Websense Q3 2007 Earnings Call Transcript

Websense Inc.(WBSN)

Q3 2007 Earnings Call

October 30, 2007 5:00 pm ET

Executives

Gene Hodges, CEO

Douglas Wride, President

Dudley Mendenhall, Senior Vice President and Chief Financial Officer

Becky Wheeler, Investor Relations Manager

Kate Patterson, Vice President Corporate Communications and Investor Relations

Analysts

Daniel Ives - Friedman Billings Ramsey

Samuel Wilson - JMP Securities

Sterling Auty - JP Morgan

Phil Rueppel - Wachovia Securities

Walter Pritchard - SG Cowen

Todd Raker - Deutsche Bank

Allan Winfield - Handley & Company

Jordan Roberts - Jefferies & Co.

Rob Owens - Pacific Crest Securities

Brian Essex - Morgan Stanley

Presentation

Operator

Good afternoon ladies and gentlemen and welcome to the Websense conference call. (Operator Instructions) And now I’d like to introduce your host, Miss Kate Patterson, Websense Vice President of Investor Relations.

Kate Patterson

Thank you. Good afternoon everyone and thank you for joining me to discuss our Q3 results. With me on the call today are Gene Hodges, Websense CEO; Doug Wride, President; Dudley Mendenhall, Senior Vice President and Chief Financial Officer; and Becky Wheeler, Investor Relations Manager. We will have three speakers today.

Before we begin let me remind you that during this conference call, management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties and other factors that may cause the company’s actual results to be materially different from historical results or any preliminary results expressed or implied during the call. The potential risks and uncertainties which contribute to the uncertain nature of these statements include, among others, risks associated with integrating acquired businesses and launching new product offerings; customer acceptance of the company’s services, products, fee structures in a changing market; the success of Websense brand development efforts; the volatile and competitive nature of the internet and security industries; changes in domestic and international market conditions; risks relating to the acquired use of cash for debt services; the risks of ongoing compliance with covenant in the senior credit facility; risks related to changes in accounting interpretations and other risks and uncertainties described in Websenses’ public filings with the Securities and Exchange Commission.

The information in this call related to financial results, projections and other forward-looking statements is based on current expectations, and we expressly disclaim any responsibilities to update forward-looking statements should circumstances change.

Our discussion also includes financial measures that are numerical measures that cannot be calculated in accordance with generally accepted accounting principles. The company believes that non-GAAP financial measures enhance investors’ ability to evaluate the company’s operating results and compare current operating results to its historical operating results.

In connection with the acquisition of SurfControl, Websense is in the process of converting SurfControl to historical financial statements, including September quarter results to US GAAP standards. For more information, please consult the press release that was issued this afternoon and which is also posted on the Investor Relations portion of the company’s website.

I will now turn the call over to Doug Wride

Douglas Wride

Good afternoon. I’d like to start by providing an acquisition update on what’s been happening in the twenty days since our last call, starting with an update with cost synergies. We continue on track to achieve the cost synergies outlined in our plan, approximately $10 million in this quarter, and $60 million during 2008.

The majority of these synergies relate to personnel related costs, between 70-80% of the Q4 and 2008 amount. Across the organization, the decisions related to personnel costs have already been made. Where legally allowed, all employees impacted between October 3, 2007 and December 31, 2008 have been informed of their situation and future with the combined company.

Some people were gone on October 3, although they remain on the payroll until the end of this month. Others stay through the end of the year, end of Q1, end of Q2, etcetera. Of course, many have been asked to stay and be part of Websense and the ongoing company.

Our April 2007 announced plan involved estimates of approximately 840 Websense employees and 620 SurfControl employees at the time of acquisition close. From a broad brush perspective, we expect to have reduced this number by about 190 by November 1, and another 60 by December 31. This number should reduce by roughly another 100 by June 30 of next year, and 50 more by the end of next year.

This reduction of approximately 400 people over 15 months will be offset by the hiring of about 100 people over the same 15 month time frame. Many of whom will be in lower cost locations. Please keep in mind that this approximately 50% net headcount reduction correlates to greater than a 50% cost reduction as a majority of the SurfControl executives were included in the reduction and they carry a higher dollar cost per employee than the average. Also, as said before, some of the cost reductions come from moving headcount to lower cost environments.

We are providing this general headcount information here to provide additional understanding of our efforts. We’ve been asked frequently about headcount by the investment community, however, the business is driven on labor and personnel costs, not headcount, so we plan to continue to report to you in the future about the cost savings, not necessarily the integration headcount metrics.

From an organizational standpoint, we’ve worked hard to be able to let every single person in our organization know their role in the combined company. We’ve strived to keep those roles uncomplicated and clear. With this in hand, their individual role is to focus and execute.

In order to provide some understanding on the organization and operation of the business, through this integration, let me provide the following: in our engineering organization, John McCormack has focused on rationalizing the two organizations.

