BMC Software F2Q08 (Qtr End 9/30/07) Earnings Call Transcript

Nov. 7.07 | About: BMC Software, (BMC)

BMC Software, Inc. (NASDAQ:BMC)

F2Q08 Earnings Call

November 6, 2007 5:00 pm ET

Executives

Derrick Vializ – IR

Robert Beauchamp – CEO

Steve Solcher - CFO

Analysts

Michael Turits - Raymond James

Tom Curlin - RBC

Tim Klasell - Thomas Weisel Partners

Philip Winslow - Credit Suisse

Brandon McKay - CIBC World Markets

Richard Sherman - MKM Partners

Derek Bingham - Goldman Sachs

IsraelHernandez - Lehman Brothers

Jeff Constantino - Banc of AmericaSecurities

Operator

Good day everyone and welcome to today’s BMC Software secondquarter earnings fiscal year 2008 conference call. Today’s call is being recorded. At this time for opening remarks, I’d like toturn things over to Mr. Derrick Vializ. Please go ahead, sir.

Derrick Vializ

Good afternoon, everyone. I am Derrick Vializ, Vice President of Investor Relations and I wouldlike to thank you for joining us today. Today’s call is being webcast and is also being recorded. An archive of the recording will be availablethis evening on our website.

In addition to today’s earnings press release, we haveposted a presentation, which we will refer to at various times during thecall. Both of these documents areavailable on our investor relations website at bmc.com/investors.

During our call, Bob Beauchamp, our CEO will provide anoverview of our second quarter performance; an update on our Business ServiceManagement strategy; and, update on our mainframe business. After that, Steve Solcher, our CFO, willprovide additional financial and operational details. Bob will then update our guidance for fiscal2008 before we open the call to questions.

Before we continue, I would like to remind you thatstatements in this discussion, including statements made during thequestion-and-answer session, regarding: BMC’s future financial and operatingresults; the development of, and demand for, BMC’s products; BMC’s operatingstrategies; acquisitions; and other statements that are not statements of historicalfact are considered forward-looking statements. These statements are subject to numerous important factors, risks anduncertainties which could cause actual results to differ from the resultsimplied by these or any other forward-looking statements.

Cautionary statements relative to these forward-lookingstatements and BMC’s operating results are described in today’s earnings pressrelease and in the financial presentation and in our Annual Report on Form10-K. All of these documents are availableon our website. These forward-lookingstatements are made as of today based on certain expectations and we undertakeno duty to update these forward-looking statements.

I would also like to point out that the company’s use ofnon-GAAP financial measures is explained in today’s earnings press release anda full reconciliation between each non-GAAP measure and the corresponding GAAPmeasure is provided in the tables accompanying the press release and in ourGAAP to non-GAAP reconciliations found on our website at bmc.com/investors.

At this time, I will turn the call over to Bob.

Robert Beauchamp

Thanks, Derrick. Goodafternoon and thank you for joining our call. Earlier today we issued our second quarter results and they demonstratethat BMC had another outstanding quarter of performance. We continue to execute our strategy forgrowth and leadership position in Business Service Management. We once again exceeded our revenue andnon-GAAP EPS guidance. We have builtpowerful momentum throughout our organization that’s providing increasedbookings, increased revenues, increased cash flows, increased efficiency andincreased profitability.

During the second quarter, bookings were up 8%, revenuesrose 9%, non-GAAP operating expenses were flat, non-GAAP operating income wasup 39%, non-GAAP EPS was up 30% and second quarter year-to-date cash flow fromoperations have more than tripled.

We also continued to demonstrate our commitment to buildshareholder value. We made two strategicacquisitions: RealOps and Emprisa Networks. Both extend our BSM strategy and strengthen our capabilities in fast-growingmarket segments.

We also took advantage of very attractive opportunities torepurchase our shares, spending a total of $200 million on share repurchaseswhich reduced our share count by about 3%.

We are very pleased with our continued success in enhancingour BSM leadership and extending our solutions and capabilities to better servecustomers and improving how we manage the business and ultimately, in buildingshareholder value.

Let’s talk about the key drivers for our performancebeginning with Business Service Management. Core BSM license bookings were up 16% for the quarter. We generated double-digit growth in core BSMlicense bookings for six consecutive quarters and we are continuing to gainmarket share.

We’ve talked in the past about the customer needs that arefueling demand, not only for BSM in general, but specifically for our BSMofferings. I would like to share anadditional data point with you. Industryconsultants IDC recently completed a survey of the corporate IT world. According to the survey, nearly 18% of therespondents have already begun to implement BSM; but more than double thatamount, another 38%, plan to do so within the next six to 12 months. So over55% of the respondents have already started down the BSM path, or will shortlybegin the journey.

While we believe the IDC survey is not all encompassing, wedo believe it reflects the trends we are seeing in the marketplace. Another leading industry consultant recentlyprojected a marked acceleration of BSM growth rates, leading to a compoundannual growth rate of over 25% for BSM in calendar 2008.

BSM adoption is increasing and we expect the pace ofadoption to continue to accelerate as we move forward. More and more companies understand how BSMcan enable them to map, measure, standardize and automate IT processesthroughout the organization; all of which ensures better alignment with thebusiness goals and priorities and much more productive uses of IT resources.

Approximately 80% of the average IT budget goes towardsoperations and a significant portion of that is labor-related. There is a tremendous opportunity to shiftthose resources towards generating more revenue and profit, and away fromoperations and cost. So there is astrong incentive for companies to implement BSM, and as the clear market leaderthey will naturally be looking to BMC to provide the complete solution.

Our track record of technology leadership and licensebookings growth in the BSM market space indicates that we are doing a good jobof winning mind share and market share in this exciting market.

