SonicWALL Q3 2007 Earnings Call Transcript

Oct.29.07 | About: Sonic WALL (SNWL)

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


Anna Yen - IR

Matt Medeiros - President and CEO

Rob Selvi - VP and CFO


Robert Breza - RBC Markets

Sterling Auty - JP Morgan

Scott Zeller - Needham& Company


Good evening. My name is Teresa, and I will be yourconference operator today. At this time, I would like to welcome everyone tothe SonicWALL Third Quarter 2007 Earnings Conference Call. All lines have beenplaced on mute to prevent any background noise. After the speaker's remarksthere 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 conferencecall. With us today are Matt Medeiros, President and CEO of SonicWALL, and RobSelvi, CFO. Before we begin, I would like to remind everyone that during thiscall we will be making forward-looking statements within the meaning of section27A of the Securities Act of 1933 as amended, and section 21E of the SecuritiesExchange Act of 1934 as amended.

Forward-looking statements include without limitation,revenue guidance for the fourth quarter of 2007, our expected GAAP and non-GAAPearnings fourth quarter of 2007, expected non-GAAP gross margin for the fourthquarter of 2007, expected revenue from Aventail product and services for thefourth quarter of 2007, the benefits of our integrated solutions strategy, theimplementation of our solutions strategy across all pipelines, the benefitsassociations with the growth of our deferred revenue, the expansion of ourglobal channel organization in developing market, market acceptance of our TZ180 solution, growth prospects for our backup and recovery business, marketacceptance of our comprehensive email solution and new networks securitysolutions and growth opportunities provided by our integrated solutionoffering.

All forward-looking statements made during this call aresubject to risks, uncertainties and assumptions that could cause actual resultsor events to differ materially from those contained in the forward-lookingstatements. For a detailed description of the risks and uncertainties thatcould cause actual results to differ materially from those expressed or impliedin these forward-looking statements, as well as the risks relating to ourbusiness in general, we refer you to the periodic reports that the company hasfiled from time-to-time with the SEC, including discussion in the risk factorsession of the company's annual report on Form 10-K for the year ended December31st, 2006 and on Form 10-Q for the subsequent period.

The company undertakes no obligation to update forward-lookingstatements at any time or for any reason. In addition the following informationincludes non-GAAP results, which exclude amortization of purchase technologyand the cost of goods sold, amortization of intangible assets and operatingexpense, restructuring charges and stock-based compensation expense. Please seeour website and our Form 8-K filed with the SEC earlier today forreconciliation 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 representing8.3% growth over second quarter of this year and 13% growth over the sameperiod last year. Pro forma earnings per share were $0.06, exceeding our Q3guidance.

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

The core business remains strong as evidence by the deferredrevenue line, which grew $16 million sequentially, despite the seasonalheadwinds typically associated with the third quarter. This represents growthin deferred revenue of 45% over the same period last year. The acceleration indeferred, driven by the growth in our subscription services business, furthervalidates the integrated solution strategy that we have been pursuing since2004 and are implanting across our product lines.

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

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

We had strong customer wins around the globe during thequarter, driven by strength in several markets. We achieved key wins in thetelecommunications sector, particularly in Asia.Chinamobile became SonicWALL customer in the Q3. And in India,BSNL, India'slargest telecom company and seventh largest in the world, purchased ourcomprehensive network security solution.

Governments across the world chose SonicWALL solution in thethird quarter. The French Ministry of Justice became a new customer, purchasingour email security solutions and a court system in Asia Pac chose our 3Gwireless 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 12institutions. SonicWALL has dedicated to further penetrating developing marketsthrough the expansion of our world class global channel organization. Duringthe quarter, we signed distribution agreement with Digital China, Redington in Indiaand RRC in Russia.We also entered into a relationship with First Distribution, our first majorchannel partner in South Africa.

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

Our backup and recovery business showed strong growth in thequarter, driven by feature set improvement to our site-to-site data replicationsolution replaced, released in late Q2. Demand for backup and recoverysolutions in Q3, met our expectations, and we continue to believe that growthprospects for this product line are excellent.

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

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

The initial release of SonicWall's new network securitysolution, 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. Thesolution is now shipping, and initial demand appears to be strong. The E-Classfamily of products more of which will be shipping this quarter represent thecombination of an aggressive development effort designed to round out ourhigh-end offerings.

These solutions demonstrate our commitment to growing withour customers and providing integrated security solutions that respond to theevolution of their business requirements. We are enthusiastic about the marketopportunity these products present and believe that there availability willprovide a catalyst for revenue growth.

On balance, it was a solid quarter for SonicWall. Wesuccessfully integrated another significant acquisition. We delivered strongfinancial performance resulting particularly in deferred revenue and operatingcash flow. We’ve reached the key product milestone with the shipment of the NSAE7500.

We continue to execute our strategy to drive customertowards integrated hardware and subscription services, solutions that willdeliver revenue growth in future periods.

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

Rob Selvi

Thanks, Matt, good afternoon. SonicWALL generated $51million in revenue in the third quarter 2007, in line with our previousguidance of $50 million to $52 million. Our product revenue mix wasapproximately 39% from the TZ product line, 31% from the PRO product line and31% from other products.

Total unit shipped in the quarter were 47,000 excluding thediscounted TZ 170 products. Unit shipments grew from 32,000 in the secondquarter 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 revenueunit volume to increase in the fourth quarter due to higher contribution fromTZ 180.

Product revenue of $25 million increased 8% sequentially and5% over the same period last year. License and services revenue at $26 millionincreased 9% sequentially and 21% over the same period last year. Thesequential increase in license and services revenue, was a result of increasedsales of comprehensive gateway security, customer support and e-mail securitysubscription services, the success of TZ 180 bundling program and VPN clientssoftware licensing.

