thousand, 22 deals over $500 million and 8 deals of over $1 million. We also closed the largest deal in McAfee’s history in excess of $5 million.
Turning now to consumer, revenue from our consumer business in the third quarter was $136 million, up 14% year over year. In fifteen out of the last sixteen quarters we have grown our consumer revenue at more than double digit rates year over year. This quarter we saw double digit revenue growth in both our online and retail businesses.
In the third quarter of ’07 we had a favorable revenue impact due to FX; the total impact was $8 million year over year for the quarter for approximately 3% of reported revenue. It is important to note that of our total revenue during the third quarter, 85% came from deferred revenue on the balance sheet. McAfee has a highly ratable business model and this continues to provide visibility into our future revenue streams.
Moving down the income statement GAAP gross profit margins for the quarter were 75.8% compared with our Q2 2007 results which were 77.3% and our Q3 2006 results which were 78%. Non-GAAP gross profit margins for the third quarter were 78.3% compared with 80.2% last quarter and 80.2% for Q3 2006. Gross profit margins for the quarter were impacted by an increase in secure content management and IntruShield hardware sales and continuing growth consumer subscriber acquisitions through channels where McAfee pays a revenue share to a partner.
Total GAAP operating expenses in Q3 2007 were $198 million, up 5% compared with last year’s $188 million. Meanwhile, total operating expenses on a non-GAAP basis were $173 million in Q3 2007 which is 6% higher than last year’s Q3 2006, when we had non-GAAP operating expenses of $163 million.
GAAP sales and marketing expenses were $91 million, non-GAAP sales and marketing expenses were $87 million or 27% of revenue. Quarter over quarter non-GAAP sales and marketing expenses decreased by approximately $4 million.
GAAP research and development costs were $54 million and on a non-GAAP basis, research and development costs were $51 million, or 16% of revenue. Quarter over quarter non-GAAP R&D expenses were sequentially flat. We will continue to invest in our technology and engineering teams, as we work to build and deliver solutions to our customers that out-innovate the competition. As we implement our strategies we are placing a great deal of emphasis on the development of intellectual property. Our R&D efforts are continuing to pay off. During Q3 2007 we added 15 new patents, bringing McAfee’s total patent portfolio to 294 patents.
GAAP G&A expenses were $38 million; non-GAAP G&A expenses were $34 million or 11% of revenue declining $2 million sequentially due to lower outside services fees. Our GAAP operating income for Q3 was $46 million; this results in an operating margin for the period on a GAAP basis of 14.4% compared to the year ago operating margin of 12.6%. On a non-GAAP basis, our operating income for Q3 was $79 million, leading to a non-GAAP operating margin of 24.7%, up from 23.3% a year ago.
Other income for the quarter was $20 million and this is up from $19 million in Q2 2007 and $13 million inQ3 2006, reflecting increased year over year cash balances and improved cash and foreign currency management strategies.
Total employee head count at the end of the quarter was 3,991, up slightly from the 3,850 employees that we reported at the end of Q2 2007.
The company’s GAAP tax rate for the quarter was 5%; on a non-GAAP basis our tax rate was 27% unchanged from a year ago.
In Q3 2007 we reported net income on a GAAP basis of $63 million or $0.38 per share on a diluted basis. Year over year we increased our GAAP earnings per share by 104%. Our third 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 22%.
Our net accounts receivable balance at the end of Q3 2007 was $156 million. DSOs were 44 days for Q3 2007 compared to 42 days in the third quarter of last year. We had a record level of deferred revenue at the end of Q3 2007; it was $954 million, up 14% on a year over year basis, and also up sequentially $47 million. Sequentially short term deferred revenue was up $24 million to end the quarter at $737 million and long-term deferred revenue was up $23 million to end the quarter at $217 million. The composition of our deferred revenue balance as of the end of Q3 2007 was 60% corporate and 40% consumer.
We ended the third quarter with cash, cash equivalents and investments of $1.54 billion; this represents a 9% increase over the second quarter of 2007 and a 25% increase over the third quarter 2006.