Consistent with the product plans for integration and discontinuation, we are retaining and investing in a UK-based black spider group to accelerate the global demand for our on-demand business. We are retaining the email filtering team in Australia to support the email filter product and prepare for cross-sale into the Websense customer base.

We are transitioning engineering support for the SurfControl web filtering offerings and their associated database maintenance, from Northern California and the UK to China. Here is the situation: where headcount decreases, as we move from a development effort to a maintenance effort, plus we are moving the remaining headcount to a lower cost environment. We began staffing for these specific positions in China prior to the close of the acquisition, and the staffing process continues today.

Even with aggressive cost-containment, we are focused on customer retention and customer satisfaction. We’ve already initiated a customer satisfaction survey with the goal of creating a baseline metric and identifying specific areas where we can improve. Just after the close, we took calls from customers who complained of long wait times on SurfControl tech support calls in Q3. Through our coordinated effort, with a now combined team, we’ve significantly improved the call wait times and begun the process of fully integrating the tech support teams to provide true 24/7 global support.

The large pieces of the product roadmap are set; we’ve already outlined product integration plans, migration paths and future development objectives. To summarize, we will continue to develop the on-demand products and the main email filtering products. We will continue to renew and support SurfControl Webfilter and mobile filter but we will wind down new orders for these products this quarter.

There are a few products with smaller billing streams that will be discontinued. Our goal is to over communicate and to give customers ample time to migrate to other Websense products and the initial communications have already gone out to our customers and channel partners.

From a sales and marketing perspective, we are again focused on customer retention, minimizing the billings disynergies as a potent top line impact for our future results. We have delivered the product roadmap message and as we have done since this acquisition was announced, there is no reason for an existing customer to change because of this transaction.

The cross-selling opportunities are exciting, but we are focused our sales teams on staying in their lanes. Closure renewals, as there are a lot of these, particularly in this fourth quarter; if you are assigned to close new business then close your pipeline. Cross-selling will be expanded upon as our sales force and our channel continue their cross-training and the back office IT systems become better integrated.

Beginning Q1 next year, we should be selling an integrated product set through an integrated sales force. We’ve been pleased with some of the early product migration interest from SurfControl filtering customers, and we’ll continue to strive to earn the loyalty of the rest of the installed base.

Marketing programs have merged and we continue to improve our costs and effort efficiencies around the world. It will take a couple of quarters to unify our global messaging but many people are working hard to accomplish this goal.

As I said back on the 10^th, everyone within the sales and marketing organization knows their role. Those who have stayed with the team have their Q4 quotas, sales plans and new business cards. They are hard at it. We are focused on the Q4 renewals, first and foremost, so for the most part, sales reps have kept their existing territories and customers.

Total headcount across the combined sales and marketing organizations will continue to change in 2008, as we balance our efforts. But for the remainder of this year, it’s pretty much business as usual. We’re also maintaining the distribution relationships established by SurfControl and actively reviewing our plans for distribution for 2008.

SurfControl had a larger OEM effort than Websense has had, and we’ve begun the process of reviewing the many OEM arrangements. Many of these arrangements generated very little revenue and would not be considered strategic in nature. Those will be terminated as soon as practicable. Arrangements that have a positive P&L impact or are strategic in nature will be actively maintained.

From an IT perspective, everything was running effectively on day one: phones, internet, email, websites, customer channel communications – these are areas that you particularly notice when there are problems and take them for granted when they are not. We hardly noticed.

We continue to evaluate back office systems and we’ll choose best of breed and move to transition and then integration. Realistically, this will take through next year and maybe beyond. Our HR legal teams have been very busy all year, and similar to IT, they love and deserve to be recognized but prefer not to be noticed.

From the accounting and finance front, we retained key SurfControl people in these areas around the world and are maintaining independent systems and processes at this point. Over time, we will integrate our efforts into single systems.

Q3 was our first close of the new company, and as a result of good planning, it went fairly smoothly. With additional cross-training, this will only get better. We are working hard on the conversion of the historical SurfControl results to GAAP. As a UK-based company, they were under the International Financial Reporting Standards, IFRS. So things such as daily revenue recognition and contra-billings and revenue were not part of their accounting policies. We expect to have this complete in order to file our 8-K-A on time by December 17. The purchase accounting evaluation of deferred revenue write-down and asset valuations continue on the same timeline for that 17^th reporting date.

In summary, in Q4 it’s all about focus and execution. Transitional employees have all been given performance incentives to complete their part in the integration and Websense employees have clear goals. Bottom line: to date we are hitting virtually every integration target we set back in April. With that, I’ll turn it over to Dudley to elaborate on the Q3 results and guidance.

Dudley Mendenhall

Thanks Doug. Rather than go through all the metrics that are available on our website and the press release I will summarize a few areas: a review of Websense Q3 results, high-level review of SurfControl Q3 results and financial guidance for Q4 2007 and fiscal year 2008.

