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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

Israel Hernandez - Lehman Brothers

Jeff Constantino - Banc of America Securities

Operator

Good day everyone and welcome to today’s BMC Software second quarter earnings fiscal year 2008 conference call. Today’s call is being recorded. At this time for opening remarks, I’d like to turn 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 would like 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 available this evening on our website.

In addition to today’s earnings press release, we have posted a presentation, which we will refer to at various times during the call. Both of these documents are available on our investor relations website at bmc.com/investors.

During our call, Bob Beauchamp, our CEO will provide an overview of our second quarter performance; an update on our Business Service Management strategy; and, update on our mainframe business. After that, Steve Solcher, our CFO, will provide additional financial and operational details. Bob will then update our guidance for fiscal 2008 before we open the call to questions.

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

Cautionary statements relative to these forward-looking statements and BMC’s operating results are described in today’s earnings press release and in the financial presentation and in our Annual Report on Form 10-K. All of these documents are available on our website. These forward-looking statements are made as of today based on certain expectations and we undertake no duty to update these forward-looking statements.

I would also like to point out that the company’s use of non-GAAP financial measures is explained in today’s earnings press release and a full reconciliation between each non-GAAP measure and the corresponding GAAP measure is provided in the tables accompanying the press release and in our GAAP 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. Good afternoon and thank you for joining our call. Earlier today we issued our second quarter results and they demonstrate that BMC had another outstanding quarter of performance. We continue to execute our strategy for growth and leadership position in Business Service Management. We once again exceeded our revenue and non-GAAP EPS guidance. We have built powerful momentum throughout our organization that’s providing increased bookings, increased revenues, increased cash flows, increased efficiency and increased profitability.

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

We also continued to demonstrate our commitment to build shareholder value. We made two strategic acquisitions: RealOps and Emprisa Networks. Both extend our BSM strategy and strengthen our capabilities in fast-growing market segments.

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

We are very pleased with our continued success in enhancing our BSM leadership and extending our solutions and capabilities to better serve customers and improving how we manage the business and ultimately, in building shareholder value.

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

We’ve talked in the past about the customer needs that are fueling demand, not only for BSM in general, but specifically for our BSM offerings. I would like to share an additional data point with you. Industry consultants IDC recently completed a survey of the corporate IT world. According to the survey, nearly 18% of the respondents have already begun to implement BSM; but more than double that amount, another 38%, plan to do so within the next six to 12 months. So over 55% of the respondents have already started down the BSM path, or will shortly begin the journey.

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

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

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

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

During the second quarter, we continued to build our reputation as the BSM leader and innovator. For example, we had a major competitive win and signed an important new contract with Merrill Lynch. As part of the deal, Merrill Lynch joined the ranks of other major companies that have standardized on the BMC Atrium CMDB, including Accenture, EDS and Lockheed Martin. We also won a large deal against the major competitor with a large Asian car manufacturer and we won our first major BSM account in the Chinese insurance industry.

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

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

“Our CMDB strategy provides the central platform for automating our governance and control environment, and assists in reducing the escalating costs of regulatory burden.”

Quoting another customer:

“To remove the CMDB now for our business can be compared to removing all patient records from a hospital.”

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

There was another very positive aspect to BMC UserWorld this year. We used it to build on our recent service automation launch. As I have said previously, we think automation is going to be a big driver for BSM going forward. For example, the IDC survey that I mentioned a few minutes ago asked the respondents, what are the key drivers for implementing BSM? The top answer was automating IT process work flows.

Our service automation solutions address all of the elements required to automate the delivery of business services, and they have been very warmly received in the marketplace.

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

“As customers rollout deployment automation across physical and virtual environments, we believe that the BMC Software’s service automation solution can reduce IT operational cost and accelerate the delivery of new IT services in data centers virtualized using VMware infrastructure.”

Our recent acquisitions, RealOps and Emprisa, also play directly into our automation strategy and extend our capabilities in this area. Emprisa, which we bought last month, is a company that we previously partnered with. Emprisa’s technology will allow our customers to 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 Book Automation that we’ve worked successfully with over the years. RealOps technology allows our customers to automate the often labor-intensive, manual operational tasks required in delivering IT services. RealOps solutions, as well as Emprisa solutions, are already integrated with the BMC Atrium CMDB and are getting a great reception from our customer base.

