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Executives

Anna Yen - IR

Matt Medeiros - President and CEO

Rob Selvi - VP and CFO

Analysts

Robert Breza - RBC Markets

Sterling Auty - JP Morgan

Scott Zeller - Needham & Company

SonicWALL Inc. (SNWL) Q3 2007 Earnings Call October 29, 2007 5:30 PM ET

Operator

Good evening. My name is Teresa, and I will be your conference operator today. At this time, I would like to welcome everyone to the SonicWALL Third Quarter 2007 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question-and- answer session. (Operator Instructions).

I would now like to turn the call over to Ms. Anna Yen, Director of Investor Relations. Ms. Yen, you may begin your conference.

Anna Yen

Thank you. Welcome to our third quarter 2007 earnings conference call. With us today are Matt Medeiros, President and CEO of SonicWALL, and Rob Selvi, CFO. Before we begin, I would like to remind everyone that during this call we will be making forward-looking statements within the meaning of section 27A of the Securities Act of 1933 as amended, and section 21E of the Securities Exchange Act of 1934 as amended.

Forward-looking statements include without limitation, revenue guidance for the fourth quarter of 2007, our expected GAAP and non-GAAP earnings fourth quarter of 2007, expected non-GAAP gross margin for the fourth quarter of 2007, expected revenue from Aventail product and services for the fourth quarter of 2007, the benefits of our integrated solutions strategy, the implementation of our solutions strategy across all pipelines, the benefits associations with the growth of our deferred revenue, the expansion of our global channel organization in developing market, market acceptance of our TZ 180 solution, growth prospects for our backup and recovery business, market acceptance of our comprehensive email solution and new networks security solutions and growth opportunities provided by our integrated solution offering.

All forward-looking statements made during this call are subject to risks, uncertainties and assumptions that could cause actual results or events to differ materially from those contained in the forward-looking statements. For a detailed description of the risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward-looking statements, as well as the risks relating to our business in general, we refer you to the periodic reports that the company has filed from time-to-time with the SEC, including discussion in the risk factor session of the company's annual report on Form 10-K for the year ended December 31st, 2006 and on Form 10-Q for the subsequent period.

The company undertakes no obligation to update forward-looking statements at any time or for any reason. In addition the following information includes non-GAAP results, which exclude amortization of purchase technology and the cost of goods sold, amortization of intangible assets and operating expense, restructuring charges and stock-based compensation expense. Please see our website and our Form 8-K filed with the SEC earlier today for reconciliation of non-GAAP and GAAP results.

Now let me hand it over to Matt.

Matt Medeiros

Thanks, Anna. Good afternoon and thank you for joining us. Earlier today we announced third quarter revenue of $51 million representing 8.3% growth over second quarter of this year and 13% growth over the same period last year. Pro forma earnings per share were $0.06, exceeding our Q3 guidance.

I will start with comments about the third quarter, before handing it over to Rob, who will provide financial details. We'll wrap up with what's ahead in the fourth quarter and take the questions.

The core business remains strong as evidence by the deferred revenue line, which grew $16 million sequentially, despite the seasonal headwinds typically associated with the third quarter. This represents growth in deferred revenue of 45% over the same period last year. The acceleration in deferred, driven by the growth in our subscription services business, further validates the integrated solution strategy that we have been pursuing since 2004 and are implanting across our product lines.

As you know, growth in deferred revenue improves our downstream visibility and predictability. It delivers a positive cash flow impact and provides us with the recurring revenue stream in future periods. And it is an indicator of the strength of our core business that may not be obvious to the top line.

Aventail closed in early July, and we are pleased with the hardware and subscription services contribution, the acquisition made to our third quarter results. We have successfully completed the engineering, marketing, IT systems integration, and the solutions are now in worldwide distribution.

We had strong customer wins around the globe during the quarter, driven by strength in several markets. We achieved key wins in the telecommunications sector, particularly in Asia. China mobile became SonicWALL customer in the Q3. And in India, BSNL, India's largest telecom company and seventh largest in the world, purchased our comprehensive network security solution.