Looking at our core Websense business for the quarter, billings at $52.2 million were wider than expected due principally to an increased competition from SurfControl primarily in our North American renewal business. When you look at the combined company, total gross billings were just over $79 million, about what we expected.

When we look at the details, I feel comfortable that Websense core business remains healthy; although the consolidated growth has slowed to the single digit range, we are continuing to see double digit growth outside North America as an offset to low single digit growth in North America.

Highlights of the Websense stand-alone billings performance, this quarter included, continued strong performance in our international regions, with international billings up 16% year-over-year, and 23% year-to-date. We see growing momentum in our ILT business, which more than doubled sequentially to $1.6 million.

A minor decline in contract lengths by about ½ month to an average length of 23.1 months as 1-year contracts increase to 50% of total billings from 48% last quarter.

Please remember that Websense year-over-year comparisons are impacted by the accounting change we made last year in Q4, where we began booking costs associated with joint marketing programs as contra-billings rather than marketing expense. If this $1.7 million cost had been accounted for as marketing expense, billings would have been up by $570 thousand on a year-over-year basis. Starting with Q4 2007, we will have comparable accounting standards with previous quarters.

While US billings were down modestly year-over-year as previously stated, we believe this was primarily to increased competition from SurfControl in our renewal base. Our new business in the US showed healthy year-over-year growth, and our average contract value for our new filtering business was flat year-over-year, suggesting a stable pricing environment.

Net revenue of $50.4 million was up about 10% year-and-year and flat sequentially as the revenue growth rate continues to reflect the slower growth in billings. Operating expenses were up year-over-year due principally to higher sales and market R&D associated with our new initiatives in SMB and IOP and with growth in international. However on a sequential quarterly basis, expenses were basically flat as we are passed the heavy investment stage of the cycle and in an environment of slow billings growth, we are aggressively managing expense growth.

Cash flow from operations from the quarter was $13.9 million and is $37.6 million for the ninth month year-to-date. After the close and funding of the acquisition, we had about $100 million in cash. It is our expectations that pro-forma before restructuring costs, net operating cash flow in fiscal year 2008 will exceed fiscal year 2007 by at least $15 million. In 2008, net positive operating cash flow, coupled with approximately $100 million in cash resulting from the acquisition, will provide sufficient cash resources to accelerate debt repayment.

In summary for the quarter, we exceeded our non-GAAP diluted earnings per share, coming in at $0.24 versus guidance of $0.22-0.23.

In terms of SurfControl’s Q3 results, consistent with our estimates on October 10, SurfControl had billings of approximately $26.9 million, and they were slightly profitable on an operating basis, consistent with their Q2 results.

Keep in mind that SurfControl has historically reported its results under IFRS rather than GAAP, and approximately 10-15% of their revenue was for perpetual licenses. When we have completed that conversion we will provide you with combined pro-forma company results by mid-December, for the nine months ended September 30, 2007.

Moving onto to financial guidance for the fourth quarter and 2008, I want to start with a few presentation changes: after this quarter we will no longer provide quarterly guidance but rather we will provide annual guidance with quarterly updates, as quarterly variations are difficult to predict and not always the best way to manage the business. In an effort to help model potential quarterly variability, we have posted the combined Websense and SurfControl billings for the past four quarters on our investor website.

Secondly, now that we have included the acquisition and begun the complete integration of the SurfControl and Websense product suites, this will be the last time it will be meaningful to discuss results as if the companies were separate.

With that, let me move to the details on guidance for the rest of fiscal year 2007 and preliminary outlook for fiscal year 2008. Consistent with our past messages, we remain commitment to the accretion estimates that we had announced at the acquisition of SurfControl. $10 million of cost savings in Q4; $60 million in cost savings in 2008; 20% earnings accretion over Websense stand-alone; and $15 million cash flow accretion in 2008 for restructuring and other one-time costs associated with the acquisition.

I would also reiterate due to the outlook for soft billings growth in North America, we will aggressively manage expenses as an additional assurance that we are committed to achieving our original financial goals of the transaction.

The following are key assumptions in developing a combined forecast: in terms of billings, we are forecasting continued growth in new products in international, which will be offset by the discontinuation of smaller, non-strategic and unprofitable SurfControl product lines; possible synergies in the Surf customer base, as we transition renewal customers to the Websense product suite, and the total growth of our North America market which is still our largest segment.

The central theme of this acquisition is to grow cash flow and we will not sacrifice that objective by retaining or growing unprofitable product billings. Nevertheless, as we look beyond 2008, we expect that new products, cross-selling opportunities in international markets will become large enough to reinvigorate overall consolidated growth.

In terms of expenses, total S&A expenses for the combined company will of course decline in 2008 over a pro-forma presentation of 2007, due to cost reductions on the Surf side and that will leave us with an expense run rate that is in alignment with a slow growth billings environment.

