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Websense Inc. (NASDAQ:WBSN)

Q4 2007 Earnings Call

January 29, 2008 5:00 pm ET

Executives

Kate Patterson - VP, IR

Gene Hodges - CEO

Doug Wride - President

Dudley Mendenhall - CFO

Becky Wheeler - IR Manager

Analysts

Samuel Wilson - JMP Securities

Alan Weinfeld - Henley & Company

Todd Raker - Deutsche Bank

Sterling Auty - JP Morgan

Katherine Egbert - Jefferies

Philip Rueppel - Wachovia

Phil Winslow - Credit Suisse

Peter Kuper - Morgan Stanley

Rob Owens - Pacific Crest Securities

Operator

Good afternoon ladies and gentlemen and welcome to the Websense conference call. (Operator Instructions). As a reminder ladies and gentlemen this call conference is being recorded.

I'd now like to introduce your host Kate Patterson, Websense's Vice President of Investor Relations. Ms Patterson please go ahead.

Kate Patterson

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

I would like to first let you know about our upcoming Fourth Annual Financial Analyst Briefing, which will be held in San Francisco on April 9th, in conjunction with the RSA Conference. We'll be sending out more information and registration details in the coming weeks.

Before we begin to review the financial results let me remind you that during this conference call, management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Such statements are subject to known and unknown risks, uncertainties and other factors that may cause the company's actual results to be materially different from historical results or any preliminary results expressed or employed during the call.

The potential risks and uncertainties which contribute to the uncertain nature of the statements include, among others, risks associated with integrating acquired businesses and launching new product offerings, customer acceptance of the company's services and products, fee structures in a changing market, the success of Websense brand development effort, the volatile and competitive nature of the internet and security industries, changes in domestic and international market conditions, risks relating to the required use of cash for debt services, the risks of ongoing compliance through the covenants in the senior credit facility, risks related to changes in accounting interpretations, and other risks and uncertainties described in Websense's public filings with the Securities and Exchange Commission.

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

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

For more information regarding the non-GAAP financial measures please consult the press release that was issued this afternoon and which is also posted on the investor relations portion of the company's website. Reconciliations of our non-GAAP financial measures to the GAAP financial measures are also available on our website.

I will now turn the call over to our Chief Financial Officer, Dudley Mendenhall.

Dudley Mendenhall

Thank you, Kate. Let me walk you through some financial highlights and then move on to our 2008 guidance. For billings we post growth about 8% to 7%, compared to the combined billings of SurfControl and Websense to Q4 a year ago, or $108.6 million this quarter versus $101.9 million in Q4 of 2006. Overall Websense billings were up about 15% from a year ago and SurfControl billings were down about 6%, which is much less than the negative synergies that we had forecast previously.

For all of 2007, combined, pro forma net billings of $356 million were up 8% from the previous year. Consequently we outperformed our original Q4 guidance of billings of $92 million to $95 million, primarily due to better customer retention on the SurfControl side and continued strength in our international business, which contributed well over 50% of total billings and was up about 23% from Q4 a year ago on a combined company basis, and up 25% for all of 2007. International billings grew strongly in both the enterprise and SMB market segments.

While total billings in the U.S. in the quarter and for all of 2007 were relatively flat, consistent with previous trend-lines. We did experience an up tick in SMB and both new business and renewals in the fourth quarter. Further in Q4 in the U.S. market we witnessed a recovery to the normalized pricing environment, which we've experienced principally from SurfControl prior to the closing.

Turning to revenue, non-GAAP revenue was $86.2 million prior to the Q4 impact of a non-cash write-down to SurfControl’s deferred revenue. The impact of this write-down was $25.2 million. We will continue to report on revenue prior to this purchase accounting haircut to provide visibility to our normalized run rate.

The strong performance against the December high end guidance of $79 million of revenues was due to higher billings in Q4 and the completion of converting SurfControl's revenue from IFRS to GAAP.

Our Q4 non-GAAP operating model demonstrated the cost synergies of the acquisition with pro forma operating income of 27.6%, a significant improvement of a Websense standalone in the previous three quarters of 2007, which ranged from 24.3% to 25.5 %.