Governments across the world chose SonicWALL solution in the third quarter. The French Ministry of Justice became a new customer, purchasing our email security solutions and a court system in Asia Pac chose our 3G wireless solutions for their wireless infrastructure needs.

Education was also strong for us across the U.S. In the third quarter, we signed contract with MissouriState University, George MasonUniversity and the University of Southern California as well as several 8 to 12 institutions. SonicWALL has dedicated to further penetrating developing markets through the expansion of our world class global channel organization. During the quarter, we signed distribution agreement with Digital China, Redington in India and RRC in Russia. We also entered into a relationship with First Distribution, our first major channel partner in South Africa.

From a product standpoint, our network security business performed well, driven by strength in our organic SSL VPN products, as well as newly acquired product from Aventail. We were also pleased with the market acceptance of our new bundled TZ 180 solution. The TZ 180 doubled sequentially in terms of both units and revenue in the third quarter.

Our backup and recovery business showed strong growth in the quarter, driven by feature set improvement to our site-to-site data replication solution replaced, released in late Q2. Demand for backup and recovery solutions in Q3, met our expectations, and we continue to believe that growth prospects for this product line are excellent.

For years customers have relied up SonicWall solution for their data in transit. Now, customers expect the same performance, ease of use and affordability from our backup and recovery solutions that protect their data in raid and in risk, replacing legacy tape backup technologies.

Demand for SonicWall's email security solution also experienced robust growth in the third quarter. Email is a critical application and, of course, effective spam filtering is a key to any good offering. We are seeing a new generation of buyers who are looking for more from their email security. These buyers are enthusiastic about comprehensive email security solution that SonicWall provides, including not only best in class spam filtering but also compliance, anti-phishing, anti-virus and total email protection.

The initial release of SonicWall's new network security solution, the NSA E7500 was an important milestone for our high-end appliances. And we believe it will establish a new hide bar for ATM performance. The solution is now shipping, and initial demand appears to be strong. The E-Class family of products more of which will be shipping this quarter represent the combination of an aggressive development effort designed to round out our high-end offerings.

These solutions demonstrate our commitment to growing with our customers and providing integrated security solutions that respond to the evolution of their business requirements. We are enthusiastic about the market opportunity these products present and believe that there availability will provide a catalyst for revenue growth.

On balance, it was a solid quarter for SonicWall. We successfully integrated another significant acquisition. We delivered strong financial performance resulting particularly in deferred revenue and operating cash flow. We’ve reached the key product milestone with the shipment of the NSA E7500.

We continue to execute our strategy to drive customer towards integrated hardware and subscription services, solutions that will deliver revenue growth in future periods.

Now, let me turn it over to Rob to review our financial results.

Rob Selvi

Thanks, Matt, good afternoon. SonicWALL generated $51 million in revenue in the third quarter 2007, in line with our previous guidance of $50 million to $52 million. Our product revenue mix was approximately 39% from the TZ product line, 31% from the PRO product line and 31% from other products.

Total unit shipped in the quarter were 47,000 excluding the discounted TZ 170 products. Unit shipments grew from 32,000 in the second quarter to 46,000 in the third quarter, up 44% sequentially. As Matt mentioned, TZ 180 results more than double from Q2 to Q3. And we expect TZ total revenue unit volume to increase in the fourth quarter due to higher contribution from TZ 180.

Product revenue of $25 million increased 8% sequentially and 5% over the same period last year. License and services revenue at $26 million increased 9% sequentially and 21% over the same period last year. The sequential increase in license and services revenue, was a result of increased sales of comprehensive gateway security, customer support and e-mail security subscription services, the success of TZ 180 bundling program and VPN clients software licensing.

The year-over-year increase in licensing services revenue was primarily the result of increase sales of comprehensive gateway security, customer support and e-mail security subscription services. Multi-year subscriptions accounted for approximately 21% of subscription service billings in the third quarter.

Aventail contributed $3.9 million to revenue in the quarter and contributed to both product and services revenue. On a percentage basis, North America represented 69%, and international represented 31% to total revenue. Europe, the Middle East and Africa contributed 19%; Asia Pacific and Japan contributed 11%, and the remainder was contributed from other regions of the world.

