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Aruba Networks (NASDAQ:ARUN)

Q3 2012 Earnings Call

May 17, 2012 5:00 pm ET

Executives

Maria Riley - Director

Dominic P. Orr - Chairman, Chief Executive Officer, President and Chairman of Corporate Development Committee

Hitesh Sheth - Chief Operating Officer

Michael M. Galvin - Chief Financial Officer and Principal Accounting Officer

Keerti Melkote - Co-Founder, Chief Technology Officer and Director

Analysts

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Mark Sue - RBC Capital Markets, LLC, Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Jeffrey T. Kvaal - Barclays Capital, Research Division

Jason Ader - William Blair & Company L.L.C., Research Division

Brian T. Modoff - Deutsche Bank AG, Research Division

George C. Notter - Jefferies & Company, Inc., Research Division

Matthew Hoffman - Cowen and Company, LLC, Research Division

William H. Choi - Janney Montgomery Scott LLC, Research Division

Jack Monti - UBS Investment Bank, Research Division

Richard Valera - Needham & Company, LLC, Research Division

Erik Suppiger - JMP Securities LLC, Research Division

Rajesh Ghai - ThinkEquity LLC, Research Division

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the Aruba Networks Earnings Conference Call. [Operator Instructions] This conference is being recorded today, Thursday, May 17, 2012. And at this time, I'd like to turn the conference over to Maria Riley with The Blueshirt Group. Please go ahead, ma'am.

Maria Riley

Good afternoon and thank you for joining us on today's conference call to discuss Aruba Networks Fiscal Third Quarter 2012 Results. Today's call is also being broadcast live over the web and can be accessed in the Investor Relations section of the Aruba Networks website at www.arubanetworks.com. With me on today's call are Dominic Orr, Aruba's President and Chief Executive Officer; Mike Galvin, Aruba's Chief Financial Officer; Keerti Melkote, Aruba's co-founder and Chief Technology Officer; and Hitesh Sheth, Aruba's Chief Operating Officer. After the market closed, Aruba Networks issued a press release announcing the results for its fiscal third quarter ended April 30, 2012. If you would like a copy of the release, you can access it online at the company's website or you can call The Blueshirt Group at (415) 217-7722 and we will fax or e-mail you a copy. We would like to remind you that during the course of this conference call, Aruba Networks management will make forward-looking statements, including statements regarding the company's expectations regarding growth drivers, including the rapid proliferation of mobile devices, BYOD and IT spend; customer adoption and penetration of our MOVE architecture, mobility access switches and software solutions; and the company's future economic performance, pipelines, financial conditions, tax rates and results of operations. These forward-looking statements involve a number of risks and uncertainties some of which are beyond our control, which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today and you should not rely on them as representing our views in the future. And we undertake no obligation to update these statements after this call.

For a more detailed discussion of these risks and uncertainties, please refer to our quarterly report on Form 10-K, filed with the SEC on March 8, 2012, as well as our earnings release posted a few minutes ago on our website. A copy of today's documents may be obtained from the SEC or by visiting the Investor Relations section of our website. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the Investor Relations section of our website, located at www.arubanetworks.com and in our earnings press release. I would like to announce that Aruba will present at the Barclays Global Technology Media and Telecommunications Conference on May 22 in New York City and The RBC Communication Technology and Semiconductor Investor Day on June 5 in Boston. We will look forward to seeing many of you there. Now I'd like to introduce Dominic Orr, President and Chief Executive Officer of Aruba Networks. Dominic?

Dominic P. Orr

Thank you, Maria. Good afternoon and thank you for taking the time to attend our third quarter conference call. We achieved our 12th consecutive quarter of record revenue in Q3, growing revenue 25% year-over-year, 4% sequentially to $131.9 million. The record proliferation of mobile devices and the BYOD phenomenon in the workplace continues to fuel our momentum. We believe these trends, combined with our differentiated mobility solutions, will continue to drive Aruba's growth for many years to come. Our traditional key verticals, including education and healthcare, performed well in the quarter, along with the general enterprise. In fact, I'm very pleased to report a record quarter for bookings in Q3, with solid growth across all major geographies. While the macro environment may be [indiscernible] in the U.S. and Europe, we continue to believe that core Wireless LAN demand remains solid. In Q3, we had our strongest quarter ever of new customer acquisitions, bringing our cumulative customer total to over 20,000. Key wins this quarter for our core wireless LAN products included some of the largest business-related social networking sites, one of the world's largest car manufacturers, a leading electronics and semiconductor company, one of the largest life insurance and financial services companies in the world and a major city in Asia that placed outdoor mesh network.