Emprisa and RealOps extend our capabilities in IT process automation. Automation is the next step in the evolution of BSM and we’re determined to extend our leadership in this space.

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

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

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

We are certainly seeing a positive impact this year from our mainframe business. In fact the past four quarters have been strong for us. As always, it’s worth noting the business is cyclical and that quarterly bookings can also fluctuate. Our fundamental view of the business is that it is large, 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 renewal business, we continue to attract new customers and win share. In fact, during the second quarter, we won over 30 competitive replacements, new customer wins or new product deals. In the US, this includes a major information processing company; in Asia, National Australian Bank; and in Europe, Alliance. So that covers our two business units.

Now I’d like to shift gears to discuss one other important initiative, the structural improvements we’re making to our company’s efficiency and productivity. Over the past seven quarters we have consistently grown revenues while keeping our non-GAAP operating expenses roughly flat to declining, even after absorbing incremental costs from multiple acquisitions, internal investments and negative currency impacts.

One of the main drivers underpinning this performance is our success in globalizing our business operations. For example, we recently passed an important milestone and now have over 1,000 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 our workforce 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 the second quarter and the first half, and we expect continued solid performance in the second half. I will comment later on our improved guidance for the year but before I do that, let me turn the call over to Steve Solcher for a more detailed operational and financial review.

Steve Solcher

Thanks, Bob. Second quarter results reflect another quarter of solid financial performance. Whether you look at bookings, revenues, operating margin, earnings or cash flow, we improved in virtually every category. In addition, we have now met or exceeded our revenue and non-GAAP EPS guidance for ten quarters in a row. This also marks our sixth quarter in 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 expense control. We have held non-GAAP operating expenses flat for the last four quarters, while growing revenue in the mid single-digits.

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

With that, let me begin by reviewing our financial results. In the second quarter, non-GAAP operating income increased by 39% to $119 million; non-GAAP operating margin increased 6 percentage points from a year ago to 28%. Non-GAAP net earnings for the second quarter were 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 shares outstanding in the second quarter of 202 million versus 209 million in the year ago period.

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

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

The weighted average contract length for total bookings on a trailing 12-month basis was 2.4 years compared to 2.2 years for the year ago period. On an annualized basis, trailing 12-month bookings were $742 million, up 6% compared to the year ago period. This marks the seventh consecutive quarter in which we’ve achieved annualized bookings growth on a trailing 12-month basis. Please refer to slide 7 in our presentation.

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

Partially offsetting the impact of higher core BSM license bookings was the decline in the distributed systems management license bookings during the quarter. Like the MSM business unit, DSM performance can be skewed by large transactions and the timing of contract renewals. Over the first half of the year, DSM license bookings were up 16%.

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

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

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

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

From a geographical perspective, revenue growth was balanced with the US increasing 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 a sequential basis. Professional services revenues were $29 million in the second quarter, up 31% compared to $22 million in the year ago period. We have spent a lot of time re-training and improving the skills of our consulting organization to support our BSM strategy and this effort is beginning to show progress.

Moving next to operating expenses. I continue to be very pleased with our ability to control operating expenses. Our non-GAAP operating expenses were $302 million, roughly flat on a year-over-year basis. It is important to highlight that expenses have been flat even after absorbing expenses from acquisitions, internal investments and the negative impact of currency movements.

There are a few key drivers underlying our ability to hold down costs that should continue to trend positively for us going forward. These include continuing our expansion into low cost locations, reengineering core processes and eliminating redundancies in systems and applications. Our overarching goal is to further simplify, standardize, and automate key business processes 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 of the second quarter was $512 million, down $8 million sequentially. During the quarter, we deferred $64 million of license revenues or 45% of license bookings, and recognized $72 million of deferred license revenues from the balance sheet.

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

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

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

During the second quarter, we repurchased 6.7 million shares and we now have slightly under 1 billion remaining in our stock repurchase program.

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

Robert Beauchamp

Thank you, Steve. As I mentioned, I am pleased with our second quarter and first half performance. We’re executing well across our business to drive growth in bookings, revenues, earnings and cash flow. We’re investing 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 virtually every measure, it is shaping up to be another year in which we continue to create value for our shareholders.