Non-GAAP gross margin was 72.2% roughly in line with the second quarter and our previously stated expectations of 71% to 72%. For Q4 we expect non-GAAP gross margin to be in the range of 71% to 72%. Non-GAAP operating expenses were $33 million in the third quarter compared to $27.6 million in the prior quarter and $32.4 million in the same period last year. The increase in OpEx both quarter-over-quarter and year-over-year is attributable primarily to compensation and related expenses associated with the Aventail acquisition.

In terms of non-GAAP results, total operating expenses represented approximately 66% revenue for the quarter. Operating expenses for research and development represented 19.2% of revenue. Sales and marketing expenses representing 37.2% of revenue and general and administrative expenses represented 9.5% of revenue. At the end of the third quarter, total regular employee headcount was 631 compared to 482 at the end of the second quarter with the growth coming primarily from employees added from Aventail.

We recorded GAAP tax expenses related to income taxes of 300,000 against GAAP pre-tax income of 50,000. For the quarter, non-GAAP expense was $2.3 million against non-GAAP income before taxes at $6.2 million. GAAP loss for the third quarter was $300,000 or $0.0 per diluted share.

Stock-based compensation expense before tax primarily associated with expense in the stock option was approximately $3.3 million for the third quarter of 2007. Non-GAAP net earnings for the third quarter were $3.9 million or $0.06 per diluted share slightly ahead of our guidance of $0.04 to $0.05 per share.

Non-GAAP net earnings for third quarter exclude $2.2 million of amortization of purchased intangible assets and in process research and development and $3.3 million of stock-based compensation expense.

And now I'll review the balance sheet and cash flow statement.

As Matt mentioned we had another strong cash flow quarter generating $17 million in cash from operation. Total cash, cash equivalents and short-term investments was $229.1 million. During the quarter, we spent $25 million on the purchase of Aventail, and we used $19.7 million to repurchase 2.3 million shares of our common stock. As of the end of the quarter, we have repurchased a total of approximately 14 million shares and approximately 100 million remains against total repurchase authorization of 200 million.

Net accounts receivables were $22.5 million in the third quarter compared to $18.7 million in the prior quarter. DSO was 40 days compared to 36 days in the prior quarter. Net inventories were $5.1 million in the third quarter compared to $4.5 million in the previous quarter and $5.6 million in the same period last year. Net inventories consist of inventory at two of our top U.S. distributors and finished goods at our third party manufactures.

Total annualized inventory churn on a non-GAAP basis were 11 times, slightly less efficient than our performance in the prior quarter. Deferred revenue at $91.5 million increased 21% sequentially and 45% in comparison to the same period last year. $3.8 million of the $91.5 million deferred revenue balance was assumed from the Aventail acquisition.

I'll now complete my comments with guidance for the fourth quarter of 2007. For the fourth quarter, we expect revenue in the range of $53 million to $56 million, including revenue contributed from the Aventail acquisition of $4.5 million to $5 million. We expect earnings per share to be in the range of $0.06 to $0.07 per diluted share on a non-GAAP basis. On a GAAP basis, inclusive of a total of approximately $4.6 million pre-tax of combined amortization of purchase intangible assets and stock-based compensation expense, we expect earnings per diluted share in the range of $0.01 to $0.02. This is the only statement SonicWALL will be giving during the quarter with respect to guidance unless a decision is made to provide an update.

Now, I will turn the call back over to Matt.

Matt Medeiros

Thanks Rob. SonicWALL continues to execute on the strategy of providing integrated hardware and subscription service solutions that are effective, easily used and affordable across all of our products and market segments. We've gone through an important evolution in the first three quarters of this year. At the beginning of 2007, we embarked upon an ambitious development and investment plan to round out our product and service offerings. We committed to provide an integrated security solution that respond not only to the capacity needs of our customers but also to the growth of their businesses and the evolution of their business requirements.

We are now positioned to deliver on these commitments with the complete portfolio of best-in-class networking security, data protection and e-mail security solutions, optimized to deliver and run software subscription services.