We continue to experience momentum in customer adoption of our broader MOVE architecture. Key wins included a luxury department store chain in North America for their wireless and wired access network, and along with Brandeis and Texas A&M Universities, many educational institutions have selected our wireless infrastructure campus-wide, in addition to our wireless LAN solutions. Just like what we saw in the early days of wireless LAN technology, we believe we are seeing higher education lead the way in embracing adoption of our MOVE architecture.

We're also making progress with our ClearPass platform. We are very encouraged by the number of requests for ClearPass pilots and are very excited by the responses we have seen from both new and existing customers. Additionally, I am pleased to announce that we have recently won the business of a major global bank for our ClearPass solution being deployed over their legacy physical wireless LAN infrastructure. And now, we're deploying the follow-on project for the branch networks using our VBN solution. We believe this new technology will help us penetrate into large enterprise accounts. As we stated at our Analyst Day, these are architectural wins and have longer sales cycles when compared with our traditional wireless LAN sales.

In the third quarter, we saw increased momentum among service providers for our managed services, an area in which the value proposition of our product portfolio resonates. Key wins included a global coffee company for all of their stores in Canada; one of the top 3 convenience store chains in Japan; Canada's largest quick service restaurant chain; and in a major city-wide 11n network upgrade in Asia managed by a leading service provider in the region. It's worth noting that the managed service segment of the service provider market has always been and remains a key component of our go-to-market strategy and a profitable one at that. These recent wins are evidence of our increased momentum in this space.

Now, before we go over more detailed run-through of our financials, I would like to announce that Hitesh Sheth, our COO, will be leaving us on June 1, 2012 to pursue other opportunities. Hitesh has been a significant contributor to Aruba over the past 3 years and on behalf of all of Aruba's employees, I want to take this opportunity to thank Hitesh for his contributions to the company. Hitesh, we respect your decision to pursue a new direction and I, along with your colleagues, wish you all the best. I will now turn the call over to Hitesh

Hitesh Sheth

Thank you, Dom. First, I'd like to say that I'm very grateful for the opportunity I've had to be part of Aruba over the last 3 years. It has been a real privilege to work with Dom, the executive team and the entire Aruba family. Dom is a very special leader and someone for whom I have the highest respect and from whom I've learned a lot. The time has come for me to take those learnings and apply them to a new venture. I personally believe that Aruba has a phenomenal future ahead and I'm bullish about the company's prospects. I wish the company the very best in every success. I would now like to turn the call over to Mike for a detailed financial review of the quarter.

Michael M. Galvin

Thank you, Hitesh. In Q3 2012, total revenue came in at the high end of our guidance range at $131.9 million, a 4% increase sequentially and 25% year-over-year. Product revenue of $110.5 million increased 4% sequentially and 24% year-over-year. Professional services and support revenue of $21.1 million increased 5% sequentially and 30% year-over-year. U.S. revenue grew 24% year-over-year, representing 59% of total Q3 revenue. International revenue grew 25% year-over-year, representing 41% of total revenue for Q3. Year-over-year revenue growth was strong across all theaters, consistent with our bookings performance as Dom mentioned. Total non-GAAP gross margin in Q3 was 72.4%, an increase from 70.3% in Q3 '11, and a decrease from 74.2% in Q2 '12. Our Q3 '12 non-GAAP gross margin result is above our guidance range of 70% to 72%.

As discussed last quarter, several unique transactions that favorably impacted our Q2 '12 non-GAAP gross margin were not expected to repeat in Q3 '12. In Q4 '12, we expect total non-GAAP gross margin to be between 70% and 72%. Q3 non-GAAP product gross margin was 71.2%, an increase from 68.8% in Q3 '11 and a decrease from 73.2% in Q2 '12. Q3 non-GAAP services gross margin was 78.3% compared with 79.3% in the prior quarter and 78.4% in the same period a year ago. Non-GAAP research and development expense was $19.2 million, flat to Q2 '12 in dollars and down 60 basis points as a percentage of revenue compared to Q2 '12. Non-GAAP sales and marketing expense increased to $40.6 million in Q3 from $38.7 million in Q2. As a percentage of revenue, Q3 sales and marketing was 30.7%, in line with Q2. Non-GAAP G&A expense decreased to $8.5 million in Q3 from $9.2 million in Q2 '12. As a percentage of revenue, G&A expense in Q3 was 6.4%, a decrease of 90 basis points from Q2.

Total headcount at the end of Q3 was 1,166, a decrease of 27 from the prior quarter. In total, Q3 non-GAAP operating expenses were $68.3 million or 51.8% of revenue, down from 53.2% in Q2 '12. Operating expenses as a percentage of revenue in Q3 were a record low for the company. While we will continue to make investments in the business, we expect to continue to grow revenue faster than expenses as a general trend. Our non-GAAP operating profit in Q3 was $27.2 million or 20.6% of revenue, a decrease of 40 basis points from the prior quarter. Our non-GAAP tax rate of 28.4% improved slightly and was within our guidance range of 28% to 29%. As we have previously discussed, our overall tax rate is subject to change, including from the projected geographic mix of the company's revenue, as well as changes resulting from any new U.S. or international regulations or interpretations.