Let me now update you on our guidance for fiscal 2008. We’re raising our guidance and now expect non-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 of special items related to expenses for amortization of intangible assets, in-process research and development, share-based compensation, and restructuring activity.

The assumptions underlying this full year fiscal 2008 estimate 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 are increasing our expectations for cash flow from operations. We now expect cash flow from operations to improve to between $525 million and $575 million.

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

Before we take questions, I would like to mention to you that we recently conducted a review of our practices regarding earnings guidance. The purpose of the review was to determine whether we should discontinue providing any guidance, shift to providing annual guidance, or continue with our current practice of annual and quarterly guidance.

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

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

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

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

Question-and-Answer Session

Your first question comes from Michael Turits - Raymond James.

Michael Turits - Raymond James

A very strong quarter all round. It looks like both this quarter and last quarter 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 the back half or you think 6% is a good number for the year?

Steve Solcher

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

Michael Turits - Raymond James

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

Steve Solcher

Yes.

Michael Turits - Raymond James

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

Steve Solcher

So that’s correct. In the past, our guidance had been we wanted the decline in the annualized number to be no worse than 5%. What we are changing our guidance to say is that we actually believe going forward that this number is going to be positive. So from the MSM unit, we are now guiding to what I would say a low to mid single-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 an absolute basis is going to drop, but at the same time you are going to see contract length shorten. The beauty of that is on an annualized basis it will grow.

Michael Turits - Raymond James

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

Robert Beauchamp

Michael, I will tell you that we separated mainframe, as you probably know, into a dedicated business unit. The MSM unit is standalone. It has its own general manager. It has its own dedicated salesforce. It has its own dedicated pre-salesforce, marketing campaigns. It runs in many respects like a separate organization focused on achieving its own goals.

That has just really paid off for us in so many ways, not the least of which is just the amount of visibility and analytics that we have on the individual transactions that we are doing every quarter that are coming into the pipeline are much stronger. That group is watching the health of the deals, the quality of the business very, very tightly.

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

Michael Turits - Raymond James

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

Robert Beauchamp

I don’t think so. Because this group is innovating and working on new technologies integrating into BSM, we get some nice competitive uplift. I think that some of our competitors have been distracted and have really been focused so much on growing bookings that I’m not sure that they’re as focused on their products as we are.

Our team is very skilled, again, at selling value. What our products 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 an entirely independent division, not just sales and marketing, but down through code and development and so on?

Robert Beauchamp

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

Tom Curlin - RBC

Is that driven exclusively by performance metrics and accountability 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 its focus years ago and was blending everything together and selling financial transactions. We became, if you recall the earnings calls of several years ago, we were very focused on reinvigorating the 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 the ability 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 just raw booking growth from a license perspective. On the mainframe side, let me just ask it in qualitative terms. Have you seen some deceleration this quarter and may be over the next couple of quarters, just in overall flow of business on mainframe driven by the transitional issues that IBM is seeing with the mainframe product line?

Robert Beauchamp

No, we have not.

Operator

Your next question comes from Tim Klasell - Thomas Weisel Partners.

Tim Klasell - Thomas Weisel Partners

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

Steve Solcher

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

Robert Beauchamp

From a contribution standpoint it is profitable today and one of our most strategic focus areas is to improve the profitability of that unit while maintaining the growth trajectory.

Tim Klasell - Thomas Weisel Partners

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

Robert Beauchamp

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

Competitively, there is less intensity in many areas here. We do have the lumpiness so that is a true statement but I would say that also just in execution the one area of our business that I would have liked to see better this last quarter was DSM. I think some of that is execution related. The product portfolio as you know was rewritten and brought forward and was some excellent technology, but it 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 half is we decided that the product line was absolutely competitive and ready to go to market in a big way. Beginning in Q3 we have changed the sales comp plan and moved away from what is largely an in-house renewal sales force for DSM and beginning in the second half of the year, the sales focus for our large, direct sales force that sells the whole BSM suite will now be compensated and have goal set around DSM as well.

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

Tim Klasell - Thomas Weisel 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 million last year at this time.