We are enthusiastic about the revenue growth opportunity provided by these new solutions in the fourth quarter and beyond. In the fourth quarter, we are looking forward to strengthen SMB, particularly in the TZ 180 product line, which just has earned great recognition by CMP, CRN has been best in class for SMB.

We also anticipate continued adoption of our high performance solutions including email security SSL, VPN and now are UTM, NSA products. These best in class high performance solutions provide a new stream of opportunity through our traditional channels.

And finally, we expect to see expansion of our partnerships. The E7500 has drawn great interest from new and existing channels and OEM partners based on strong reviews of its performance, giving SonicWALL an opportunity to further advance our position in the market, through strategic relationships with key industry players.

I want to thank employees, our board and our partners for a great quarter. And I know that we're all looking and working toward a continued strong performance in Q4. Before I turn the call over questions, I would like to remind you that we will be at the JP Morgan Conference in Boston and Goldman Sachs Conference in New York next week.

Thank you, and Teresa, if you can turn it open to questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Robert Breza with RBC Markets.

Robert Breza - RBC Markets

Hi, good afternoon; thanks for taking my question. Matt, one question, would love to just get your comments quickly when you look at the number of units are down year-over-year, how should we think about that going forward, and obviously you’re getting a good increase in your ASP.

And then a question for you Rob, as you look at the deferred revenue can you characterize how we should think about that rolling off the balance sheet, maybe, not next quarter, but as we get in the 2008 and maybe just talk about some of the dynamics you are seeing a deferred revenue with the success in cross of selling additional services? Thanks, guys.

Matt Medeiros

Yeah, Rob

Rob Selvi

Yeah, thanks Rob.

Matt Medeiros

You know, Rob. You know earlier and as inline with our prepared remarks we grew deferred revenue 21% sequentially and 44% year-over-year. We also mentioned that we went through a pretty exhaustive product transition plan through the first three quarters of 2007. And we really are looking forward to Q4 as being kind of that quarter where we can start to see unit growth again through the new products that we delivered in our UTM space.

The deferred revenue has been very important to us. It’s been a key objective of our strategy. And I do think that we've got that process well understood. And we certainly see unit return growth already taking shape. As I mentioned, we’ve doubled our unit sales from last quarter and the TZ 180, which is primarily that unit volume driver. So we’re pleased with our progress and we look for the opportunity for Q4 it really demonstrated in the terms of unit growth.

Rob Selvi

Yeah. In terms of deferred revenue, you know, we had about close $16 million of growth in deferred revenue in the quarter as saw Rob $15.9 million. The substantial majority is that growth was in the form of subscription services, so you are right, and expecting growth going forward in subscription services, particularly as this bugling strategy takes hold even further. And we continue to stay on the aggressive growth ramp and deferred revenue.

In terms of how to model that growth going forward it’s, I would say that the average aging of the subscriptions deferred revenue has been maintaining somewhat over the past few quarters, given the popularity our multi-year subscription services products. So that has an impact into the velocity of the growth of subscription services revenue as a part of license and services revenue.

And then, of course, there is the license component, which is the smaller component of license and services revenue, but that has been relatively flat over the last couple quarters. And whether or not we see resurgence in that is dependent upon the number of factors. So, it's hard to give you a specific guidance going forward, but you can expect to see growth.

In this particular quarter, we had the additional impact of having the Aventail deferred revenue as part of the deferred revenue beginning balance have rolled off, you know, the balance sheet. And that was added to license and services revenue by about $1.3 million. Now, of course, next quarter we'll continue to have that component, but we won’t have the incremental benefit of that one-time growth step provided by Aventail.

Robert Breza - RBC Markets

That's great. That's very helpful. Thanks, guys.

Matt Medeiros

Thanks, Rob.

Operator

Our next question comes from Sterling Auty with JP. Morgan.

Sterling Auty - JP Morgan

Yeah, thanks guys. Just want to follow-on couple of those questions. So again, there was $16 million increase quarter-on-quarter in deferred revenue, you said what $3.8 million of that which from Aventail, for the bulk of it was organic?