One area where we will see a natural decline in expenses is in costs associated with moving to future distribution, as we indicated on October 10. Now that we have developed a full complement of resellers both in the US and abroad, these costs should now begin to scale and decline as a percentage of billings.

Additionally, we are adjusting our margin structures globally to provide maximum compensation for new business rather than renewals. After 2008, future expense growth will be rigorously tied to billings growth.

Revenues: this is currently the most difficult item for us to forecast due to various accounting treatments that must be applied to SurfControl’s revenues. SurfControl’s financials have been presented following IFRS rules, therefore a conversion to GAAP must be completed which will have an impact on both historical and future periods revenue. The IFRS to GAAP conversion will cover adjustments such as conversions from monthly to daily revenue recognition; spreading the perpetual license revenue over life of contract and contra-revenue; accounts for marketing payments and rebate channel partners.

Secondly, most of SurfControl’s deferred revenue balance will be written off in accordance with GAAP accounting. As it relates to Q4 and fiscal year 2008 guidance, our estimates are based on a preliminary assessment of GAAP revenue for the combined companies, prior to the write-off of deferred revenue at Surf. Therefore for the fourth quarter 2007, we are forecasting net billings in the range of $92-95 million; pro-forma revenues of $76-79 million; non-GAAP operating margin of 24-25%; non-GAAP EPS in the range of $0.20-0.23. This assumes an average tax rate of 35% and an average share count of 46 million shares.

I would note that our non-GAAP tax rate was unusually low in the third quarter at 29% due to the expiration of certain statutory reserves. For fiscal year 2008, we are forecasting net billings in the range of $330-345 million, reflecting single-digit growth for Websense and disynergies for SurfControl; pro-forma revenues of $305-320 million; non-GAAP operating margin in the range of 28-30%; non-GAAP diluted earnings per share o $1.10-1.17, and this assumes an average tax rate of 35% and an average share account of 47 million shares.

At this point, I will now turn the call over to Gene.

Gene Hodges

Thank you Dudley. Good afternoon. 2007 has been a year of rapid change for Websense. As the smoke clears, I’m very excited about our opportunities for 2008 and beyond. Our company is positioned to deliver increased profit and cash flow, while delivering one of the most compelling sets and solutions to customers you can find in the security market today.

As you heard to date, the SurfControl acquisition is going extremely well. This is Websense’s first large acquisition and after a protracted deal process that took almost a year, the integration process is going quite smoothly indeed.

IOP activity has also reenergized in Q3, as we’re learning to do suite selling with our security filtering products. We built and shipped the Express product in Q3 to grow our position in the mid-market, and complemented it with an efficient no-touch transaction system. We’ve expanded our partner base, both organically in terms of Surf acquisition to almost 5,000 resellers.

Our international sales remains strong in Q3, and we believe they will continue to grow throughout 2008. In fact in 2008, the combined company will see about 50% of billings coming from outside North America, so we are positioned to grow with those international markets.

Our 2008 plan reflects a different approach than we took in 2007. To ensure we deliver increased profit and cash flow, we will control expenses tightly rather than forward invest for top line growth. We believe the investments we’ve already made could result in more growth than is shown in our 2008 plan. But before we make additional investments, we’ll wait to see if this growth materializes.

The two biggest factors driving our plan for 2008 are the state of the core web filtering market and the expanded product set and distribution system we enjoy after the SurfControl acquisition. I’d like to give you a recap so you can see how we feel about those factors.

The health of the overall filtering market is one of your most frequently asked questions. Together Websense and SurfControl represented over 40% of the web filtering market, and therefore we think the performance of the combined company gives a pretty good indication where the market overall stands.

The third quarter was an unusual quarter in the web filtering market. Websense felt unusual price compression from SurfControl, especially in the North American enterprise customer area. We do not think we’ll see this negative impact again in Q4.

SurfControl performed well in a tough third quarter, exceeding our expectations. Most SurfControl sales representatives, feeling that they might lose their jobs and having low quota targets for the quarter, sold like there was no tomorrow. Part of that selling like there’s no tomorrow, especially in North America, was to pull some business forward to the future. We expect neither of these behaviors, both of which were positive, to SurfControl’s third quarter billings, to continue into the fourth quarter.

Given the third quarter was a bit unusual, we can learn more about the overall health of the market by looking at a longer term frame. When we compare the first nine months of ’06 with the first nine months of ’07, the total web filtering market growth, adding Websense and SurfControl together, was 3%. We do not see large market share shifts happening in the web filtering market, and we do not see large systematic pricing changes. The 3% growth rate is indicative of at least a lower bound on the overall market growth.

We believe that intense competition in the last two quarters, between the largest two players in the web filtering segment, probably did have some short term effect of decreasing growth both through price compression and defocus. Hence, the overall market growth rate for the web filtering segment is probably somewhat above the combined Websense and SurfControl growth rate, indicating an underlying market growth rate of probably somewhere around 5%.