Please note that the $350 million cash outflow associated with the planned acquisition of SafeBoot is expected to be in the fourth quarter of 2007.
During the third quarter of 2007 we generated a total of $119 million in GAAP operating cash flow; the cash flow summary for the quarter is as follows: first, starting with GAAP net income of $63 million we had $19 million for depreciation and amortization; we had $10 million of non-cash adjustments to reconcile the net income, including stock compensation and other; we had $9 million for deferred taxes and we had $18 million for changes in working capital, deferred revenue and other items. This adds up to a total of GAAP operating cash flow of approximately $119 million. This compared to $85 million in the prior quarter and is up on a year over year basis by 50%. The sequential increase in operating cash flow is driven by higher profits and greater quarterly growth in deferred revenue.
Below the operating cash flow line we have $7 million for capital spending in the third quarter.
I would now like to give you an update on the SafeBoot acquisition. There is no change in our expectations regarding the completion of the acquisition of SafeBoot. We expect the transaction to close in the fourth quarter of 2007 pending regulatory review and approval. The integration planning process is going smoothly and both teams are excited about the business opportunities in data protection that this combination presents.
Guidance, which I will now provide, includes our current expectations regarding the impact of SafeBoot on our fourth quarter 2007 results. Please note that we are assuming a GAAP EPS dilution of $0.04 per share and non-GAAP EPS dilution of approximately $0.02 per share in Q4 of 2007, due to the SafeBoot acquisition. This is due to the amortization of purchase technology and the impact of deferred revenue writedowns and conversion to a ratable revenue model. We still expect the SafeBoot acquisition to be neutral to 2008 non-GAAP EPS, accretive to 2009 non-GAAP EPS, and dilutive to 2008 GAAP EPS.
Now, I'd like to provide you with our guidance regarding our expectations for our results in the fourth quarter of 2007. The following updated guidance replaces and supersedes any previous guidance with respect to future periods and is now and as of today only. I would like to remind listeners that guidance is based upon management's current expectations and 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 fourth quarter of 2007, we expect revenue of between $330 million and $350 million. We expect our GAAP operating income margin to be 14% to 16%; we expect our operating income margin on a non-GAAP basis to be between 24% and 26%. We assume a GAAP tax rate for the fourth quarter of 22% and a non-GAAP tax rate of 27%.
We expect share count to range between 164 million and 166 million shares. Also for the fourth quarter of 2007 we expect GAAP EPS between $0.28 and $0.32 per share. On a non-GAAP basis we expect EPS between $0.42 and $0.46 per share on a diluted basis.
I'll now turn the call back over to Dave.
All right, Eric. Thank you. As Eric just summarized, Q3 was a strong quarter for McAfee. To wrap up this afternoon I'd like to share some interesting, additional highlights from the quarter.
First off on our consumer business we signed or extended 13 agreements and launched 62 new or enhanced online partnerships. Selected new partners included Cox Communications, 02 in the UK, Sovereign Bank, Covad, HansaNET and VersaTel in Germany. At Dell, we will be default and recommended security partner from November 2007 through January 2008 in all Dell regions except the U.S.
In addition, siteAdvisor downloads have now crossed the 90 million mark. We are well on our way to exceeding the 100 million download goal we set for ourselves at the beginning of the year, and it establishes a strong base for our monetization plans. We fully expect that the combination of extended and new partners plus additional platforms for the web and mobile will help drive our future growth in the consumer business.
Turning to the mid-market business, revenue again grew double-digits year over year for the third consecutive quarter and sales of the Total Protection Solution called TOPS to the mid-market grew more than 170% year over year.
In our enterprise segment, as I mentioned earlier, we had eight deals over $1 million including our largest deal ever where we displaced a major competitor. We had an additional 85 enterprise competitive displacements, up from 56 last quarter adding nearly 1 million more nodes during the quarter.
Our security risk management offering continued to gain broad market acceptance with large accounts such as the U.S. Department of Commerce and USDA and Gannett. We are pleased to announce additional growth drivers for our services businesses, as well, including the launch of two new major support programs for our enterprise customers. This came as a direct result of the feedback from our customers and partners. The pilot programs have just rolled out with excellent feedback to date. McAfee continues to enjoy high service renewal rates in excess of 90%.