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

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

Non-GAAP gross margin was 72.2% roughly in line with thesecond quarter and our previously stated expectations of 71% to 72%. For Q4 weexpect non-GAAP gross margin to be in the range of 71% to 72%. Non-GAAPoperating expenses were $33 million in the third quarter compared to $27.6million 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 isattributable primarily to compensation and related expenses associated with theAventail acquisition.

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

We recorded GAAP tax expenses related to income taxes of300,000 against GAAP pre-tax income of 50,000. For the quarter, non-GAAPexpense 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 primarilyassociated with expense in the stock option was approximately $3.3 million forthe 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 $0.04to $0.05 per share.

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

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

As Matt mentioned we had another strong cash flow quartergenerating $17 million in cash from operation. Total cash, cash equivalents andshort-term investments was $229.1 million. During the quarter, we spent $25million on the purchase of Aventail, and we used $19.7 million to repurchase2.3 million shares of our common stock. As of the end of the quarter, we haverepurchased a total of approximately 14 million shares and approximately 100million remains against total repurchase authorization of 200 million.

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

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

I'll now complete my comments with guidance for the fourthquarter of 2007. For the fourth quarter, we expect revenue in the range of $53million to $56 million, including revenue contributed from the Aventailacquisition of $4.5 million to $5 million. We expect earnings per share to bein the range of $0.06 to $0.07 per diluted share on a non-GAAP basis. On a GAAPbasis, inclusive of a total of approximately $4.6 million pre-tax of combinedamortization of purchase intangible assets and stock-based compensationexpense, 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 withrespect 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 strategyof providing integrated hardware and subscription service solutions that areeffective, easily used and affordable across all of our products and marketsegments. We've gone through an important evolution in the first three quartersof this year. At the beginning of 2007, we embarked upon an ambitiousdevelopment and investment plan to round out our product and service offerings.We committed to provide an integrated security solution that respond not onlyto the capacity needs of our customers but also to the growth of theirbusinesses and the evolution of their business requirements.

We are now positioned to deliver on these commitments withthe complete portfolio of best-in-class networking security, data protectionand e-mail security solutions, optimized to deliver and run softwaresubscription services.

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

We also anticipate continued adoption of our highperformance solutions including email security SSL, VPN and now are UTM, NSAproducts. These best in class high performance solutions provide a new streamof 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 OEMpartners based on strong reviews of its performance, giving SonicWALL anopportunity to further advance our position in the market, through strategicrelationships with key industry players.

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

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



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

Robert Breza - RBCMarkets

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

And then a question for you Rob, as you look at the deferredrevenue can you characterize how we should think about that rolling off thebalance sheet, maybe, not next quarter, but as we get in the 2008 and maybejust talk about some of the dynamics you are seeing a deferred revenue with thesuccess 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 ourprepared remarks we grew deferred revenue 21% sequentially and 44%year-over-year. We also mentioned that we went through a pretty exhaustiveproduct transition plan through the first three quarters of 2007. And we reallyare looking forward to Q4 as being kind of that quarter where we can start tosee unit growth again through the new products that we delivered in our UTMspace.

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

Rob Selvi

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

In terms of how to model that growth going forward it’s, Iwould say that the average aging of the subscriptions deferred revenue has beenmaintaining somewhat over the past few quarters, given the popularity ourmulti-year subscription services products. So that has an impact into thevelocity of the growth of subscription services revenue as a part of licenseand services revenue.

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

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

Robert Breza - RBCMarkets

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

Matt Medeiros

Thanks, Rob.


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

Sterling Auty - JPMorgan

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

Rob Selvi

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

Sterling Auty - JPMorgan

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, Iwould consider, sort of, acquired deferred revenue. We also generated posttransaction, its post to closing of transaction. New service sales they wereadded to deferred revenue, so the first number of $3.9 million was the acquireddeferred revenue than there was an additional $1.5 million in post acquisitionbillings that was added to deferred revenue as well.

Sterling Auty - JPMorgan

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

Rob Selvi

Exactly right.

Sterling Auty - JPMorgan

Okay. You made in your prepared remarks some descriptions interms of within subscription service you listed the bundle, the typical onesthat we are seeing for the last couple of quarter, but can give us more colorin terms of granularity, is it one or two things that are making up the bulk ofthe 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 comingfrom?

Rob Selvi

Yeah, the two principal components of the growth and subscriptionsdeferred revenue are support and the comprehensive gateway security EPMsolution.

Matt Medeiros

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

Sterling Auty - JPMorgan

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

Rob Selvi

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

Sterling Auty - JPMorgan

Okay. Last question on the unit item, is there a point likeyou talked about growth in the fourth quarter, is there kind of critical pointwhere you need to see that unit volumes start to pickup, so that you will getthe 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, whichis primarily driven by the unit volumes that we need based on the new productsthat we've introduced, the TZ180, the 190 and of course the entire NSA familythat we're introducing this quarter, and it’s a very critical part of it.

Sterling Auty - JPMorgan

Okay. Great, thank you.


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 aboutTZ 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 hadsome comments about backend recovery email security. But is the Aventailactually 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


Matt Medeiros

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

Scott Zeller - Needham & Company

And when you talked, you had the positive color on back ofrecovery email security. Could you tell a little more about that because exingout Aventail, I guess quarter-to-quarter, maybe the percentage breakdown wouldhave looked similar to last quarter perhaps. But you said that there was goodimprovement quarter-to-quarter with those two product categories?

Rob Selvi

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

Scott Zeller - Needham & Company

Okay, great. Thank you very much.

Matt Medeiros

Thanks, Scott.


There are no further questions at this time.

Matt Medeiros

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


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

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