At 5% a year, the web filtering market is not a rocket, but it is a slow and steady growth that generates steady cash flows. Websense offers the best technology and has the best developed distribution infrastructure and where we can right size the investment to make this business highly profitable.

We expect to lose some web filtering market share in 2008 due to disynergies in the SurfControl base. This results in us assuming an overall negative growth in the web filtering portion of our plan for 2008. The growth rate for web filtering should stabilize and then return to positive market growth rates by 2009.

The level of SurfControl disynergy as we see today is below what we planned, and therefore this represents an important potential upside to our 2008 plan.

To understand the potential growth opportunities of our expanded product line, it is most instructive to look at it through the eyes of a sales person or reseller and see what they will see as opportunity.

2008 looks like it could be a very good year to a Websense sales person or reseller. The product set is expanded and can now be positioned as a strategic security offering. The installed base has doubled and the reseller partner base has doubled as well from the start of 2007.

Today, we enjoy a customer base of 50,000 plus customers and have new products to sell to most of them, and remember on the Websense side, we had over an 85% satisfaction rate. For large enterprise customers, we have a strong combination of Websense Security Suite, ILP, and on-demand enterprise e-mail, all shipping now. These products will be integrated and enhanced throughout 2008, making our story even more compelling.

Our Websense resellers have an excellent opportunity to move up from selling point products, which is often the sales cycle focused predominantly on price, to value and suite selling of what we are calling intelligent content protection.

The customers we’ve discussed the intelligent content protection strategy with are definitely showing increased interest in Websense as a strategic security vendor. This gives our reps and resellers a reason to touch every one of our installed enterprise customers at a higher level in their organization than we have before, which simultaneously improves both retention rates and new business sales.

From medium sized businesses, we have Websense express and surfing mail filtering shipping now. We are working with our Australian e-mail engineering team to integrate Surf e-mail filtering with Websense express. Both will be sold through our recently developed no-touch transaction system, which is now in place in the U.S. with Websense express.

We will roll out this more efficient transaction system globally in the first half of 2008 for both of these exciting products.

In small businesses, we will lead with mail control and web defense, the SurfControl on-demand e-mail and web filtering products. These products will also be priced, packaged and distributed through our no-touch distribution approach for SMB. As we’ve said before, small business is mostly upside to both parts of the combined company and we’ll have a highly competitive product set and distribution methodology to address this opportunity by the second quarter of 2008.

For every size customer then around the world, there are several new sales opportunities for our reps and resellers to pursue. So our plan gives them lots of opportunity for upside in 2008.

We have assumed no billings growth in our plan and, given expected disynergies from the web filtering billings, we are right-sizing the expense structure accordingly. It is important for us to have numbers we can hit next year all year, and we feel confident we can meet this plan.

Our flat billings plan delivers increased cash flow and profits as we achieve savings in the combined company structure. In addition, we have growth opportunities that can help us overachieve by improving retention rates in the SurfControl base, continuing our international growth, increasing sales of the new products to SMB, and sales of hot new technologies in both information leak prevention and on-demand to large enterprise customers around the world.

Our 2008 plan can deliver increased shareholder value then in two ways; first by accelerating cash flow through tight cost controls in a combined company with slow growth, and secondly, generating additional cash if we can find growth in several potential areas to help us overachieve our top line.

Our team is excited and confident about our opportunities in 2008 after this year of rapid change and we hope that you will be too.

Now, we will turn the call back over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll go first to Daniel Ives with Friedman Billings Ramsey.

Daniel Ives - Friedman Billings Ramsey

Thanks. Where do you see the long-term operating margin potential of the combined company past ’08?

Gene Hodges

What we’ve said in the past is that we would target somewhere in the low 30% range. The company had higher margins historically but I think we were under-invested in future growth opportunities and clearly that’s something that we’ve had to make up for over the past 18 months or so.

Daniel Ives - Friedman Billings Ramsey

Given what happened this quarter with SurfControl competing with Websense, how have you tried to rectify that so that doesn’t happen again? And maybe you’ve kind of gone through [shutdown] with the channel -- could you just go through that and how we can have confidence that’s not going to happen again?

Gene Hodges

It’s very simple. We simply won’t grant the discounts. As we manage both sides of the organization, we are not going to grant a discount on one of our products which is being sold against another one, and that is within our right to do.

Daniel Ives - Friedman Billings Ramsey

Okay. Thanks.

Operator

Our next question comes from Samuel Wilson, JMP Securities.

Samuel Wilson - JMP Securities

Good afternoon, everyone. Three questions, one for Dudley; just real quickly, do you have a snapshot of the fourth quarter of what your net cash balance will be and the interest or the yield you expect to get on that? Just a rough guess of interest and other income for the fourth quarter.