Our revenue performance and improved operating margins allowed us to exceed our EPS guidance by a large margin as well, despite higher costs of goods sold, due to our hosted on-demand product line, higher sales commissions due to the fourth quarter billings as they are paid in the quarter incurred and not amortized, and a higher tax rate in Q4 that resulted in a full year tax rate of just under 36%, higher than our guidance range of 35%.

For the quarter we generated pro forma EPS of $0.28 versus high end guidance of $0.23 and for the full year 2007 pro forma EPS was $0.95.

In terms of other metrics, our average contract length was very stable at 23.4 month up modestly from 23.1 month in Q3 due to a small increase in three years subscriptions. Our average contract value of $8,100 is down from the previous year, reflecting a higher concentration of SMB business, which controls lower price points.

On the balance sheet we ended the year with a strong liquidity position of $86 million in cash and marketable securities after pre-paying our debt $20 million down to $190 million, which gave us debt net of cash of only $104 million at year end.

As you may recall from our last earnings call, we had approximately $100 million in cash after closing the Surf acquisition on October 3rd. In the quarter we covered all of our cash severance and restructuring cost from cash from operations and also modestly increased our cash balances before debt repayment.

Our balance sheet has significant acquisition-related fluctuations in the quarter. Total deferred revenue went from $219 million at the end of Q3 to $287 million at the end of Q4, an increase of $68 million. This reflects $20 million of retained SurfControl deferred revenue after the write-down plus deferred revenue growth from the strong billings in Q4.

Total intangible assets of $539 million are divided between approximately $386 million of indefinite life and $153 million of definite life. Amortization of the definite life intangible assets, which includes customer, technology, non-compete agreements and trade names, will generate about $50 million in GAAP expense in 2008.

The definite life intangible will amortize over approximately the next nine years with 32% in 2008, 25% in 2009 and declined in subsequent years. Accounts receivable increased about $34 million due to the acquisition and strong billing growth. Days on hand dropped from 73 days in the prior quarter to 66 days, thanks to stronger collections.

Given our strong cash position, we anticipate continued debt pre-payments as well as a resumption of our share repurchase program on a limited basis this quarter. Under the terms of the credit facility, we can spend initially up to $25 million for share repurchase of a formula of adjusted net income.

Now turning to our forward guidance, we are increasing the mid point of our 2008 billings guidance range by approximately $13 million to $350 million, and narrowing the range from $15 million to $10 million, reflecting our increased understanding of the SurfControl business model.

Our new 2008 billings guidance is for total net billings of $345 to $355 million. Our pro forma net billings of $356 million in 2007 includes $8 million of products and OEM billings that we are discontinuing, which gives us $348 million in 2007, adjusted for these amounts.

Although we clearly saw strength in our Q4 billings, we are still maintaining our previous cautious forecast for modest billings growth in 2008. As you think about building your financial model for 2008, we are expecting seasonality to follow the historical Websense patterns.

If you look at the average seasonal patterns over the last few years, you will see we have been down about 35% sequentially in Q1, 20% to 25% up sequentially in Q2, flat in Q3 and up about 25% to 30% in Q4. For non-GAAP revenue, we are increasing the mid point of the range by $17.5 million to $330 million, as well as narrowing the range.

Our new 2008 non-GAAP revenue guidance is $325 to $335 million. The increase reflects the stronger Q4 billings number and a slightly higher revenue yield from Surf billings and our revised estimation of the impact of the IFRS to GAAP conversion.

Recall that we have converted SurfControl to a 100% subscription based model versus the 10% to 15% of the revenue previously as licenses and we have converted the daily revenue recognition. Reflecting the higher revenue guidance and operating margins in the range of 28% to 30% we are raising our anticipated pro forma EPS range to $1.15 to $1.25.

This represents year-over-year growth of 26% at the mid point. This assumes a pro forma tax rate of 35%. Our tax rate is complicated by several factors from the acquisition included royalty and cost sharing agreements and the relative amount of revenues is booked in certain foreign task locations.

In today's earnings release we have provided you with the key drivers for our 2008 guidance. Further, although we are no longer providing quarterly guidance, we recognize that due to the acquisition it will be difficult to forecast quarterly revenue trends, so we are providing a range for quarterly revenue of $82 million to $85 million per quarter.