During the second quarter, we continued to build ourreputation as the BSM leader and innovator. For example, we had a major competitive win and signed an important newcontract with Merrill Lynch. As part ofthe deal, Merrill Lynch joined the ranks of other major companies that havestandardized on the BMC Atrium CMDB, including Accenture, EDS and LockheedMartin. We also won a large deal against the major competitor with a largeAsian car manufacturer and we won our first major BSM account in the Chineseinsurance industry.

Last week, I was at BMC UserWorld our premier customerevent, which we hosted in Vancouver. I am happy to note that it was well attendedby our customers and partners. One ofthe most exciting aspects of this UserWorld was the presentations and feedbackfrom some of the world’s largest and best-run IT organizations; on the ROIrecognized from the BSM implementations. Presentations included information onhow the BMC Atrium CMDB and supporting solutions continue to deliver value in compliance,governance and controls, process automation, business process performance andemployee on-boarding, just to name of few.

Here are some comments from our customers reflecting theimportance of BMC Atrium CMDB, and I quote:

“Our CMDB strategyprovides the central platform for automating our governance and controlenvironment, and assists in reducing the escalating costs of regulatory burden.”

Quoting another customer:

“To remove the CMDBnow for our business can be compared to removing all patient records from ahospital.”

As impressive as these quotes are regarding the BMC AtriumCMDB, our customers recognize their greatest benefits from the integratedsolutions that utilize the Atrium CMDB. One especially encouraging report came from a Motorola executive. In the course of three months, Motorola wasable to save $11 million by executing changes in a controlled environment. Our incident management solutions enabledthem to realize a 30% to 32% reduction in cycle times for returning customersto productivity. This was the result ofjust one production pilot, in just one part of Motorola’s business. We alsohave presentations from Lehman Brothers, the Williams Companies, Dell, EDS,Accenture, and many others, focused on the value delivered by BSM fromBMC.

There was another very positive aspect to BMC UserWorld thisyear. We used it to build on our recentservice automation launch. As I havesaid previously, we think automation is going to be a big driver for BSM goingforward. For example, the IDC surveythat I mentioned a few minutes ago asked the respondents, what are the keydrivers for implementing BSM? The top answer was automating IT process workflows.

Our service automation solutions address all of the elementsrequired to automate the delivery of business services, and they have been verywarmly received in the marketplace.

One of our key global partners, VMware who was with us lastweek at the BMC UserWorld in Vancouver,recently stated

“As customers rolloutdeployment automation across physical and virtual environments, we believe thatthe BMC Software’s service automation solution can reduce IT operational costand accelerate the delivery of new IT services in data centers virtualizedusing VMware infrastructure.”

Our recent acquisitions, RealOps and Emprisa, also playdirectly into our automation strategy and extend our capabilities in thisarea. Emprisa, which we bought lastmonth, is a company that we previously partnered with. Emprisa’s technology will allow our customersto easily and automatically roll out changes to thousands of network devices,all from a BSM change management perspective. This is called change in configuration management. According to Forrester Research, it’s an over$2 billion market that’s slated to grow by 28% this calendar year.

Back in July, we acquired RealOps, a leader in Run BookAutomation that we’ve worked successfully with over the years. RealOps technology allows our customers toautomate the often labor-intensive, manual operational tasks required indelivering IT services. RealOpssolutions, as well as Emprisa solutions, are already integrated with the BMCAtrium CMDB and are getting a great reception from our customer base.

Emprisa and RealOps extend our capabilities in IT processautomation. Automation is the next stepin the evolution of BSM and we’re determined to extend our leadership in thisspace.

Lets move on now to discussing our mainframe business. This is also a business where we’redetermined to build upon our leadership and we’re extremely pleased with itsperformance so far in fiscal 2008. The advantagesof creating a standalone business unit for our mainframe business are clear; interms of increased focus and greater accountability, accelerated innovation andimproved results.

Earlier in the call, I mentioned a survey on the BSM marketbut I’d also like to note a survey that we recently conducted on the mainframemarket. It confirmed that large-scalemainframe users -- which represent the primary market we serve -- continue tosee strong demand for new capacity and they are projecting increased spendingon this platform. Most of the declinewithin the mainframe environment is coming from smaller firms with smaller mixcapacity footprints, which is not our core customer base.

Over 90% of our customers surveyed had a positive outlook onthe long-term health of the mainframe as a viable platform for new and existingworkloads. Clearly the mainframe market is healthier than most people thoughtjust a few years ago and perhaps more importantly, most forecasts indicate thatthe market will remain steady in the years ahead.

We are certainly seeing a positive impact this year from ourmainframe business. In fact the pastfour quarters have been strong for us. As always, it’s worth noting the business is cyclical and that quarterlybookings can also fluctuate. Our fundamental view of the business is that it islarge, relatively stable and highly profitable. We are the leader and our strategy to remain the leader is working.

While the mainframe business is thought of as a renewalbusiness, we continue to attract new customers and win share. In fact, during the second quarter, we wonover 30 competitive replacements, new customer wins or new product deals. In the US,this includes a major information processing company; in Asia, National AustralianBank; and in Europe, Alliance. So that covers our two business units.

Now I’d like to shift gears to discuss one other importantinitiative, the structural improvements we’re making to our company’sefficiency and productivity. Over thepast seven quarters we have consistently grown revenues while keeping ournon-GAAP operating expenses roughly flat to declining, even after absorbingincremental costs from multiple acquisitions, internal investments and negativecurrency impacts.

One of the main drivers underpinning this performance is oursuccess in globalizing our business operations. For example, we recently passed an important milestone and now have over1,000 BMC employees in India. This represents 19% of our workforce or 25%of non-sales employees in our two development centers in India.