Second, for Gene, it’s been now a couple of weeks since the close of the transaction. Obviously three weeks after your previous conference call. Have you noticed in general the use of [slice] not being a factor in the marketplace? And we’ll leave it that. Thank you.

Kate Patterson

Can you repeat the second question for Gene?

Samuel Wilson - JMP Securities

So it’s been -- when you first did your conference call, it sound a little bit like you were surprised by the behavior of the Surf guys after the close of the transaction and what occurred. It’s now been four weeks. I’m just wondering -- what’s pricing like in the market? Are you seeing it calm down like you thought it would post the close of the transaction?

Gene Hodges

Let me go ahead and take that one first. Obviously pricing remains highly competitive in the web filtering market, but we certainly won’t see the unusual pricing that we saw in the third quarter, and neither will we enjoy -- understand there is a plus and a minus here -- the let’s sell it because there’s no tomorrow drive factor that saw overachievement on the Surf side in Q3.

Dudley Mendenhall

In terms of the question on the cash balances, as we have said, post closing we had approximately $100 million in cash and on a permanent basis, we don’t expect that cash to go down. We expect that cash to build. That could be subject to some temporary working capital adjustment but I think it’s safe for you to start with $100 million and then build that cash balance according to your own model from a cash flow generation standpoint. And at some point, we will, of course, prepay debt but we’ve not provided any specifics on that at this point in time.

Samuel Wilson - JMP Securities

What was the total amount of debt again, the final debt number that you ended up taking down?

Dudley Mendenhall

$210 million.

Samuel Wilson - JMP Securities

Perfect. Thank you very much.

Operator

Our next question comes from Sterling Auty with JP Morgan.

Sterling Auty - JP Morgan

Thanks. A couple of questions; you kind of gave some color as to how you got to the billings guidance for ’08 but can you be willing to drill it down and say how much of that billings is the organic side, so we can get a sense as to what you think the contribution from Surf is?

Dudley Mendenhall

Again, we made some assumptions about disynergies and products that we would be discontinuing, so if you looked at it strictly today, Websense brand versus Surf brand, which again as we’ve emphasized, that will not be terribly meaningful going forward because of the product migration issues, certainly the sales decline would come out of a Surf brand, with Websense continuing to generate, call it mid-single digit organic growth.

Sterling Auty - JP Morgan

Okay, and around the BlackSpider product, what is your sense as to what you think contract lengths will do over the next couple of quarters or over the next four quarters as it’s under the Websense umbrella?

Gene Hodges

You know, we are incredibly bad at guessing contract lengths. Most of the BlackSpider contracts are one-year contracts, about 70%. One might guess that over the longer term, that market will take the type of dynamic that we’ve seen both in filtering and in antivirus before that as customers become comfortable with the vendor, they would move out to longer contract lengths. But frankly, we’re too new to this market to tell you if that’s going to occur this year or not.

Sterling Auty - JP Morgan

Okay, and last question, can you remind us, what is the interest rate on the debt and what should we think about kind of a quarterly interest expense on the debt load to be initially?

Dudley Mendenhall

The approximately blended LIBOR, including the swap that we have in place from a modeling standpoint today would be about 5%, and then we would have a LIBOR spread of 2.50 on top of that, so for modeling purposes, I think you are fairly safe assuming 7.25% to 7.5% all-in rate.

Operator

Our next question comes from Phil Rueppel with Wachovia Securities.

Phil Rueppel - Wachovia Securities

A couple of questions, thank you. First of all, for the move away from quarterly guidance in 2008, is that really -- is that based on the difficulty in predicting the transition and absorbing the SurfControl business? Or is it indicative of just a general change in your business that means it’s sort of less visible on a quarterly basis?

Dudley Mendenhall

Well, I think that there’s actually a third element, which is just that element that most companies have moved away from quarterly because it is very difficult to be precise and the market doesn’t always seem to be forgiving if you are not precise enough on a quarterly basis.

But I think it is a combination of all of the elements that you’ve mentioned. We do have a significant amount of product migration from Surf to the Websense side, and really didn’t want to spend a lot of time trying to be absolutely precise for you in terms of what the quarters might look like.

Douglas Wride

I would also add that traditionally, we would be giving Q407 only guidance, and we knew that as folks tried to put together their numbers for ’08, since this business has changed dramatically, we needed to give a little bit more information about that.

Phil Rueppel - Wachovia Securities

Okay, thanks.

Operator

Our next question comes from Walter Pritchard with SG Cowen.

Walter Pritchard - SG Cowen

I’m wondering if you guys -- you talked about renewals being a little weak this quarter, pressured by what seems like a one-time event. Can you maybe quantify the renewal rate for the September quarter on the Websense side?

Gene Hodges

The renewal rates, Walter, were at historical levels. We simply got lower prices on renewals in a vicious competitor with Surf.