Non-GAAP net income for the quarter was $19.4 million or $0.16 per diluted share. This compares to $19.4 million or $0.16 per diluted share in Q2 '12 and $18.8 million or $0.16 per share in Q3 '11. The weighted average shares outstanding were 121.9 million shares on a diluted basis. On a GAAP basis, net income was $6 million or $0.05 per share compared with a Q2 '12 net loss of $11.4 million or $0.11 per share and a Q3 '11 net income of $3.2 million or $0.03 on a per-share basis.

A full reconciliation of GAAP and non-GAAP information is contained in our financial results press release issued this afternoon. Turning to the balance sheet, we finished Q3 with cash and short-term investments of $316.5 million, an increase of $40.7 million over the prior quarter. Cash flow from operations was a record $28.4 million. We ended Q3 with $83.6 million of accounts receivable, up from the Q2 '12 balance of $69.2 million. Days sales outstanding were 57 days, up from 49 days in Q2 '12 and flat with 57 days in Q3 '11. We had a less linear shipping quarter in Q3 '12 than our historical Q3's, but the quality and aging of our accounts receivable remains excellent. Our target range for DSO remains 50 to 55 days.

Moving down the balance sheet, total deferred revenue of $91.3 million increased 47% year-over-year and is up $26 [ph] million from Q2 '12. Short-term deferred revenue of $71.0 million increased 42% year-over-year and decreased 2% sequentially. The primary reason for the decrease in short-term deferred revenue was slightly lower inventory levels at our distributors. Aruba inventory totaled $20.5 million at the end of 2, a decrease of $3.9 million from the end of Q2.

Let me now turn to our fourth quarter of fiscal 2012 guidance. The macroeconomic environment appears to be mixed, with continuing solid demand for core WLAN products as reflected in our pipeline of bookings. Balancing all of these factors, we expect Q4 '12 revenue to be in the range of $136 million to $138 million, an increase of 20% to 21% year-over-year or 3% to 5% sequentially. We expect non-GAAP EPS to be approximately $0.16 to $0.17 per share, using 124 million shares on a diluted basis. With that, let me turn the call back over to the operator to take your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Ryan Hutchinson from Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

So the question's around the guidance. If I look at the midpoint, I just want to be clear. I assume there's no China service provider revenue in the quarter, so it's basically, by my calculation, it's about 27%. So can you just talk to what you think the market growth rate looks like? And as part of that, can you explain what you mean by elongated sales cycles and if, in fact, that's taking hold with respect to the guidance or is it simply macro?

Dominic P. Orr

So I believe that if you look at Aruba's product growth compared to our major competitor, we have consistently been taking more market share and we expect, in Q4, with our current guidance, we will continue to take some share. Regarding the elongated sales cycle, I refer back to our ClearPass pilots and using that as a tool to get into the enterprise. The bank that I referred to, we spent a lot of energy to implement ClearPass over the Cisco wireless infrastructure. As a result now, we're expanding the following project to their branch network. Those are the kinds of projects that we love to continue to get in fact, expect them, and those projects, compared to the traditional building out of wireless LAN for a University campus, for hospital, for military installations, that is the longer cycle that I referred to today and exactly the same thing that I referred to in our analyst day when I say some of the new strategic architectural win projects using ClearPass, getting into the Fortune 500, that will involve a longer sales cycle and it is intended by the company, and that is part of our strategic objective. Let me just emphasize that we do not see any sales cycle change in our traditional core Wireless LAN business and that has never been intended otherwise. And I think there might have been some misinterpretation in the past.

Michael M. Galvin

And Ryan, just confirming. Your 27% attrition is right is right. And also, on a sequential basis, the guidance at 3% to 5% is really solidly in the range that we've guided historically, just as an extra data point.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Okay and just to clarify then, in the current quarter that just was completed, was there any China service provider related revenue and are you expecting any in the upcoming quarter?

Michael M. Galvin

No, there was not in Q3 nor are we expecting any in Q4. And of course, when I say that, I'm referring to this kind of hotspot business that we were doing. The service providers are still strategic partners of ours. But that business, no, there's none in there. And our -- as you said, 27% relative to the Q4 guide and with regards to our Q3 results that we just announced at 25%, that would've been 31% year-on-year taking into account the Q3 year ago hotspot business.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

And just, Dom, just so we're all clear here. With respect to the guidance then, there is no expectation with the elongated sales cycles? Or is there some of that, just not within the core business?

Dominic P. Orr

The guidance has taken into account that all our core Wireless LAN business have exactly the same sales cycle as we have seen, not impeded by any macro factors. It also has taken into account that we have directed strategically part of our sales and services force into cracking the longer sales cycle strategic accounts using ClearPass as the beachhead.