As we continue our position as the global leader in BSM,we’re going to take additional steps to transform our business and ourworkforce in order to successfully compete and achieve world-class levels of productivity.

Our main messages for the quarter are:

  • We achieved accelerated growth in BSM.
  • We continue to make strategic investments to enhance our leadership and extend our capabilities in BSM.
  • We continue to achieve solid performance for our mainframe business.
  • We maintain solid expense management with a focus on achieving best in class productivity.
  • We continue to demonstrate our commitment to build shareholder value.

In short, we feel very good about our performance in thesecond quarter and the first half, and we expect continued solid performance inthe second half. I will comment later onour improved guidance for the year but before I do that, let me turn the call overto Steve Solcher for a more detailed operational and financial review.

Steve Solcher

Thanks, Bob. Secondquarter results reflect another quarter of solid financial performance. Whether you look at bookings, revenues,operating margin, earnings or cash flow, we improved in virtually everycategory. In addition, we have now metor exceeded our revenue and non-GAAP EPS guidance for ten quarters in arow. This also marks our sixth quarterin a row of double-digit growth in our core BSM license bookings.

Our non-GAAP operating margin continues to expand, now 28%in the second quarter through a combination of revenue growth and expensecontrol. We have held non-GAAP operatingexpenses flat for the last four quarters, while growing revenue in the midsingle-digits.

Another key metric I would like to briefly highlight isoperating cash flow, which has significantly increased for the second quarterin a row. In fact, 2008 first half cashflow from operations more than tripled over 2007 first half, increasing from $83million to $319 million. As you know,bookings drive cash flow and based on the level of bookings through the secondquarter, we have increased our full year outlook for cash flow from operations.

With that, let me begin by reviewing our financialresults. In the second quarter, non-GAAPoperating income increased by 39% to $119 million; non-GAAP operating marginincreased 6 percentage points from a year ago to 28%. Non-GAAP net earnings for the second quarterwere at $96 million, an increase of 24% over fiscal 2007. Non-GAAP diluted EPS for the period was $0.48,up 30% compared to the year ago period. This reflects a non-GAAP effective tax rate for the quarter of 31%. These non-GAAP results reflect diluted sharesoutstanding in the second quarter of 202 million versus 209 million in the yearago period.

GAAP operating income in the second quarter was $91 millioncompared to $60 million in the year ago period. GAAP net income and fully diluted EPS were $78 million and $0.39compared to $58 million and $0.28 in the second quarter of fiscal 2007.

Turning now to bookings, total bookings of $341 million wereup 8% compared to the year ago period. License, maintenance, and professional services booking were all upduring the quarter. With licensebookings up 7%, maintenance bookings were also up 7% and professional servicesbookings were up 20% as compared to the year ago period. Total bookings on a trailing 12-month basiswere $1.8 billion, up 16% compared to the year ago period.

The weighted average contract length for total bookings on atrailing 12-month basis was 2.4 years compared to 2.2 years for the year agoperiod. On an annualized basis, trailing12-month bookings were $742 million, up 6% compared to the year agoperiod. This marks the seventhconsecutive quarter in which we’ve achieved annualized bookings growth on atrailing 12-month basis. Please refer toslide 7 in ourpresentation.

Now let me turn to the performance of each of our businessunits. For our ESM business unit,license bookings are the best measure of performance. Total ESM license bookings were $85 millionin the second quarter, up 4% over the year ago period. Within our ESM business unit, licensebookings of our core BSM product group were up 16% in the second quarter. As we’ve noted, this is the sixth consecutivequarter of double-digit growth in our core BSM license bookings. Please see slide 8 of our presentation forhistorical license bookings growth.

Partially offsetting the impact of higher core BSM licensebookings was the decline in the distributed systems management license bookingsduring the quarter. Like the MSMbusiness unit, DSM performance can be skewed by large transactions and thetiming of contract renewals. Over thefirst half of the year, DSM license bookings were up 16%.

Turning to our mainframe unit, we believe the MSM businessunit is best evaluated on the basis of total and annualized bookings over thetrailing 12 months. In the secondquarter, total MSM bookings on a trailing 12-month basis were $770 million withan average contract length of 3.1 years. In the year ago period, total MSM bookings were $642 million with anaverage contract length of 2.9 years. Normalizing for contract length, total annualized MSM bookings for thetrailing 12 months were $245 million, an 11% increase.

As we’ve often said, this is still a lumpy business in whichbookings can vary from quarter to quarter. As Bob noted, we are pleased with the solid performance and trends wehave seen in our MSM business over the past four quarters. Our full year expectation for the businesshas improved. However, as we enter thesecond half of fiscal 2008, we have difficult comparisons to our performance inthe second half of fiscal 2007. We nowexpect fiscal 2008 MSM annualized bookings to be flat to slightly up compared to2007.

Turning to revenues, total revenues for the quarter were $421million, a 9% increase compared to fiscal 2007 second quarter. License revenues were $151 million, anincrease of 9% compared to a year ago. During the quarter, the percentage of licensed bookings that wasdeferred was 45%. This is up 7percentage points from the 38% ratable rate in the second quarter of fiscal2007, but its down significantly from the 58% ratable rate in the first quarterof fiscal 2008. This lower ratable ratewas driven from a lower volume of term transactions in the second quarterrelative to the first quarter.

In the second half of fiscal 2008, we would expect thelicense ratable rate to be lower than last year. As you know, the higher ratable rate impactsour results in several ways. It affects the amount of revenue we recognized inthe current period as well as the amount we defer on our balance sheet. This deferred license revenue adds visibilityinto our revenues stream in future periods.