Lastly, McAfee is now the only company to offer data protection management integrated under a centralized management console called ePO. This was a catalyst for several significant transactions during the quarter. We look forward to additional integrations of SafeBoot in the ePO, further enhancing our data protection business unit which will be led by SafeBoot’s talented CEO, Gerhard Watzinger.
With a little over two months left in 2007, we continue to work hard on the initiatives that we have outlined for you this afternoon, and we are working hard to end 2007 with 12 consecutive quarters of record revenue.
We're completing our 2008 plan and I look forward to sharing our business strategies and financial guidance with you in early February. Thank you for joining us this afternoon and we'll turn it over to the operator to answer your questions.
Thanks, Dave. Before the operator polls for questions, I would like to inform you that McAfee will be presenting at the Goldman Sachs conference in New York City on Tuesday, November 6, the UBS conference in New York City on Tuesday November 13th and the Lehman Brothers conference in San Francisco on Wednesday, December 5.
Operator, please poll for questions. In the interest of time, limit yourself to one question. Thanks.
McAfee, Inc. (MFE) Q3 2007 Earnings Call October 25, 2007 4:30 PM ET
(Operator Instructions) Your first question comes from Rob Owens - Pacific Crest.
Rob Owens - Pacific Crest
Good afternoon, everyone. Can you talk a little bit about the operating margin performance in the quarter? You gave the headcount numbers they are up quarter over quarter, but yet you are finding a lot of efficiencies here. What is driving some of that?
I think that obviously we're striving to improve the operating margin. We've mentioned it a couple of quarters past where we've had some excess costs in a couple of areas, G&A we've had outside service fees a bit higher than we would have liked at different times. We have also had ups and downs in the marketing spend.
What we're trying to do is again get G&A efficiencies as we move through temporal issues. Secondly, in regards to marketing, we have the opportunities I think for efficiency, we have a pretty healthy marketing budget but we're starting to see much greater efficiencies by consolidating vendors to have much more impactful programs. I think we saw a little bit of that in this past quarter.
The one area where we do expect to spend a bit of more money in terms of OpEx in the future is in sales capacity. We see a lot of opportunities and in all geographies around the world we're expecting to add direct quota carrying capacity given the ever-increasing demand for the integrated SRM solutions that we offer.
So there are some savings in some areas but again we see opportunities to spend a bit more in the sales area. All in, again, we're looking again to drive towards higher operating margins; year-to-date the first nine months we're just about at the 25% mark for non-GAAP operating margins. So we have made good progress versus the first nine months of last year.
I would also add, one of the first things I came in here to McAfee and tried to do was look at accountability and segmentation as a way of really driving and improving on the operating efficiencies of the company. We spent a significant amount of time in the first couple of months really trying to understand how do we understand where the efficiencies could be gained, putting in programs to drive it. Eric just mentioned some of the marketing programs, G&A programs and just trying to make sure we've leveraged the dollars that we're spending, and at the same time holding individuals accountable for their businesses.
We now have a matrix we call 3 x5x3. It has three segments, five geographies and three product lines. We have leaders in each one that have a P&L and each one is there to make their businesses more profitable. This is just getting good operational controls and continuing to drive them as the year goes on.
Your next question comes from Daniel Ives - FNB.
Daniel Ives – FNB
Hey, guys, solid quarter. Question with Q4 guidance, what is the revenue contribution from the SafeBoot?
We're not sure exactly what day we will close the transaction after clearing the regulatory approval. There is obviously a fair amount of estimation involved here.
The second comment I would make is that SafeBoot to-date standalone has operated under more of an upfront revenue model. We expect to shift it more to a ratable model and to the extent that they have balance sheet defers that we have to writedown as well in the process. Given all of those factors, we're expecting the revenue contribution for the stub period of Q4 to be de minimus for SafeBoot.
Daniel Ives - FNB
You talked about the largest deal in the history, large deals are going very solid. Do you expect that trend to continue given what you guys have done on the product perspective. Dave, what are you hearing from customers? Is that a trend you expect to continue into '08?