Operator

Our next question comes from the line of Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

If I look at your year-over-year revenue growth that's decelerating and I guess the upside is also getting smaller and smaller. Now it doesn't seem to be a penetration issue since you're increasing your sales and marketing. So I'm trying to see what is actually slowing. Is it U.S? Is it more Europe on your core business? And kind of the delta between kind of how you are tracking at the -- above the high end and how you came in, where would the incremental I guess, slowness was?

Dominic P. Orr

So first of all, if you take into account of the China still is by the hotspot business, back that out a year ago, we -- our growth is basically -- it had moved from about 40% plus to mid 30%. So that is approximately a 10% delta. I would say one component, if you talk about what is the noticeable change in growth, if you look at our 3 macro theaters, Europe is the one that we have seen, even though it's growing very nicely but for the last well over a year, Europe has grown significantly faster than the other 2 theaters. The last quarter, it has dropped back down to the same rate and it was tied to the fact that starting from southern Europe and moving more widespread, we think, quite a number of government-funded projects being frozen and we actually have to take that into account in our guidance in Q4 that we do not expect that situation to improve.

Mark Sue - RBC Capital Markets, LLC, Research Division

Dom, and so nothing really in the U.S.? Are you seeing any pause in some enterprise verticals? Not sales cycles extending but maybe expanding closure rates and U.S. verticals in the core business?

Dominic P. Orr

We have not seen any noticeable closure rates in our U.S. business. But for U.S., for the federal sector, we are in between some of the major program deployments. As you recall, most of our U.S. federal government projects are program related, not project runway related and it just happened this couple of quarters that in between major program deployments. So we have not had the benefit of major federal program expansion. From a revenue perspective, we continue to be encouraged to be winning significant design wins and having bookings in pilots for major projects and programs that we are very encouraged about. In fact, we expect in the coming years, we continue to remain in a very strong posture there. But in terms of revenue contribution in the current quarter and in the last quarter, that federal business has not been as strong a contributor as a year before.

Operator

Our next question comes from the line of Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Can you talk a little bit about kind of the trend between the addition of new customers and how that has been very strong versus the decelerating of revenue? Are the customers smaller there? How should we think about that?

Michael M. Galvin

So I think as a lot of you know historically, about 2/3 to 3/4 of our installed base, of our revenue each quarter has come from the installed base. We were a little bit higher than that range this quarter. Part of that, we are getting some MOVE penetration into the installed base, which is increasing that number a little bit. But also, to your point, on new customer growth, it has been very strong. And a lot of that new customer growth is in, just in terms of sheer numbers, it's in the mid-tier, which is a new growth area for us and a new area that we're expanding in. And so that strong growth, in terms of numbers of new customers, is coming at, because it is the mid tier and it's a different product platform, the ASP or average deal size in the mid-tier is going to be inherently a little bit smaller than our traditional platform.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Is there a different gross margin profile for that mid tier?

Michael M. Galvin

The gross margin is pretty comparable. Everything we've seen so far fits pretty well into our profile.

Kent Schofield - Goldman Sachs Group Inc., Research Division

And then last question, on the linearity comment. Can you break that down a little bit by geo as well? I mean, was the linearity a little bit longer in terms of the U.S. as well as Europe? Or was it more in Europe?

Michael M. Galvin

I don't have it explicitly broken down but I would say, just as a general point, the U.S. and Europe were, let's say, more of the impacts on that than Asia Pacific, Japan was this quarter.

Operator

Our next question comes from the line of Sanjiv Wadhwani with Stifel, Nicolaus.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

A quick clarification, Mike. I just wanted to clarify, if we exclude the China service provider business, you said growth in April would've been 31%. Was that the right number?

Michael M. Galvin

That's correct.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Two questions. One is, I know you're talking about a mixed sort of macro environment. I'm curious, Dom, are you seeing any changes in the education vertical as far as sort of deployments or funding, just given that Q4 is typically a stronger education quarter, right?

Dominic P. Orr

Yes, we do not expect any slowdown in the EDU sector.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Got it. So that still remains pretty robust going into Q4?

Dominic P. Orr

Yes.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Any thoughts on a buyback, gentlemen, at these levels? I mean obviously, the stocks have come under quite a bit of pressure over the last couple of months. I'm just curious what the board and what you are thinking, Dom, on the buybacks?

Dominic P. Orr

Yes, there are thoughts and there will be active dialogue with the board and we will keep you appraised and -- as we make progress. Definitely, a lot of talk.

Operator

Our next question comes from the line of Jeff Kvaal with Barclays Capital.