Walter Pritchard - SG Cowen

And then just looking at the number of new seats, I guess, on a net basis, added about 900,000 sequentially. It looks like one of the best quarters you’ve had in terms of seat adds for about two years, and yet the billings were disappointing, which would indicate the pricing that you mentioned, Gene, but just in terms of seats, what does that seat add number tell us? Does that tell us a lot of deals? S&B really picking up and driving that volume, or was it large deals that drove that volume? Thanks.

Gene Hodges

The volume was predominantly driven by large deals and some of those were competitive takeaways where we were very price aggressive.

Operator

Our next question comes from Todd Raker from Deutsche Bank.

Todd Raker - Deutsche Bank

I was hoping you could quantify your expectations around DLP for the Q4 period and what we should be thinking this product line as we go into ’08, since you are talking about the annual growth profile of this company.

And could you give us a sense for how material BlackSpider is today?

Gene Hodges

We don’t want to guide to the individual product lines. We did say seven to 10 for the year for DLP and after our disappointing second quarter, we said we expected it to be at the lower end of that range and that’s also what we are shooting for.

BlackSpider last quarter was about $5.2 million in billings. The second calendar quarter, which was Surf’s fourth fiscal quarter, was about 5.5, I believe, so the annualized run-rate of that business is somewhat north of $20 million and the market growth rate has put my analysts at about 50%.

Todd Raker - Deutsche Bank

Okay, thanks, guys.

Operator

Our next question comes from Allan Winfield with Handley & Company.

Allan Winfield - Handley & Company

I was curious -- if you look at the IDC numbers on how fast web filtering is growing, in 2007 their prediction was 13% growth for the web filtering market and in anti-spyware, where I know you guys play a role, it’s supposed to be up 22%. Is there any way to reconcile that with what you said that the web filtering market -- you said about 5%?

Gene Hodges

I think the best way to reconcile it is some people who forecast the number have P&L responsibility and some don’t. I certainly understand how IDC derived their numbers, but we are in some very large percentage of the filtering, web filtering sales cycles around the globe and there are not nearly as many players in what they would categorize as their other category as we see. In other words, the market is somewhat more concentrated with secure being very tough and with Blue Coat having a slightly larger sale and with Surf and ourselves probably have a slightly larger share.

Douglas Wride

I would also say that it’s difficult to predict what the growth is going to be in the SMB space when it comes to filtering. We all acknowledge that there seems to be a largely untapped opportunity there, but what it’s yield is is more difficult to pull together. We think that we can grow nicely outside of North America. Our North American growth will be largely dependent upon how successful we are in that SMB space, or using the on-demand business as we deploy that into the U.S.

Operator

Our next question comes from Katherine Egbert with Jefferies & Co.

Jordan Roberts - Jefferies & Co.

Hi, this is actually Jordan Roberts in for Katherine. I was hoping you guys could just speak generally to the spending environment in North America.

Gene Hodges

We are pretty lousy macro economists. We did not see any impact that we would attribute to macro trends like the credit blip, except that it made closing our debt syndication a little bit crazy. So all in all, it seems to be a reasonably benign environment without signs of heating up to a big Q4 budget flush or going in to the deep freeze.

Operator

We go now to Rob Owens with Pacific Crest.

Rob Owens - Pacific Crest Securities

Gene, for the first part of this year, you talked about market growth yourself somewhere in the mid-teens. I’m just curious, what has changed for you? Is it a function of pricing? Is it a function of just unable to quantify a yield out of SMB? Are units just not where you thought they would be? Maybe just give us a little more color there.

Gene Hodges

I think it is, now having seen Surf’s books and our books and paid more attention to competitive encounters, so we know who is out there and there is significant competition in this market. We don’t see growth going somewhere else. When you look at the factors like appliances that might deliver e-mail and filtering, for example. They are popular but you are certainly not seeing an explosion of this market going to those guys.

Probably the biggest negative impact, and we’re really just learning about it, is in small business where we see very aggressive pricing patterns by guys like Barracuda and Sonic Wall, that there, we’re really kind of moving in to a territory where they’ve been and we haven’t.

Rob Owens - Pacific Crest Securities

So strategically, you are trying to consolidate a 5% growth opportunity. Do you think then Websense needs to look for other categories, other verticals to get into relatively soon?

Gene Hodges

No. I think first we need to make sure that this cash cow is healthy, and second, when I look down the list of growth opportunities that we have, the current secular growth rate may be 5% but I think SMB is a relatively untapped market and that an effective vendor could open that market up, which could raise that growth rate in ’09 or even in the second half of ’08, if we were able to execute well.

Operator

Our next question comes from Brian Essex with Morgan Stanley.

Brian Essex - Morgan Stanley

Good afternoon, guys. Sorry, I dropped the call so I apologize if some of this is repetitive, but I was wondering if you could offer a little bit of color around expectations for gross margin in a couple of fronts. One, the mix of the SurfControl products, particularly with BlackSpider now in the mix. And the other on the front of any room for upside to historical levels, whether it’s through SMB or any other efforts to your gross margin?