From a geographical perspective, revenue growth was balancedwith the USincreasing 7% and international increasing 11%. Maintenance revenues for the second quarter of 2008 were $241 million,an increase of 6% compared to a year ago and a $6 million increase on asequential basis. Professional servicesrevenues were $29 million in the second quarter, up 31% compared to $22 millionin the year ago period. We have spent alot of time re-training and improving the skills of our consulting organizationto support our BSM strategy and this effort is beginning to show progress.

Moving next to operating expenses. I continue to be very pleased with ourability to control operating expenses. Our non-GAAP operating expenses were $302 million, roughly flat on ayear-over-year basis. It is important tohighlight that expenses have been flat even after absorbing expenses fromacquisitions, internal investments and the negative impact of currencymovements.

There are a few key drivers underlying our ability to holddown costs that should continue to trend positively for us going forward. These include continuing our expansion intolow cost locations, reengineering core processes and eliminating redundanciesin systems and applications. Ouroverarching goal is to further simplify, standardize, and automate key businessprocesses and there is room for further improvement.

I am going to move on now to the balance sheet. Total deferred license revenue at the end ofthe second quarter was $512 million, down $8 million sequentially. During the quarter, we deferred $64 millionof license revenues or 45% of license bookings, and recognized $72 million ofdeferred license revenues from the balance sheet.

Total deferred revenue decreased by 5% sequentially to $1.7billion. This decline reflects theseasonality of our business in a period in which new booking did not offsetrevenues recognized.

Software development costs on the balance sheet were $112million, $5 million more than at the end of the first quarter, as wecapitalized $21 million and amortized $17 million during the quarter.

Cash and marketable securities at September 30 were $1.5billion. For the quarter, cash flow fromoperations was $154 million, an increase of $126 million over the prior yearperiod. Major non-operating uses of cash during the quarter include $54 millionfor an acquisition and $200 million for share repurchases.

During the second quarter, we repurchased 6.7 million sharesand we now have slightly under 1 billion remaining in our stock repurchaseprogram.

With that, I’ll turn the call back over to Bob for hisconcluding remarks.

Robert Beauchamp

Thank you, Steve. As I mentioned, I am pleased with oursecond quarter and first half performance. We’re executing well across our business to drive growth in bookings,revenues, earnings and cash flow. We’reinvesting internally and through acquisition to extend our BSM leadership,adding growth engines to the enterprise; and, we’re controlling cost,increasing efficiency and improving profitability.

We are now half way through our fiscal 2008 and by virtuallyevery measure, it is shaping up to be another year in which we continue tocreate value for our shareholders.

Let me now update you on our guidance for fiscal 2008. We’re raising our guidance and now expectnon-GAAP EPS for the year to be in the range of $1.78 to $1.86 per share. Non-GAAP EPS excludes an estimated $0.38 ofspecial items related to expenses for amortization of intangible assets, in-processresearch and development, share-based compensation, and restructuringactivity.

The assumptions underlying this full year fiscal 2008estimate include:

  • We are raising our guidance for revenues and now expect revenue growth to exceed 6%.
  • Total bookings growth in the low single-digits.
  • A license bookings ratable rate similar to last year.
  • Non-GAAP operating expenses that are essentially flat.
  • A non-GAAP effective tax rate of 30%.

As a result of our strong first half performance, we areincreasing our expectations for cash flow from operations. We now expect cash flow from operations toimprove to between $525 million and $575 million.

Turning to our guidance for the third fiscal quarter, weanticipate third quarter revenues to range between $430 million and $445million, and non-GAAP EPS to be in a range of $0.46 to $0.51. This reflects a non-GAAP effective tax rateof 30%. Non-GAAP EPS for the thirdquarter excludes an estimated $0.10 of special items related to expenses foramortization of intangible assets, in process research and development,share-based compensation, and restructuring activity.

Before we take questions, I would like to mention to youthat we recently conducted a review of our practices regarding earningsguidance. The purpose of the review wasto determine whether we should discontinue providing any guidance, shift toproviding annual guidance, or continue with our current practice of annual andquarterly guidance.

In the course of this best practices review, we considered anumber of reports and studies from a variety of sources, and ultimately weconcluded that the guidance we give should reflect more closely how we managethe company. As a result, we will be moving to annual guidance only. This change will be effective beginning withour 2009 fiscal year.

Let me assure you that we are committed to maintaining thelevel of transparency necessary to enable investors to have a broader, morequalitative and meaningful picture of our strategy and of the opportunities andchallenges we face.

Finally, I want to note for you that we plan to hold ourAnnual Investor Day on February 27 here at our headquarters in Houston. We hope you put it on your calendars now andwill be able to join us for it.

With that, we will now turn the call over to questions.

Question-and-AnswerSession

Your first question comes from Michael Turits - RaymondJames.

Michael Turits -Raymond James

A very strong quarter all round. It looks like both this quarter and lastquarter you had total trailing 12-month annualized bookings up 6%. I think it was up 8% last year. Do you expect to see that accelerate in theback half or you think 6% is a good number for the year?

Steve Solcher

Michael, I would tell you that you should expect it toaccelerate in the second half. It reallygoes to the mix of business that we think we’re going to see in the second halfwhere MSM is going to be less as a percent of the total and as a result ofthat, you’re going to see, we call it a [WACL], but the weighted averagecontract length actually contracting for the second half of the year. So I would tell you that even though we endedthe full year last year, to your point at an 8% growth rate, you should expectthat or greater.

Michael Turits -Raymond James

8% or greater on the annualized trailing 12 months total bookingsgrowth this year.

Steve Solcher

Yes.

Michael Turits -Raymond James

I wanted to confirm on the mainframe side, you said that theyou expect annualized mainframe bookings up. Is that flat to slightly up, isthat the guidance?