Jeffrey T. Kvaal - Barclays Capital, Research Division

Two questions for you, both about the guidance. I guess, given the linearity in the April quarter, why wouldn't you assume a little bit of a lengthier sales cycles in the July quarter? And then secondly, you had suggested at the Analyst Day that there's a possibility of revenue acceleration in the second half of the year, back ideally into the 35% plus range. Is that still sort of possible? How should we think about that?

Dominic P. Orr

[indiscernible] Jeff, to your first question about a little bit back end loaded in terms of linearity in Q3 and how that affected our guidance, we really, we take the same process every quarter in terms of looking at the pipeline, the conversion metrics, the inputs of our sales management. We take into account the macro factors that are out there and the things we see. We package it all together and we try to put a prudent a number out there that we feel good about. And so that process really was the same this quarter. And then [indiscernible] second question. Hey Jeff?

Jeffrey T. Kvaal - Barclays Capital, Research Division

Yes. The Second question?

Michael M. Galvin

Sorry could you repeat the second question?

Jeffrey T. Kvaal - Barclays Capital, Research Division

Absolutely. The second question is about revenue acceleration in the second half of the calendar year.

Dominic P. Orr

Okay. I think we did not put a specific timeframe on that and what I was saying on that day was that this whole new MOVE architecture with the ClearPass platform as a leader getting the enterprise is going to take multiple quarter to take traction. And as what is shown in this large global bank, once we have traction, we will have annuity business and when we have that annuity business added on top of the project based verticals, that is when we expect that revenue reacceleration. And I feel very much on track on the plan as we articulated 1.5 months ago.

Jeffrey T. Kvaal - Barclays Capital, Research Division

Should we continue to expect revenue acceleration as you anniversary the Azalea deal?

Dominic P. Orr

We're not giving guidelines more than a quarter at a time. I think as the time progresses, you will hear us set the proper guidance. But at this moment, all I can tell you is that our strategy has been executed efficiently and the market's feedback and the early pilot customer feedback is that we are dead on, on our strategic objectives. So we will continue to execute. We will not change strategies.

Operator

Our next question comes from the line of Jason Ader with William Blair & Company.

Jason Ader - William Blair & Company L.L.C., Research Division

A couple of quick questions for you guys. First of all, on the linearity, what did you guys see happen in the quarter? Why do you think it was so back end loaded? Was it just purely macro? Was it a specific region, a specific vertical? What kind of was behind your expectations as you move to -- into the third month?

Dominic P. Orr

So I could recall that the first half of the quarter was very quite linear as compared to previous Q3. As we got into the second half of the quarter, we had a pretty sudden halt of government-funded project, first in Southern Europe, and that was brought in slightly across. And we spent the second half of the quarter regrouping and making sure that we have some more accelerated projects in other regions to make it up. And I think that, for me, is a major factor for some of the linearity to our reaction time to this -- some of the frozen government-funded projects in Europe.

Jason Ader - William Blair & Company L.L.C., Research Division

And federal was in line with your expectations or was that also below your expectations?

Dominic P. Orr

Our federal was in line. In fact, federal bookings was very good quarter-to-quarter, but from the revenue contribution, let's say compared to over a year, it was lower because of the in-between program deployment cycle, which was expected. There was no surprises in federal. There was close to zero surprise in the federal business for us. Everything executed well.

Jason Ader - William Blair & Company L.L.C., Research Division

And then Mike, on the headcount, it was down 27 in the quarter. Could you provide some color on why headcount would be down given the fact that you guys are still growing pretty fast?

Michael M. Galvin

Yes. So on any given quarter or every quarter, we channel P&L holistically, obviously, in terms of getting to our objectives. And going into this quarter as we talked about last quarter, we did know that the gross margin was going to come down from that record last quarter. And so really, throughout the P&L, we got to make these tradeoffs every quarter to hit our objectives. And so we look at that and that's an expense item and so to deliver the kind of operating leverage, et cetera, knowing what was going on with gross margins, we modulate that just like in a quarter, we may increase it or programmatic spend, et cetera. It is just one of the many factors.

Dominic P. Orr

And also, we have monthly, a very tight and responsive control of the operations and budget side. And when we saw the -- in mid-quarter, some of the linearity is not coming in, we kind of took tight control of headcount in terms of replacement and so on and controlled it through to the end of the quarter and that partially explains that.

Jason Ader - William Blair & Company L.L.C., Research Division

So you didn't actually lay people off. You just didn't hire.

Dominic P. Orr

No it is just a prudent -- when we see in the quarter that the linearity was all that we expected of the European situation. We just take very, very precautionary measures and make sure that we don't over extend.

Jason Ader - William Blair & Company L.L.C., Research Division

And last question for me, just on Mike's comment on the mid market, what kind of effect is Aruba Instant having in the mid market? Is that the primary product you're selling there?