I do. I mentioned I was optimistic about the outlook. We had closed multiple multi-million dollar deals already in Q4. The sales teams are working hard. This is a good quarter for IT spend and certainly a good quarter for McAfee. So I'm encouraged. The pipeline is building. You probably saw North America was kind of our weakest theater, if you will, but we put in some great management in North America now with Joe Sexton coming in as well as a number of other good executives. I am optimistic that we are improving our model there. We're going after larger transactions as well as a number of transactions. So, I see a trend continuing.
Your next question will come from the Todd Raker - Deutsche Bank.
Todd Raker - Deutsche Bank
Hi, guys, nice quarter. I was hoping you could give a little more insight competitively now that Symantec has 11.0 is shipping. I know you have talked about forklift upgrades and some opportunity to pick up market share. Now that the product is out there, can you quantify where you see your advantage is, vis-a-vis the new Symantec product?
Sure Todd, this is Dave. I couldn't resist the forklift word after their earnings call yesterday. But we still see a lot of competitive favorability on our side. I mentioned specifically the number of competitive displacements going from 56 to 85, nearly 1 million nodes. We have the suites fully integrated, our TOPS product and as you know we have TOPS for consumer all the way up to TOPS for enterprise. It is all managed through ePO as a single console architecture. We've now got with ePO 4 the data protection part included, DLP, which is a huge area for us to get management of data as a part of our endpoint strategy. We're working hard on SafeBoot now to get that integrated.
So I see the scalability of our platform for the endpoint as being a critical factor. We have some customers now with hundreds of thousands of nodes being managed by ePO. It is the scalability competitive side. It is the breadth of the suite, everything from the anti-virus side to the anti-threat with data protection, to the spyware, to the personal firewall to the HIPS environments, all integrated in one suite with one management console. It is a very elegant solution with a lot of cost efficiencies.
I was particularly proud, one of the areas I was watching closely for was how do the beta programs and production programs now go with ePO 4 and we were literally getting the customers upgraded and updated in hours, for tens of thousands of nodes. If you think about hours to deploy a major infrastructure component, it is pretty impressive.
So we're very excited about that and we really spent a considerable amount of time on this recent upgrade to make sure that the utilities for moving from the old versions to 3.X ePOs to the 4 were seamless and that is paying off. The Customer Summit verified that.
So I think we have got a good competitive wind behind our sails right now and it is coming down to execution. Can we execute? Will our salesforce really be able to take advantage of these technologies and so far the data is looking good.
Your next question will come from Phil Winslow - Credit Suisse.
Dennis Simpson for Phil Winslow - Credit Suisse
I was wondering if you could comment on the trends in the SMB market and also how some of the programs to improve that channel are tracking?
This was the first year that we really put in some accountability into this segment and the results are starting to prove successful. We have a gentleman, [Dell Rodenborough] who has really built us a combination largely of telesales but a little bit of a field sales model and we focused it entirely on the channel and making sure we can create leverage there.
Eric talked a little bit about some of the growth, double-digit growth again, three quarters in a row in that mid-market segment and we have a good product line here. TOPS for SMB as well as some managed services around the SaaS model. As you know, we took advantage of the consumer model that team had built to leverage upward into the SMB. So the combination of accountability there with the team, coupled with the leverage of our SaaS model has given us some opportunity to continue to grow that.
We also leveraged some offshore resources with India in a combination to really make sure the cost was in check. I'm optimistic there is a lot of green field. We have a new product line called the SIG 3000 which is our lower end appliances really designed for the few thousand dollar category to go after some of this market. We just introduced the virtual appliance and delivery model so that we could speed up the time to get the content and get the product to our customers, real important in SMB. We see some real opportunity over time and we're going to do our best to win that market.
Your next question will come from Heather Bellini - UBS.
Heather Bellini - UBS
I just wanted to clarify one thing. I had a couple questions emailed to me. In terms of the large deal that was signed in the quarter, Eric, did you recognize any revenue from that in the quarter, or did most of that go into deferred?