Steve Solcher

So that’s correct. Inthe past, our guidance had been we wanted the decline in the annualized numberto be no worse than 5%. What we arechanging our guidance to say is that we actually believe going forward thatthis number is going to be positive. Sofrom the MSM unit, we are now guiding to what I would say a low to midsingle-digit annualized number.

Michael Turits -Raymond James

That’s total trailing?

Steve Solcher

Total trailing, so you’ve seen it come out at 11%. Second half of the year for MSM on anabsolute basis is going to drop, but at the same time you are going to seecontract length shorten. The beauty of that is on an annualized basis it willgrow.

Michael Turits -Raymond James

Can you talk a little bit about the dynamics there? A couple years ago, this was one of theweakest parts of your business, from my perspective, facing a lot ofcompetition on pricing from IBM, expansion of their product portfolio. What’sgoing on that’s stabilizing this at this point from both a competitive and ademand perspective?

Robert Beauchamp

Michael, I will tellyou that we separated mainframe, as you probably know, into a dedicatedbusiness unit. The MSM unit isstandalone. It has its own generalmanager. It has its own dedicated salesforce. It has its own dedicated pre-salesforce,marketing campaigns. It runs in manyrespects like a separate organization focused on achieving its own goals.

That has just really paid off for us in so many ways, notthe least of which is just the amount of visibility and analytics that we haveon the individual transactions that we are doing every quarter that are cominginto the pipeline are much stronger. That group is watching the health of thedeals, the quality of the business very, very tightly.

We rank all of our top deals; at the end of each quarter wego back and we look to see the annual run rate and to see whether thatcustomer’s actually spending more with us on an annual basis because that’s asign of health if we are actually seeing that customer spend more money withBMC every year going forward. We look at contract length, we look at the expirationdate, and just really good quality blocking and tackling of that unit islargely what’s due credit for that.

Michael Turits -Raymond James

You think it is execution, not a change in the competitivedynamics of the market?

Robert Beauchamp

I don’t think so. Because this group is innovating andworking on new technologies integrating into BSM, we get some nice competitiveuplift. I think that some of ourcompetitors have been distracted and have really been focused so much ongrowing bookings that I’m not sure that they’re as focused on their products aswe are.

Our team is very skilled, again, at selling value. What ourproducts do for the customer and I just think we’re executing better.

Operator

Your next question comes from Tom Curlin - RBC.

Tom Curlin - RBC

Just following up on the way you’ve divided the MSM group,now does that apply to the R&D efforts as well? I mean is it essentially operating as anentirely independent division, not just sales and marketing, but down throughcode and development and so on?

Robert Beauchamp

That’s correct. It has its own separate supportorganization, its own separate development organization. They even have the G&A that the financepeople and IT people we have and HR people that while they report of coursestraight line into the functional areas into say Steve’s office, they havededicated, like a mini CFO just for that unit, so it is really a veryself-sustaining, independent organization.

Tom Curlin - RBC

Is that driven exclusively by performance metrics andaccountability or is that also about strategic flexibility?

Robert Beauchamp

It is absolutely designed to execute better. I mean that’s the reason we did it. We did it because the organization lost itsfocus years ago and was blending everything together and selling financialtransactions. We became, if you recallthe earnings calls of several years ago, we were very focused on reinvigoratingthe ability to sell value, to sell software again and we’ve done that. That’s why it was done. It certainly has the effect of giving us theability to look at our business separately, but that was not the intention.

Tom Curlin - RBC

It gets a bit confusing in terms of annualized versus justraw booking growth from a license perspective. On the mainframe side, let me just ask it in qualitative terms. Have you seen some deceleration this quarterand may be over the next couple of quarters, just in overall flow of businesson mainframe driven by the transitional issues that IBM is seeing with themainframe product line?

Robert Beauchamp

No, we have not.

Operator

Your next question comes from Tim Klasell - Thomas WeiselPartners.

Tim Klasell - ThomasWeisel Partners

On the operating margin expansion, good numbers there and Ithink you have been telling us that was mostly going to come off the ESMside. Is that the case? Could you give us maybe some qualitative feelfor how close ESM margins are to MSM margins?

Steve Solcher

Tim, the thing that I would tell you is we don’t breakoutfully allocated P&Ls for either of the business units. You will see us breakout direct contributionmargin and you will see a 5 point improvement in that direct contributionmargin year over year in the ESM business. I think it’s safe to say that MSM is significantly more profitable thanESM and we will leave it at that. I willtell you that ESM has some room to grow and we are focused on growing that tobest in class.

Robert Beauchamp

From a contribution standpoint it is profitable today andone of our most strategic focus areas is to improve the profitability of thatunit while maintaining the growth trajectory.

Tim Klasell - ThomasWeisel Partners

On the DSM side, obviously Symantec has some of itscomponents up for sale; Mercury was acquired inside of HP. It seems like maybe the competitive headwindshould be lifting a bit there, but was it just purely lumpiness in the deals oris there a change in that overall marketplace we should be aware of?

Robert Beauchamp

I think there are three different things there in thatquestion. One of them is I agree withyou that the headwinds should be lifting somewhat. I think that it’s a good time to be focusingon this market. The surveys we see, theconsultants we speak with, the customers I talk with would tell you that thereis a generational refresh at hand.

Competitively, there is less intensity in many areashere. We do have the lumpiness so thatis a true statement but I would say that also just in execution the one area ofour business that I would have liked to see better this last quarter wasDSM. I think some of that is executionrelated. The product portfolio as youknow was rewritten and brought forward and was some excellent technology, butit still had some gaps. We’ve filled some of those gaps through acquisitions, ProactiveNet,et cetera; we’ve brought it together.