Dominic P. Orr

Yes, and it is getting very good reception. As I mentioned before, that is [ph] the product which carried the same gross margin profile so the net effect is it's starting to take us into the mid tier market, which we did not participate before. Having said that, this is still only a quarter and a half effort. So like any market, it takes multiple quarters to ramp. So I'm very encouraged with the early signs but it's still in the kind of early stage in the game.

Operator

Our next question comes from the line of Brian Modoff with Deutsche Bank.

Brian T. Modoff - Deutsche Bank AG, Research Division

Can you talk just about what you're seeing competitively? Are you seeing any increased visibility from some of the smaller players in the market coming after your business on the kind of the Fortune 500 and as you've seen Cisco get more aggressive in terms of their pricing or their strategy in the wireless LAN area?

Dominic P. Orr

I think the -- we certainly sense that the Cisco competition is strong and we're seeing them more and I think the part of the reason is the overall macro economy that make everybody more intense and partially because there are more larger size projects there so that is attracting the attention of, not just Cisco and I would say generally all the traditionally large wire infrastructure companies, they try to get a go at some of these larger projects. But competitively still, it's really in the lot, Fortune 500 is still between us and Cisco. As regarding to the smaller newcomers, I think as we mentioned in the previous quarter, the most active areas, the lower EDU, the smaller scale EDU projects, the K-12, that is a very active market and a lot of players are trying to get into there.

Operator

Our next question comes from the line of George Notter with Jefferies and Company.

George C. Notter - Jefferies & Company, Inc., Research Division

I wanted to ask about potential for some slowdown in your business in federal at year end, you've got an election going on around that time, you got turnover in Congress. Certainly, I guess, it sets up the potential for budget impasses or government slowdowns and is that something you consider when you look forward? Is that a risk in your mind?

Dominic P. Orr

Absolutely, George. When we look at our forecast and our guidance, we look at all the key verticals and federal is obviously one of them. But I want to clarify that once again, that most of our federal business are program related and a lot of this program, in fact, all of the programs are multiyear programs, very few of them are tied specifically to quarter-to-quarter such as fluctuation. And they refer to -- I would not use the word slowdown, as you have. In fact, I think in terms of project pipeline and the number of design wins, actually, I see accelerated wins, as actually BYOD is happening in the federal market as well. So a lot of our advantages in BYOD, the ClearPass, all brings the one that is so effective in penetrating a large organization, it's also getting very effective in federal. So I'm very encouraged about the expeditious speed up of the business. I expect that federal will continue to be rising terms of project wins. What I was referring to was that from a revenue contribution perspective in this quarter and last quarter, that we have not had as much a contribution in revenue compared to a year ago just because of the timing quarter-to-quarter, execution of those multiyear programs. So I would not, clearly not use the term slowdown to describe our federal business.

Operator

Our next question comes from the line of Matt Hoffman with Cowen & Company.

Matthew Hoffman - Cowen and Company, LLC, Research Division

I think you mentioned that distributor stocks were on the low side. The question is whether you believe the stock levels have declined because of strong sales being pulled forward for your products or is that really a reflection of caution by distributors on a wider IT spending environment?

Michael M. Galvin

Yes, it was a fairly slight decline in terms of the overall picture. And as we've talked about before, the snapshots at a quarter end can be a little bit lumpy. I think generally, if you follow those balances on kind of more of a rolling quarter average, it obviously does reflect kind of the pace of the business in that particular region that the distributor is supporting. So we saw it was a slight decrease and we've had other quarters recently with beer increases, partially driven by timing of when they take the stocking orders. So we don't read too much into that except we map all of our distributors, in general, with the pace of the theater or region that they're supporting.

Matthew Hoffman - Cowen and Company, LLC, Research Division

Does your guidance account for some sort of increase in the stock levels in the channel in the quarter? And I have one more follow-up on account.

Michael M. Galvin

Well, if I understand the question correctly, just to be clear, none of that stocking into those distributors counts in our revenue. We only get revenue on sell-through when they sell that revenue through. And their sell-through of our product is part of our overall pipeline and forecasting process.

Dominic P. Orr

So our guidance does not reflect stocking level. It just affects the sale revenue.

Michael M. Galvin

Correct.

Matthew Hoffman - Cowen and Company, LLC, Research Division

Great. And a last question here on the headcount and OpEx moving forward. Obviously you guys did a good job of holding back on hiring there in the third quarter. But can you keep from rehiring those departures over the next quarter or two? And what kind of an impact will that have on OpEx moving forward?

Michael M. Galvin

Yes, we definitely are still investing in the business, without a doubt. And at the same time, like we have, we think we can continue to show leverage in that line. As we get closer to our operating model targets, the quarter-to-quarter improvement of that leverage slows down gradually. And it's not perfectly linear every quarter. Obviously, sometimes it can go up based on the timing of things. But as a general trend, particularly in our sales and marketing line, in our G&A lines, we think we can continue to show that leverage as a trend and we're absolutely still investing in the business and headcount, et cetera.