It went into deferred and it was a combination of contribution to short-term as well as long-term deferred, given the magnitude of the transaction.
Heather Bellini - UBS
I know you guys don't like to set margin expectations looking out further down the road but you clearly have outperformed over the course of the last year or so. I'm just wondering if you could help us calibrate how to think about how much more efficiency you might be able to see in the business, especially as you're outperforming on the top line.
I think that we'll get some natural efficiencies here. As you know, we're dealing with some temporal issues that have tended to keep our outside services fees a bit higher than we would like. Those will work those out in the short term. So that is going to will provide some natural leverage.
We found ways to be much more effective in terms of our total marketing dollar spend here. So I think that's going to be an opportunity. But what we're seeing here is two types of opportunities. The organic opportunities we see with the product portfolio now, endpoint encryption coming into that. We see the opportunity to deploy more quota carrying capacity out in all the geographies. So we are going to build these teams because we know that they're going to be highly profitable.
I think that as we work through the restatement of the legal issues, we'll produce leverage on G&A. Internally we're going with that. Marketing efficiencies, sales opportunities, we're operating at 24.9% non-GAAP operating margin through the first nine months of 2007 and that's pretty consistent with the mid-20s targets we've had out there for some time. But we think we can likely do a bit better here over time.
Your next question comes from John Walsh - Citi.
John Walsh - Citi
Good afternoon, guys. Can you talk about the international market versus North America and why the disparity in the growth, and maybe where that came in relative to plan with the U.S. being only up 2%?
We've had a good strong several quarters now of international growth, this quarter being 25% again. This is an area we're executing well. We set up a lot of accountable in the four theaters that we consider international. those being EMEA, Latin America, Asia and Japan. We have good leadership there, we have good momentum there. The momentum is spread across both our consumer mid-market and enterprise business, so we're operating well.
At the end of the day, execution is everything. I have been honest in the past that our North American business is probably where we need to continue to execute better. We brought in a lot of staff there and we've really tried to work on that and we're starting to see those results and we'll continue to see some upside in our growth opportunities there.
I don't see anything market wise, I don't see anything from an industry point of view that suggests that North America is different for us as an opportunity than international. But this is a scenario where you do see a little bit more computing power and capacity coming online in these emerging markets and we're taking advantage of that. McAfee is a pretty global company. I was attracted to SafeBoot because of the international side of SafeBoot. I think we said this on the call but SafeBoot is offered in 22 languages. They're operating in 70-plus countries already. They thought about being a global company first and they did a good job of that. They've got a nice footprint in Japan, a nice footprint in Eastern Europe. They have a footprint in most of the major regions that can help us with growth and take advantage of some of the things we're already doing internationally while at the same time giving us upside in North America.
This is an execution game for us in North America and we're working hard on it.
Your next question will come from the line of Sterling Auty - JP Morgan.
Sterling Auty - JP Morgan
I wonder if you can go into a little bit on the deferred revenue? It looks like the total deferred revenue growth finally reaccelerated after quite some time. Can you talk to us about whether it was the mix of contracts, mix of products sold, or just a little bit more color on deferred revenue?
We had a pretty good as-predicted close to our quarter, so I think that helped in terms of getting all the deals across the finish line in a timely manner, so that helped. As noted, the larger transactions that we did in the quarter was basically all deferred, so that's going to contribute a little bit to the build there, both in short term and long term.
The metric we give in terms of the amount of revenue in the quarter coming off the balance sheet, 85%, that's relatively consistent with what we have seen in the last couple of quarters, so really no change in the model. Nothing unusual to report, other than good execution year over year in terms of the big deals. We're able to upsize some more transactions, we're starting to get what we would characterize as standardization and architecture wins.
Again, with a stress tested version project version 4, powered by ePO, we have the ability on a per node basis to do larger deals over multiple periods of time across multiple endpoint products. That all helps to driving deal velocity and also building deferred. But again, no net change in anything else in the business in terms of the recognition model. It is all status quo sequentially.
Your next question will come from the line of Derek Bingham – Goldman Sachs.