What we have just done at the beginning of the second halfis we decided that the product line was absolutely competitive and ready to goto market in a big way. Beginning in Q3we have changed the sales comp plan and moved away from what is largely an in-houserenewal sales force for DSM and beginning in the second half of the year, thesales focus for our large, direct sales force that sells the whole BSM suitewill now be compensated and have goal set around DSM as well.

So we’re turning up the heat on DSM, but we’re couple ofquarters behind where I thought we would be and we didn’t have as good asnumbers as I’d have like to had on DSM in Q2.

Tim Klasell - ThomasWeisel Partners

Any mega deals in the quarter, anything over $5 million or$10 million in the quarter?

Steve Solcher

We had 19 deals over a $1 million compared to 23 over $1 millionlast year at this time.

Tim Klasell - ThomasWeisel Partners

Okay, no color on mega deals?

Steve Solcher

No.

Operator

Your next question comes from Philip Winslow - CreditSuisse.

Tim Philip Winslow -Credit Suisse

Hi, guys most of my questions have been answered, but I justwanted to get back on the mainframe side. Obviously you are seeing an improving price environment and also prettydecent demand. Over the next couple of quarters here, just with the release ofthe next cycle of the mainframe, how do you see that affecting your bookings? December,and then the release comes in calendar 1Q08?

Robert Beauchamp

Well, in general I would say that it’s about the time forIBM to start coming out with their new -- if they stay true to their old format -- we should see the new products comingout from IBM soon. That always has along-term uplift for us. Short term, ithas very little effect as we sell into the existing install. So when those contracts expire, whatever theexisting install base is, that is the bulk of our opportunity.

As we mentioned in the call, we did have 30 transactions wherewe either competitively replaced new contracts or new products into existingcustomers and so we are focused on that business. It is still largely renewalbusiness and we have good visibility into that. In terms of the second half, Steve do you have any comments?

Steve Solcher

I think the only thing I would say that would be additive wouldbe is last year second half we had incredible performance within the MSM groupand at the beginning of this year we had visibility into those toughcomps. So our initial guidance for thisbusiness was a decline in the high single-digits; it’s improving. Now most ofthat improvement is because of over performance in the first half. But we feel comfortable and we feel goodabout the business and hopefully here in the second half you will see betterresults.

Operator

We will hear now from Brandon McKay - CIBC World Markets.

Brandon McKay - CIBCWorld Markets

I’ve got two quick questions for you, one to go back toTim’s question for a second. With leveraging ESM, what’s the main thing that isholding that back? Is that mostly a function of sales and marketing dedicatedto that business?

Robert Beauchamp

On DSM?

Brandon McKay - CIBCWorld Markets

On just the ESM business in general?

Robert Beauchamp

Well, on the ESM in general DSM is the part of it that isnot doing as well as we would like. Onthe core BSM, it’s rocking. That businessis doing very well. You are talkingabout on the operating margins?

Brandon McKay - CIBCWorld Markets

Yes.

Roger Plank

I am sorry. Onoperating margins, it’s just a combination of factors. The average deal size continues to grow, thenumber of deals we are wining. I mean wewon some very nice deals last quarter. So therefore sales productivity should be going up as we see largerdeals.

I mean I was on the phone this morning with two very largebanks, one headquartered in New York, one headquartered in Europe, discussingimplementations of ESM and one of the top people there said his goal is tostandardize on as much BMC Software as possible. So we should see some productivity from thatangle the CMDB and the incredible -- Imean really remarkable -- success we are having with having many of the world’slargest corporations standardized on our integration platform; our integrationarchitecture should help that as well.

From a development standpoint, because we are integratinginto that common environment in our R&D organizations, we have R&Defficiencies that are derived from that. From the IT organization, there are a number and we have talked about itin the past. There are a number of automation simplification initiatives andthe executive that I hired, Jay Chung, is really focused full time reportingdirectly to me on improving our expense structure through automation. We had some very good progress with that onthings like electronic product distribution, but we still have some of thebiggest productivity gains yet to come on order to cash and in customer supportand some other areas that we are excited about. It’s really not one thing there is a number of things that will drive it.The senior management team all feel very confident that its achievable.

Brandon McKay - CIBCWorld Markets

It sounds like you guys are ‘BSMing’ your own business tosome extent and just wondering if you look out to ‘09 -- you don’t get a ton of clarity, but -- canyou keep expenses flat? You’ve talked about going forward it sounds like acouple of quarters, but is there something that could go into ‘09, or expensesneed to come up a little bit?

Steve Solcher

I don’t want to give you ‘09 guidance yet but I think yourassumption is correct. I think our view is that we are trying to do some directionalthings infrastructure-wise that allow us to scale without adding a dollar ofexpense for every dollar of revenue. So I think you are exactly on the pointthat Bob and I both feel very confident about, that as we continuing to see topline accelerate, we are not going to see the level of spending accelerate alongwith it so you should see margin expansion as a result of that.

Robert Beauchamp

Another way to say it is we still have plenty of room for long-termstructural improvement through automation and just through better execution andwe’ve got quite a bit of opportunity to do that over the quarters ahead.

Brandon McKay - CIBCWorld Markets

You’ve talked about that mainframe survey that you did withyour own clients. If you look at the results this time what do they compareagainst whenever the last time you did the last survey it was?

Steve Solcher

You know I can’t tell you, I don’t know when I reviewed theresults of that it was I didn’t go into the comparative aspects of that. The mainframe manager that did it willcertainly have that, but I don’t have it at my fingertips.

Operator

Your next question comes from Richard Sherman - MKM Partners.

Richard Sherman - MKMPartners

A question on the change in the sales compensationstructure, I missed part of that. I was wondering if you could may be repeatwhat you said and may be amplify exactly what kind of changes you’re makingthere?