Tim Klasell - Thomas Weisel Partners

Okay, no color on mega deals?

Steve Solcher

No.

Operator

Your next question comes from Philip Winslow - Credit Suisse.

Tim Philip Winslow - Credit Suisse

Hi, guys most of my questions have been answered, but I just wanted to get back on the mainframe side. Obviously you are seeing an improving price environment and also pretty decent demand. Over the next couple of quarters here, just with the release of the 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 for IBM to start coming out with their new -- if they stay true to their old format -- we should see the new products coming out from IBM soon. That always has a long-term uplift for us. Short term, it has very little effect as we sell into the existing install. So when those contracts expire, whatever the existing install base is, that is the bulk of our opportunity.

As we mentioned in the call, we did have 30 transactions where we either competitively replaced new contracts or new products into existing customers and so we are focused on that business. It is still largely renewal business 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 would be is last year second half we had incredible performance within the MSM group and at the beginning of this year we had visibility into those tough comps. So our initial guidance for this business was a decline in the high single-digits; it’s improving. Now most of that improvement is because of over performance in the first half. But we feel comfortable and we feel good about the business and hopefully here in the second half you will see better results.

Operator

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

Brandon McKay - CIBC World Markets

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

Robert Beauchamp

On DSM?

Brandon McKay - CIBC World Markets

On just the ESM business in general?

Robert Beauchamp

Well, on the ESM in general DSM is the part of it that is not doing as well as we would like. On the core BSM, it’s rocking. That business is doing very well. You are talking about on the operating margins?

Brandon McKay - CIBC World Markets

Yes.

Roger Plank

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

I mean I was on the phone this morning with two very large banks, one headquartered in New York, one headquartered in Europe, discussing implementations of ESM and one of the top people there said his goal is to standardize on as much BMC Software as possible. So we should see some productivity from that angle the CMDB and the incredible -- I mean really remarkable -- success we are having with having many of the world’s largest corporations standardized on our integration platform; our integration architecture should help that as well.

From a development standpoint, because we are integrating into that common environment in our R&D organizations, we have R&D efficiencies that are derived from that. From the IT organization, there are a number and we have talked about it in the past. There are a number of automation simplification initiatives and the executive that I hired, Jay Chung, is really focused full time reporting directly to me on improving our expense structure through automation. We had some very good progress with that on things like electronic product distribution, but we still have some of the biggest productivity gains yet to come on order to cash and in customer support and 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 - CIBC World Markets

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

Steve Solcher

I don’t want to give you ‘09 guidance yet but I think your assumption is correct. I think our view is that we are trying to do some directional things infrastructure-wise that allow us to scale without adding a dollar of expense for every dollar of revenue. So I think you are exactly on the point that Bob and I both feel very confident about, that as we continuing to see top line accelerate, we are not going to see the level of spending accelerate along with 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-term structural improvement through automation and just through better execution and we’ve got quite a bit of opportunity to do that over the quarters ahead.

Brandon McKay - CIBC World Markets

You’ve talked about that mainframe survey that you did with your own clients. If you look at the results this time what do they compare against 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 the results of that it was I didn’t go into the comparative aspects of that. The mainframe manager that did it will certainly have that, but I don’t have it at my fingertips.

Operator

Your next question comes from Richard Sherman - MKM Partners.

Richard Sherman - MKM Partners

A question on the change in the sales compensation structure, I missed part of that. I was wondering if you could may be repeat what you said and may be amplify exactly what kind of changes you’re making there?

Robert Beauchamp

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

What we’ve done differently, what we have been doing essentially is offering the inside salesforce on the phone have been the primary people that are paid on DSM renewals. What we done here is now we are leaving that there, but we are also shifting the compensation and offering significant compensation to the sales and sales management of the ESM core salesforce for DSM revenues. So they will be focused on renewals, they will be focused on driving new customers they will be focused on selling larger transactions that include DSM and selling BSM is a larger portfolio that includes the whole core BSM and DSM together in 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 IT executives at a CIO event for two days. After dinner, one of our large customers who just standardized on our core BSM products came up to me and he said, please send someone to talk to me about the DSM solution because I believe that I need to buy your DSM product line and integrate it into the core BSM solution.