Derek Bingham – Goldman Sachs
First, I just wanted to get your thoughts on the gross margin outlook and you mentioned some of the things that caused it to come down a little bit, hardware sales and some of the consumer OEM agreements. Could you give some color about where we should expect that to trend?
Gross profit margins came down a little bit sequentially, about 1.5 points or so, a little bit more than that. What we're seeing is back to the comments in mid-market where we typically can sell either the managed service or the SCM appliances, SIG 3000, et cetera. We are having good results on the hardware side. Again, there is a physical cost of goods component associated with that.
We're doing also larger hardware deals both with SCM and intruShield and again as those deals get larger they tend to be discounted a bit more in a linear fashion; that is as expected and those compress the gross profit margins a bit as well.
So no change in, for example, a per unit cost of goods structure. If anything, we do a bit better quarter over quarter. It is a function of a bit more mix in hardware, success in mid-market and slightly larger transactions on the physical appliances side.
The other factor contributing to this is, again, with our partner-led model we have a lot of rev share that is continuing to drive the growth in consumer and so the rev share component for that is factored into the gross profit margin percentage we report.
Derek Bingham – Goldman Sachs
The rev shares are what kind of deals? Are they OEM deals or ISP deals?
Typically PC OEM deals. But pricing, I think the important comment here is that pricing is steady and if anything, I would say the impact here sequentially is really a bit more oriented towards the hardware mix where we're having a bit more success in the segments than we noted.
I'll also say that we are very conscious of that and obviously these virtual appliance approaches and alternate delivery models are things we can do to put in place, but they're brand new and we just launched – in fact, we just showed a press release last week around our virtual delivery model. So this is an area that we would like to come up with new creative ways to distribute the technology, maybe soften some of that and make sure we're focused on improving that.
Your next question will come from the line of Israel Hernandez - Lehman Brothers.
Israel Hernandez - Lehman Brothers
The question I have is on the consumer business, which grew I think it was about 14% in the quarter, outpacing your largest competitor there. Is there any reason to believe that type of growth in the mid-teens isn't sustainable over the next several quarters? Or is there something around pricing we should be aware of that would perhaps lead us to a lower number? Thanks.
I wouldn't comment necessarily on what the trend is there, but I will say that I took particular note to talk about some of the drivers that we do have in consumer. We're very excited about the triple-play launch that we did. We're really the first one to really come out with both web mobile and the areas of the PC, and it is really the same environment, single suite approaches using our SaaS model to go after that. We just had a pretty big refresh, big upgrade on Falcon release, our 2.0 release. This was getting out to millions of users at this point and it just kicked in. So we're getting it out to the retailers, getting it out to the OEMs and I hope that is a little bit of catalyst for us.
I mentioned the siteAdvisor area. We reached 90 million downloads. That is amazing, nobody gets to 90 million downloads; this company had about 500,000 downloads about 16 to 18 months ago. We reached 90 million. We are going to hit a 100 million here shortly. There is a real opportunity to monetize that and we'll talk some more as we go forward there.
But this is a nice set of things that we can continue to do. I'd also offer that SafeBoot really creates some opportunity for us across triple play as well. While SafeBoot as a company prior to working with McAfee did not go after consumer, they have multiple consumer products and I believe that mobile encryption is an interesting area. We see the loss of cell phones all the time in the consumer markets and people want to look to protect them. We can take advantage of some of those opportunities as part of our triple play.
So we're continuing to really focus in on growth drivers there and make sure we're driving that. The results have been good so far.
Your next question comes from Walter Pritchard - Cowen.
Walter Pritchard - Cowen
Dave, maybe you could update us on TOPS and that opportunity. How far away or how far through the base are you in upgrading and what your expectations around Q4 are with TOPS and the upgrade, given that's a big renewal quarter?
Walter, that was a very insightful question because when I look at my strategy and I look at what I have for opportunity you just nailed probably the biggest one we have. A large portion of our install base continues to be one, two, three, product kinds of install base. We have a multitude of products that are integrated in a single agent, single console model and with going after the install base with upgrades and cross sells is a big opportunity for us.