Robert Beauchamp

Generally what we did is we called in all of the -- the wayour salesforce is structured we have the MSM sales team that is separate. We have a global accounts team that handles let’scall it a few dozen of the world’s largest accounts and sells everything. Then we have an ESM salesforce that is the largestpercentage of our salesforce. These arethe people out there selling BSM everyday, all day; change configurationmanagement, asset management, et cetera. Then we also have an in-house renewal sales force that works onmaintenance renewals of things like the old Patrol or the DSM renewal businessand then we have a channel organization for geographic coverage and for thevery low end.

What we’ve done differently, what we have been doingessentially is offering the inside salesforce on the phone have been theprimary people that are paid on DSM renewals. What we done here is now we are leaving that there, but we are also shiftingthe compensation and offering significant compensation to the sales and sales managementof the ESM core salesforce for DSM revenues. So they will be focused on renewals, they will be focused on driving newcustomers they will be focused on selling larger transactions that include DSMand selling BSM is a larger portfolio that includes the whole core BSM and DSM togetherin a significant transaction.

I will tell you an example. This is not good news, this is just a story to illustrate it. We recently had a group of CIOs and senior ITexecutives at a CIO event for two days. Afterdinner, one of our large customers who just standardized on our core BSMproducts came up to me and he said, please send someone to talk to me about theDSM solution because I believe that I need to buy your DSM product line andintegrate it into the core BSM solution.

I realized that when he said that, that was not a positivestatement. Essentially what it meant waswhen we had sold him BSM, we had not aggressively pursued the DSM sale and soat a meeting with the sales leadership they concur. They also believe that theproducts are there now, the markets are right, the products are right, so weare turning up the compensation across the large ESM sales force so they willbe more focused on it going forward.

Richard Sherman - MKMPartners

As you look at your mainframe renewal opportunity as youenter this fiscal year, about how far along are you in terms of percentage, incovering those renewals? Are you 60%,70% of the way, 50% of the way? It seemslike the cash flow guidance which is nicely higher and will be significantlyhigher this year, it seems like maybe there is some timing on some of thosemainframe renewals that may have come earlier in the year than in the back halfof the year?

Steve Solcher

That’s true. Is yourquestion around fiscal year ‘08? If its‘08 I would tell you that you are looking about, we are about halfwaythrough. The level of performance youhave seen in the first half I would tell you that we’re looking for the samelevel of performance, slightly better in the second half.

Richard Sherman - MKMPartners

Last question, at the user forum, it seems like there is avery different kind of conversation that the customers are talking aboutlargely around service catalog, service automation and yet on the conferencecalls we end up talking about mainframe and Patrol and the like. It seems like that service automation pieceis really what’s driving the BSM business and at high end with Atrium CMDB.

Robert Beauchamp

Absolutely, and sometimes on these calls we basicallyprepare for the questions we know that are going to be asked, but internallywhat we talk about, I mean, you were there. You saw some of the top, some very senior IT executives of some of theworld’s largest IT organizations just throw praise after praise on not on thepromise of our ROI but on ROI realized around standardizing on ourarchitecture, standardizing on our solutions.

I mean, you’re absolutely right that is what’s driving it,that’s what BSM is, that’s this excitement around BSM that we talk about allthe time, is just really, it’s an entirely, it’s a new generationarchitecture. The old generation wasclient server-based. It was installed inthe ‘90s to support client server and the new generation for automating the datacenter of the future is BSM and that is absolutely what’s driving theexcitement.

Steve Solcher

That is why our salesforce is motivated, they’re fired up. Imean you just see it in the customer conversations are different, it’s a verydifferent environment.

Operator

Your next question comes from Derek Bingham - Goldman Sachs.

Derek Bingham -Goldman Sachs

My question is on core BSM license bookings, up I think 16%,and I think that was on a tougher compare, because things really started totake off about a year ago in terms of acceleration. I just wanted to get your sensefor when you are doing your forecasting, is that kind of a growth rate nowwhich you would view as a normalized growth rate for that business goingforward?

Robert Beauchamp

Derek, as we said last quarter, you should see a continuingacceleration of growth in that product line. So where we grew 10% last quarter, 16% next quarter, or the quarter wejust ended, third quarter we are looking for acceleration off of that 16% andthen of course fourth quarter an acceleration off of third quarter. So we are not done yet. We know we have got some tough compares alsoin that business for the second half of this year, but we feel good about thebusiness.

Derek Bingham -Goldman Sachs

How much are larger deal sizes driving that? I mean you’vebeen able I think to add a lot of new features, new technologies, acquiredproducts around your core service management offering. How much of that bundling and added valueimpacted deals size?

Robert Beauchamp

I think it helps and we had some large deals. The one I mentioned, Merrill Lynch, was asignificant transaction. By the way,that was a major data center of the future conversion moving to newarchitectures and that’s the kind of wins we have been doing. That’s also the conversation I had with oneof the top IT people at one of the largest banks in Europe this morning on thephone. Major data center conversion tothe new architecture.

What happens in this deals is the deal size does getsomewhat bigger but also what happens is they begin to come back to us. They gofrom change config on the first order and then they come back for incidentand problem on the second order and thenthey come back for asset and discovery on the third order. So basically it solidifies us as their vendorof choice for the whole service management chain and if we do a good job thewhole systems management chain. We arenot there yet on that but that’s where we’re targeting, is to really become thede facto standard inside the organization for the solution sets that integrateinto the integration core, which we are just having so much success with rightnow.

Derek Bingham -Goldman Sachs

I just want to make sure that I get your thoughts on themacro picture as people are just starting to set their budgets for 2008, I wouldlove to hear what you are seeing in terms of sentiment when you talk tocustomers looking to next year?