Operator

Our next question comes from the line of Bill Choi with Janney Montgomery Scott.

William H. Choi - Janney Montgomery Scott LLC, Research Division

It's just I'm dealing with obviously inexact numbers here when we're talking about the number of customers added and so forth. If you're over 20,000, you're -- the rough mass is around 1,000. It's been running at 1,500 for the last 3 quarters. Just wondering if we could get a little more exact numbers here to see what's happening to the number of new customers being added on a quarterly basis and how you're finding, perhaps on a regional basis or verticals, the new customer additions and whether that differs materially from maybe a year or two ago?

Dominic P. Orr

Okay, so let me answer from an absolute number point of view. This is absolutely a record quarter in terms of number of customers but...

Michael M. Galvin

We mean, Bill, over 1,600. So it's greater than the recent quarters we reported.

Dominic P. Orr

And the reason that we are going to from now on, slightly deemphasize the absolute number of customers is as you have seen in our prepared portion of the call, our business is now moving from the core campus wireless LAN into now large strategic multiyear account, going through managed service part of the service provider business and then we're going into mid tier. So as you can imagine, a customer in each of the segments has totaled the meaning and we don't want to kind of aggregate the whole thing. In fact, inside the company, we have very specific measures in each one of the sector. In the mid tier now, obviously, you manage the major number of resellers getting into the mid tier account, in large global Fortune 500 and Global 2000. You obviously measure by each account. And for the managed service business, you actually are trying to figure out our strategic win for the service provider themselves. So if you count winning a service provider as compared to winning a mid tier customer and mix it up with the same as any one customer, that's potentially misleading. So I want to be more faithful to the way that we track our business.

William H. Choi - Janney Montgomery Scott LLC, Research Division

Thanks for that absolute detail, that helps clarify it. The other question is when you mentioned you accelerated projects as you ended the quarter, how did that impact backlog or pipeline coverage ratio versus historical levels, especially compared to when you would enter Q4 historically?

Dominic P. Orr

Well I mean, obviously, the customer implements projects at their pace. The fact that we need revenue here and there doesn't really affect the customer's deployment. What it is, is sometimes, when you have a global business, that you find it in some geography, they're having some difficulty, you're just putting more tension, you're making sure you have more discipline and more intensity in other geography. And so that is a normal way of doing, managing business. Whether that affects pipeline and so on, whatever effects that has, it is baked into our guidance. And every quarter, we look at our pipeline and look at the state of readiness and give it a closer rate and the rate is moderated by factors like you mentioned and macro factors. And everything has been baked in with what we deliver as the guidance. So there's no extra factors to be considered beyond those.

William H. Choi - Janney Montgomery Scott LLC, Research Division

Okay and then just a bunch of number questions. Can you give the direct percentage on revenue and then your 10% customers? And I don't think I captured the domestic versus international sales split?

Michael M. Galvin

Yes, that was direct versus indirect was your first one?

William H. Choi - Janney Montgomery Scott LLC, Research Division

Yes.

Michael M. Galvin

Yes. That was 92% direct, 8% direct -- 92% indirect. 8% direct.

Dominic P. Orr

No 10%.

Michael M. Galvin

Well, we have 2 published 10% they're actually both distribution partners, which have been our historic, which is Avnet and Catalyst.

William H. Choi - Janney Montgomery Scott LLC, Research Division

So Alcatel-Lucent fell off?

Michael M. Galvin

Yes. It was below 10% this quarter as it was a couple of quarters ago. And if you recall, when the China IP [ph] business, which went through Alcatel Shanghai Bell several quarters ago, when that started to fall off, that was the first time they started to fall below 10%. But the enterprise part of their business is still a very solid important part of our relationship with them. And then the international. So the U.S. mix for this quarter was 59% and international was 41%.

Operator

Our next question comes from the line of Jack Monti with UBS.

Jack Monti - UBS Investment Bank, Research Division

Let me just -- wanted to try to get a clarification. So it sounds like the sales activity kind of decelerated in the quarter but then did the order activity accelerate in your quarter end? Is that the right way to think about the follow-up on previous questions?

Hitesh Sheth

I think you're saying about the...

Michael M. Galvin

Did it accelerate, did the order flow accelerate right at quarter end? Is that what you're asking?

Jack Monti - UBS Investment Bank, Research Division

Yes. So was there a divergence between the revenue trend and the order trends? So if the sales trend kind of slowed, did the order trends slow but you still had pipeline building or did the order trend accelerate in your quarter end?

Dominic P. Orr

The answer is yes.