Dudley Mendenhall

We would expect gross margins to continue to track at the levels that they’ve been, low 90% levels. But part of this is this conversion for the Surf billings that will potentially change that.

But I think from a modeling standpoint, I think you are safe staying in that low 90% range.

Brian Essex - Morgan Stanley

Okay, and from a modeling standpoint, if we’re looking at average contract price or pricing dynamics going forward in the market, do you expect those to bounce back to where they were before the acquisition? Or do you think that maybe the dynamics around SurfControl last quarter kind of lowered the bar a little bit in the market?

Dudley Mendenhall

If you look at the smaller transactions that we are targeting and we’re talking about growth opportunities there, that’s going to drive the ASP up but it is going to reduce the deal size on an average basis. I do think that there were some aberrations in Q3 that created some negative pressure on deal size and I think that some of that will dissipate now that we are not really competing against ourselves driving dollars down.

Brian Essex - Morgan Stanley

Okay, great. Thank you.

Operator

Our next question comes from Sterling Auty with a follow-up.

Sterling Auty - JP Morgan

Just two follow-ups; one, you talked about the renewal rates and a lot of renewals. Can you talk to us about the [inaudible] on the SurfControl side? Do you have ample visibility into the renewals that are coming on the Surf side so you can capitalize on them? And I have one follow-up.

Gene Hodges

We thought you would circle back. Yes, we have good visibility on the Surf side and our reps have the lists for both in their hands and we’re pulling together the full 2008 base as we speak for our --

Douglas Wride

And largely, Sterling, if you were a SurfControl sales person focused on renewals, then you have your customer base and that hasn’t change, so you are pulling it out of the same systems, working with the same people, same vars, et cetera. So for us at a manager level, we may have to look at two screens or two systems but the individual quota carrying people are pretty focused.

Sterling Auty - JP Morgan

Okay, and then the follow-up is kind of from a macro view and it’s been asked a couple times a couple of different ways, but if you go back to the time of the acquisition and looked at what you thought would unfold over the next 24 months and compare that versus now, other than the competitive pressure from Surf going in to the close of the acquisition, what other things, if anything, have really changed?

Gene Hodges

Surprisingly little is different from our first models, and we are probably mores surprised about this than anyone, simply because there has been so many moving parts with the debt crisis, et cetera, with a long, protracted closing process and in the end, once we actually got down to the work, it’s gone pretty much as we guessed it would.

Dudley Mendenhall

I would say from a macro economic standpoint, clearly probably few of us on this call had visibility to what would be changing in the last eight, nine months as far as the global economy, exchange rates, debt crises, et cetera, and then of course, as we look out and look forward, because you asked about 24 months, if we look out say 15 months through the end of next year, that is no clearer than it would have been nine months ago looking forward. It’s pretty difficult to figure macro trends.

Douglas Wride

I think at a strategic level, we have had what I would characterize as a pleasant surprise on how valuable the BlackSpider on-demand infrastructure is going to be, because we are seeing ways that we will use this in multiple products when you look into the future of web security suites, eventually it will hook into that in the [cloud] infrastructure to do real-time classification of websites. So we’ll be able to really cover the earth without having to scan the whole Internet and we’re seeing multiple opportunities for building excellent reputation services with linkage the other way.

And the bottom line is the on-demand capability is probably even more valuable than we thought it would be.

Operator

Our next question will come from Walter Pritchard with a follow-up.

Walter Pritchard - SG Cowen

Just one follow-up; if I look at the rebate impact on the billings and the revenue this quarter and I compare it to last quarter, it looks like it was a bit higher in Q3 than it’s been. I’m just wondering, is there something that that’s as a result of or is it some accounting impact that’s not --

Douglas Wride

We set up the programs to stimulate volume through two-tiered distribution in North America. So as we said earlier this month and again today, now that we’ve got that volume flowing, now you start to change your rebate structure so that you are stimulating unique behavior that is desirable. Principally as we look to 2008, it’s about new business, not renewal business.

Walter Pritchard - SG Cowen

So to summarize, Doug, it’s more business just through the two-tier than in prior quarters?

Douglas Wride

Yes.

Walter Pritchard - SG Cowen

And then just one other thing on SurfControl -- I didn’t hear you guys give out a cash flow number, an operating cash flow number for SurfControl in Q3. Could you provide that?

Dudley Mendenhall

No, we did not provide that.

Operator

And at this time, we have no other questions standing by. I would like to turn the conference back to our speakers for any additional or closing comments.

Kate Patterson

Thank you very much. We will be available for follow-up calls this afternoon and tomorrow.

Operator

Thank you, everyone, for your participation on today’s conference call and you may disconnect at this time.

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