It’s more of a macro question as opposed to your business inparticular.

Robert Beauchamp

On macro, in general what I would say is this: we just hadGartner, Forrester and IDC, really all of the top people who cover our space inour buildings in the last 30 days, where we met with them for hours at a timeand they presented at our request to us on what they saw and I would say it wassignificant optimism from them on IT spending. Across the board, they saw bigger numbers. Some of them were so big, I franklyquestioned that they would be that good, but really quite optimistic from theindustry analysts.

From the customers, we saw the headlines from New York and we were wondering whether or not we wouldsee deals slip or deals fall out, we saw none. We have seen absolutely – I mean so far, it could happen this quarterbut we haven’t. We’ve no reason, wehaven’t seen it. We’ve seen noindication of a slowdown in spending. Right now, the macro factors seem to bequite solid.

Now I would hasten to say, I am not an economist. I certainly am not Alan Greenspan. I can’t tell you what’s around the nextcorner, but we haven’t seen it in our business and the people that are talkingto our customers and the customers I talked to have not really. I can think of twocustomers that told me that they thought that there would be some constrictionof their IT budget next year as a result of the financial services sector, butthese were customers who are writing us big checks. They have written us bigchecks.

Operator

We now go to Israel Hernandez - Lehman Brothers.

Israel Hernandez - Lehman Brothers

Bob, last week at the user’s conference you heard from anumber of your larger partners andcustomers. Particularly with respect toEDS and Accenture, what type of uptake in commitment are you getting from some ofthese large partners? Do you see them becoming an important channel fordistributing DSM going forward?

Robert Beauchamp

It’s an interesting one. It has been one of our fastestgrowing sectors, the system integrators and outsourcers been one of our fastestgrowing sectors and it is material to our business in the aggregate. It is also a major influencer becauseessentially they see deals. We had atransaction in Europe this last quarter, I believe it wasa chemical company that one of these system integrators and outsourcers won.They pulled our products into that transaction and it was very nice sizedtransaction for us.

So it’s pulls us into deals we are not in, it adds morecredibility and just more mass around BMC as you see really all of the largesystems integrators and outsourcers standardizing on BMC or for large pieces ofBMC at least, around BSM.

So it adds mass, it adds credibility, it adds moreexpertise, more momentum and it drives some nice revenues. Do I think it’s going to really change thedemand curve? I mean change the top line revenue curve markedly in the nextyear? It will be material part of our business but I am not ready to say it’sgoing to be some sort of a non-linear revenue shift force. I mean they are a big part of our businesstoday. I think it will continue to improve. It should improve faster than the overallmarket but I don’t know that it’s going to be some order of magnitude shift wesee.

Operator

Your next question comes from Jeff Constantino - Banc ofAmerica Securities.

Jeff Constantino -Banc of America Securities

I just wanted to talk on the international business. Can you talk about currently where thatstands as a percent of revenue? And thenjust your expectations for growth for the business as we look into 2008,particularly around just BSM adoption, whether you see any change in ordifference in adoption rates rather between domestic and international?

Robert Beauchamp

I’ll take the second part first and Steve will give you a specificanswer. In terms of adoption levels alot of BSM is built on ITEL. It’s builton the belief that IT best practices should not be invented and new at everyaccount. There are best practices andthat again is stronger in UK,it began there and it’s still has its home base I think really in the UKand in Central Europe and Germanyand Austria andSwitzerlandit’s strong.

I will tell you that core BSM, BMC is absolutely dominant inSwitzerland. I mean and that’s material. Switzerlandis some of the sites of some of the largest and most sophisticated IT shops inthe industry and we are doing extraordinarily well in securing virtually all ofthe major banks and financial institutions. Not all of them, but a verysignificant percentage of them.

The rest of Europe is a little slowerto adopt I think. The US is all over itnow; Asia, China and Japan or just in Japan and Korea and there is lot of talkaround ITEL and best practice is in Japan which is a change from what I sawjust a couple of years ago. We just wona very nice deal with a Chinese life insurance company and it was the full BSMthe whole ITEL methodology is why we won the deal. Ithink we are seeing implementations go around the world in their usual theusual order of new innovation.

Jeff Constantino -Banc of America Securities

One other quick one, in regard to the second half cash flowestimate in terms of raising the guidance, can you just talk about the salesand receivables that you are expecting in the second half compared to the firsthalf? Pretty much the same amount?

Steve Solcher

No, actually the second half I will tell you that, I wouldthink that it would temper off and it really is pretty much highly correlatedwith the level of bookings that we would do in any given quarter. So I already have a little bit of visibilityabout what we are going to do in what I would say the third quarter from thesecond quarter activity and it is dramatically down in the third quarter, and Iwould say even in the fourth quarter although we don’t know what we are goingto do yet in the third quarter; we haven’t seen those results.

I would tell you that the monetization piece is not a metricwe focus on. It is something that we arelargely indifferent on how customers choose to pay for their transactionswhether it be cash which would show up in trades receivables or finance itthrough finance receivables. The waythat we look at it, we are indifferent on that.

Operator

At this time there appear to be no additionalquestions. I’ll turn it back to you allfor closing remarks.

Robert Beauchamp

Well let me just close out by thanking you all for joiningus. An exciting quarter for BMC. We’relooking forward to the second half. Iwant to thank particularly those of you who attended our user conference in Vancouver,I think it gave you a unique perspective. Those of you that were there thathave written about it, have said some very positive things after talking tocustomers and it’s exciting because it feels like the BSM that we’ve beenwatching for the last year is now becoming very real for you as you talk to thecustomers and see the effect it’s having.

We look forward to speaking with you soon individually, andwe’ll see you at our investor day in February. Thank you.

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