Rob Selvi

I said, yeah, $3.9 million was Aventail, and the remainder was organic.

Sterling Auty - JP Morgan

Okay. And then, within the subscription services, you know, you kind of watch your list in…

Rob Selvi

Let me just be more clear about that. So $3.9 million, I would consider, sort of, acquired deferred revenue. We also generated post transaction, its post to closing of transaction. New service sales they were added to deferred revenue, so the first number of $3.9 million was the acquired deferred revenue than there was an additional $1.5 million in post acquisition billings that was added to deferred revenue as well.

Sterling Auty - JP Morgan

Okay. So $1.5 million from kind of Aventail piece that they probably would have generated, or you are able to generate on billed business once its was once it was part of SonicWALL.

Rob Selvi

Exactly right.

Sterling Auty - JP Morgan

Okay. You made in your prepared remarks some descriptions in terms of within subscription service you listed the bundle, the typical ones that we are seeing for the last couple of quarter, but can give us more color in terms of granularity, is it one or two things that are making up the bulk of the incremental growth because it was a very big jump in the deferred revenue, just want to get a better, ascertain a little bit better where its is coming from?

Rob Selvi

Yeah, the two principal components of the growth and subscriptions deferred revenue are support and the comprehensive gateway security EPM solution.

Matt Medeiros

Of course in the support bundle, it includes all of our firmware updates, so that’s a critical; it’s a critical software update that goes on to re-profile all of the products.

Sterling Auty - JP Morgan

And is there a comparison with TZ180 versus the TZ170 in terms of change in that bundle why the timing, why we would see this jump this quarter?

Rob Selvi

Well, it’s 100% bundled with the TZ180 sterling so that's the single largest contributor, is the fact that there is mandatory bundle with the TZ180.

Sterling Auty - JP Morgan

Okay. Last question on the unit item, is there a point like you talked about growth in the fourth quarter, is there kind of critical point where you need to see that unit volumes start to pickup, so that you will get the pull through on the services and the kind of raise your voice model?

Rob Selvi

Well, I think that’s a very important part of our guidance. I mean we're guiding a 17% year-over-year growth in the fourth quarter, which is primarily driven by the unit volumes that we need based on the new products that we've introduced, the TZ180, the 190 and of course the entire NSA family that we're introducing this quarter, and it’s a very critical part of it.

Sterling Auty - JP Morgan

Okay. Great, thank you.

Operator

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

Scott Zeller - Needham & Company

Hi, thank you.

Matt Medeiros

Hey, Scott.

Scott Zeller - Needham & Company

How are you doing?

Matt Medeiros

Doing well.

Scott Zeller - Needham & Company

Regarding the product revenue breakdown, could you tell us about TZ PRO and other, what this must have look like exing out Aventail because, obviously, nice increase quarter-to-quarter in the other category, and you had some comments about backend recovery email security. But is the Aventail actually included in the other category in the calculation?

Matt Medeiros

Yes, Aventail is the other category of new TZ PRO and other.

Scott Zeller - Needham & Company

Okay.

Matt Medeiros

So, almost a definition has to be given, but yeah, so Aventail contribute $3.9 million and we didn’t really provided a breakdown of its contribution hardware versus licensing services.

Scott Zeller - Needham & Company

And when you talked, you had the positive color on back of recovery email security. Could you tell a little more about that because exing out Aventail, I guess quarter-to-quarter, maybe the percentage breakdown would have looked similar to last quarter perhaps. But you said that there was good improvement quarter-to-quarter with those two product categories?

Rob Selvi

Clearly on a unit basis, we showed substantial growth in the e-mail security quarter-over-quarter and we had a fairly good increase in quarter-over-quarter unit volume on CDP.

Scott Zeller - Needham & Company

Okay, great. Thank you very much.

Matt Medeiros

Thanks, Scott.

Operator

There are no further questions at this time.

Matt Medeiros

Okay. All right. Well, again thank you very much for the call and we look forward to talking with several of you on one on one. Thank you, Teresa.

Operator

This concludes today's conference. You may now disconnect.

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