Jack Monti - UBS Investment Bank, Research Division

Okay. So it accelerated. Okay. And then I guess just one other thing. I was just curious if you could comment on kind of demand in the technology group, I don't think I heard it mentioned, I'm not sure maybe it was below or above, if you could give us some color there, I'd appreciate it.

Maria Riley

Jack you're kind of cutting out. Can you please repeat that?

Jack Monti - UBS Investment Bank, Research Division

Yes. I apologize. I was curious if you could comment on the demand picture in the high-tech vertical. I didn't hear it mentioned. I was curious if it came in above or below your expectation and kind of any color there would be helpful.

Dominic P. Orr

So the high-tech vertical was strong. I think as you can imagine, both the mobile devices momentum and the BYOD factors were applying full force in the high-tech vertical. So that was a good -- strong momentum in that.

Operator

[Operator Instructions] And our next question is from the line of Rich Valera with Needham & Company.

Richard Valera - Needham & Company, LLC, Research Division

I was wondering if you could comment on your expected linearity this quarter. In other words, should we expect to see any improvement in linearity as reflected in DSOs?

Michael M. Galvin

Yes, Rich. We don't break that out explicitly in terms of a guidance stem [ph] . It's just really one of the many factors we take into account with pipeline and all the metrics that we look at. So it's one of the factors that flavors into the revenue guidance.

Operator

Our next question is from the line of Erik Suppiger with JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

In the mid tier market, it sounds like you are doing more business in the mid tier market. Is that a strategic focus in terms of where you're allocating sales resources? And then you're selling more the instant product there. Are you seeing that the controller of this architecture is moving up market more or what are you -- how is your take on the controllerless architecture at this point?

Dominic P. Orr

First of all, Eric, our mid tier strategy, championed by our Instant line, is a market expansion strategy. We have not seen any noticeable bias of our traditional customer for the scale of the network they're deploying to go other than the physical mobility control of deployment. And so while it's in the very early stage, we're very encouraged by the uptake in the mid tier market of the instant power line. That is a line that we are applying market development, energy and sales department energy. It is a separate effort of our main sales force, which obviously is tasked on selling both traditional wireless LAN and the new expanded ClearPass solution. In addition to that, we now with accelerated managed service business, inside service provider, we obviously have to staff up sales development and marketing department staff to support the service provider in this rapidly increasing funnel as well. So that is the situation.

Erik Suppiger - JMP Securities LLC, Research Division

So is the strength that you're seeing in the mid market just a function of the product release in that segment?

Dominic P. Orr

It is because of a lot of the mid tier features, which primarily actually take our traditional large enterprise product and has simplified it in the high, some of the more higher scalable features and some of the perhaps not as stringent security requirement also to make us not really having to deploy the full feature set. So a lot of the Aruba Instants just make the system a lot easier to deploy and in a smaller scale environment. So that's what I meant by market expansion.

Operator

Our next question is from the line of Rajesh Ghai of ThinkEquity.

Rajesh Ghai - ThinkEquity LLC, Research Division

Mike, it's the second quarter in a row where your product revenue growth has trailed the total revenue growth and that coincides with the decline of the Chinese service provider business or your deemphasis of that business. Has that something to do with that business or is it in general, a slowdown in product revenue relative to service?

Michael M. Galvin

Yes. I think overall, it really hits on a lot of the topics we've talked about in terms of just the overall growth numbers, et cetera and the drivers behind those. Obviously, the China ASP business from a year ago does affect that. But overall, it's some of the factors that we talked about.

Rajesh Ghai - ThinkEquity LLC, Research Division

And my last question is around 11 UT [ph] upgrade. Obviously, it does increase the bandwidth and improves a lot of the performance and features of wireless LANs. It also involves a significant upgrade in terms of switches, controllers and cables. What's the possibility that there could be a pause ahead of this upgrade in 2013 just because enterprises might just wait before they want to upgrade their wireless LANs more significantly?

Keerti Melkote

Rajest, it's Keerti here. We have not seen any evidence of that so far in our surveys or in our [indiscernible] options. So BYOD trend is strong enough, that is driving demand for the core wireless LAN products. So ACE is on the horizon and when it comes, as you said, it will drive its own upgrade cycle. But in the enterprise market, at least, we think it's somewhere a year early.

Operator

And at this time, I'd like to turn the conference back to Mr. Orr for any closing comments.

Dominic P. Orr

Again, we thank you for being on the call today. I would like to take a moment to thank our valued employees, our customers and partners for their dedication and commitment and hard work. And thank you for listening and we look forward to updating you on our progress in the coming months. Good day.

Operator

Thank you, sir. Ladies and gentlemen, if you'd like to listen to a replay of today's conference, please dial 1-800-406-7325 or (303) 590-3030 using the access code of 4537751 followed by the # key. This does conclude the Aruba Networks Earnings Conference Call. Thank you very much for your participation. You may now disconnect.

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