So we made progress and we're continuing to make progress, but I think we have a lot more we can be doing there to capitalize on revenue growth for the company. We're going after that.
I think you also saw that we've offered and opened up ePO so that I can manage and potentially be able to cross-sell into our competitors' bases by having ePO manage their product lines as well. So this is a big part of our strategy, to focus in on that and we have really got a fourth generation product out there that has received good feedback and this is a top priority. Good insightful question.
Your next question comes from Sterling Auty – JP Morgan.
Sterling Auty – JP Morgan
Earlier in the year you re-focused the sales incentives around, rather than just maintenance renewals but driving the new product sales. I'm curious now it has been there for a couple of quarters, what the experience is and how important is that to driving some of these larger deals?
Sterling, good question. I think this was one of the important areas the company took upon itself, and giving credit to Eric and Roger and other folks who started that before I even came. But it is paying off. We're seeing that we're able to continue our high renewal rates and capture the renewal revenues through a lower cost model, and then getting our higher cost field sales focused in on the products, the new product bookings and going after displacements and making sure they're gone after larger deals.
So what have we seen? Last quarter was 11 deals over $1 million, this quarter eight deals over 41 million. We are picking that up. We're getting stronger growth on the product side and we're continuing to make sure that the salesforce is incented that way.
This is a little bit of evolution. We have a couple of data points now that shows that the direction is working and the accountability is there. But it takes a bit of time and I also talked about adding more capacity and so did Eric, and we want to continue to drive that at a low cost and leveraging offshore was a key component to this so we can offer a combination of business, both onshore in the Americas, as well as offshore in locations like India, coupled with our channel, coupled with the field, and that multi-prong approach to driving those product sales is really a good avenue for us. So the data points are there so far and we're hoping to keep improving on them.
Your next question will come from Matt Hidburg - RBC Capital Markets.
Matt Hidburg - RBC Capital Markets
Eric, as a follow-up to a couple of earlier questions on deferred, obviously a very, very strong build in deferred and with DSOs in line with expectations, can you talk about linearity within the quarter?
The quarter closed, the best way to characterize it is as expected. DSOs, roughly the same, year-over-year. Again, we're under a bit less pressure given the amount of revenue we have coming off the balance sheet, we're under a bit less pressure. We're getting better management of the pipeline and the forecasting that we do intra-quarter; that is something that Dave put in place when he arrived here.
The net effect of this is that we see large deals and the opportunity to upsize large deals much earlier in the quarter and we can hire or assign team accountability to close those deals. We're seeing a little more predictability with this new approach to the McAfee corporate business.
I think all of these things help maintain linearity without any extraordinary differences in Q3, versus what we've seen in prior quarters.
Your next question comes from Michael Turits - Raymond James.
Michael Turits - Raymond James
In the past bookings growth had seemed to lag revenue growth although accelerating, obviously a huge quarter on deferred. When you strip out that piece of long term that came from the large deal, do you feel like your bookings' growth is now pretty much on par with revenue growth?
Well again, the revenue plus the change in deferred is kind of a proxy; we don't necessarily endorse it. Nor is it necessarily the right thing to do to strip out one component of deferred to keep the other.
I think what's important to note here is that there are opportunities to do these larger multi-year contract commitments. We have very sophisticated tracking systems to make sure that we're not discounting too aggressively to win the multi-year deals and that is something that we all look at.
So to the extent that we're actually doing these larger enterprise deals as we did in this quarter and adding some long-term deferred, that doesn't indicate an uncontrollable lengthening of contracts or discounting. In fact, it is quite the contrary. It is indicative of more infrastructure sales, multi-year commitments and multiple endpoint products being managed.
So we look at the deferred build in the deals that caused the long-term add versus the short-term add, and again it is as expected and as we wanted it to occur during the third quarter of '07.
I'd like to say thank you to all of the participants who dialed in today. Obviously Q3 was a strong quarter for McAfee here. We look forward to continued improvement of the operating efficiencies and our growth, and look forward to talking to you again at the investor conferences as Kelsey outlined. Have yourselves a good day. Thank you very much.
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