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

Richard Sherman - MKM Partners

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

Steve Solcher

That’s true. Is your question around fiscal year ‘08? If its ‘08 I would tell you that you are looking about, we are about halfway through. The level of performance you have seen in the first half I would tell you that we’re looking for the same level of performance, slightly better in the second half.

Richard Sherman - MKM Partners

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

Robert Beauchamp

Absolutely, and sometimes on these calls we basically prepare for the questions we know that are going to be asked, but internally what we talk about, I mean, you were there. You saw some of the top, some very senior IT executives of some of the world’s largest IT organizations just throw praise after praise on not on the promise of our ROI but on ROI realized around standardizing on our architecture, 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 all the time, is just really, it’s an entirely, it’s a new generation architecture. The old generation was client server-based. It was installed in the ‘90s to support client server and the new generation for automating the data center of the future is BSM and that is absolutely what’s driving the excitement.

Steve Solcher

That is why our salesforce is motivated, they’re fired up. I mean you just see it in the customer conversations are different, it’s a very different 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 to take off about a year ago in terms of acceleration. I just wanted to get your sense for when you are doing your forecasting, is that kind of a growth rate now which you would view as a normalized growth rate for that business going forward?

Robert Beauchamp

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

Derek Bingham - Goldman Sachs

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

Robert Beauchamp

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

What happens in this deals is the deal size does get somewhat bigger but also what happens is they begin to come back to us. They go from change config on the first order and then they come back for incident and problem on the second order and then they come back for asset and discovery on the third order. So basically it solidifies us as their vendor of choice for the whole service management chain and if we do a good job the whole systems management chain. We are not there yet on that but that’s where we’re targeting, is to really become the de facto standard inside the organization for the solution sets that integrate into the integration core, which we are just having so much success with right now.

Derek Bingham - Goldman Sachs

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

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

Robert Beauchamp

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

From the customers, we saw the headlines from New York and we were wondering whether or not we would see deals slip or deals fall out, we saw none. We have seen absolutely – I mean so far, it could happen this quarter but we haven’t. We’ve no reason, we haven’t seen it. We’ve seen no indication of a slowdown in spending. Right now, the macro factors seem to be quite 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 next corner, but we haven’t seen it in our business and the people that are talking to our customers and the customers I talked to have not really. I can think of two customers that told me that they thought that there would be some constriction of their IT budget next year as a result of the financial services sector, but these were customers who are writing us big checks. They have written us big checks.

Operator

We now go to Israel Hernandez - Lehman Brothers.

Israel Hernandez - Lehman Brothers

Bob, last week at the user’s conference you heard from a number of your larger partners and customers. Particularly with respect to EDS and Accenture, what type of uptake in commitment are you getting from some of these large partners? Do you see them becoming an important channel for distributing DSM going forward?

Robert Beauchamp

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

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

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

Operator

Your next question comes from Jeff Constantino - Banc of America Securities.

Jeff Constantino - Banc of America Securities

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

Robert Beauchamp

I’ll take the second part first and Steve will give you a specific answer. In terms of adoption levels a lot of BSM is built on ITEL. It’s built on the belief that IT best practices should not be invented and new at every account. There are best practices and that again is stronger in UK, it began there and it’s still has its home base I think really in the UK and in Central Europe and Germany and Austria and Switzerland it’s strong.

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

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

Jeff Constantino - Banc of America Securities

One other quick one, in regard to the second half cash flow estimate in terms of raising the guidance, can you just talk about the sales and receivables that you are expecting in the second half compared to the first half? Pretty much the same amount?

Steve Solcher

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

I would tell you that the monetization piece is not a metric we focus on. It is something that we are largely indifferent on how customers choose to pay for their transactions whether it be cash which would show up in trades receivables or finance it through finance receivables. The way that we look at it, we are indifferent on that.

Operator

At this time there appear to be no additional questions. I’ll turn it back to you all for closing remarks.

Robert Beauchamp

Well let me just close out by thanking you all for joining us. An exciting quarter for BMC. We’re looking forward to the second half. I want 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 that have written about it, have said some very positive things after talking to customers and it’s exciting because it feels like the BSM that we’ve been watching for the last year is now becoming very real for you as you talk to the customers and see the effect it’s having.

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

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