We expect each quarter of 2008 to be within this range with a very modest decline sequentially from the fourth quarter of 2008. The modest decline is due to discontinued products and unprofitable OEM relationships, which will have an immediate impact on revenues.

Finally, although we don't provide formal guidance on cash flow, we think it is safe to assume that we expect to exceed the $60 million to $75 million in pro forma cash flow from operation estimates that are restructuring costs we discussed on earlier calls. At this time I will now turn the call over to Doug who will update you on our integration activities.

Doug Wride

Thanks, Dudley. I am pleased to report that we continue to make excellent progress on the integration of SurfControl's operations. Our strategy has been focused around synergy in three ways: through cost reduction, customer retention, and cross selling opportunities. Regarding synergy through cost reduction, I am pleased to say that we are on track to reduce overall expenses of the combined organization by at least $60 million in 2008, from what expenses would have been, had the two companies operated separately, consistent with what we have outlined in the past.

Approximately 70% of the synergies will come from headcount reductions, and headcount related expenses. Although we will continue to have transitional employees through Q2, as of January 31st we will be about three fourths of the way through this process. At the end of 2007 about 350 former SurfControl employees remained with Websense, out of the about 600 at the time we announced the acquisition. This amount will probably decrease by another 150 by the end of Q2.

Related to these decreases, we have replaced about 50 of these employees in our preferred locations such as Santiago and Beijing, and will continue this relocation effort through Q2. So by the end of this quarter, Q1, our net headcount increase resulting from this acquisition will be fairly stable at around 300 employees.

Additionally we have eliminated about 50 SurfControl contractors and temporary employees to-date, not reflected in the headcounts I've provided. In addition to staying on track with the headcount and related costs, we've made significant progress in facilities consolidation, our second largest savings opportunity.

We have closed duplicate or unnecessary small offices in France, Germany, Israel, Japan, Singapore, and Massachusetts, and during the process of closing, are offering other facilities for sublease, such as the SurfControl U.S. and global headquarters in Northern California, and Congleton in England respectively.

We're also combining our two operations in both Southern England and Sydney, Australia into one office in each area.

Net, our non GAAP Q4 expense run rate of $62.4 million includes cost synergies of a little over $10 million from what expenses would have been had the two companies operated separately. Customer acquisition was the key benefit from this transaction and customer retention was also an important emphasis for Q4.

Our stay-in-your-lane strategy of keeping sales reps focused on their legacy business paid off well. Although we did not officially make migration offers or encourage cross selling of the different product sets, we were pleasantly surprised by the number of customers interested in migrating to Websense products.

In Q1 we will continue to emphasize customer retention. We have outlined what we believe is a compelling, voluntary migration program that allows customers of SurfControl products to migrate to competitive Websense products for an additional cost generally ranging from 10% to 30% depending on the product.

We will also begin cross selling products into our combined installed base of over 50,000 customers. We see the on demand product offering continuing as a good opportunity for growth in 2008. The market penetration in the U.S. has been small to date, so this should be an important growth driver this year.

Since both Websense and SurfControl sell primarily through networks of value added resellers, partner retention has been as important as end user customer retention. In mid-January we launched a new partner program that combines the best of both programs. SurfControl partners were welcomed in to the combined program at the equivalent tier they were in at SurfControl, and we have offered them additional margin opportunities through existing Websense programs that include deal registration and rebates.

Only time will tell, but our expectation is that we will retain the majority of SurfControl's channel partners. We've made significant efforts in terms of margin structure, product operating training, and support to make it in their best interest to do so.

There are several other key integration milestones worth mentioning. We began publishing security URLs to the SurfControl database in December, delivering on our promise to maintain and enhance the value of the SurfControl filtering product. Although the SurfControl database will not offer the full Websense database, it does have expanded security categories.

We've successfully transferred the support for the SurfControl web filtering product to our operations in Beijing from SurfControl's U.K. operations. This effort should be largely finalized by the end of this quarter.

We successfully combined the two websites, creating a single store front for customers. We continue to work to enhance the quality of this site. We completed the conversion of SurfControl's historical financial statements from IFRS to GAAP. These converted statements are posted on our website as an 8-K filing in December 2007.

We integrated the sales teams on a global basis, with new quota, territories and sales plans based on the single company. The sales and marketing team integration continues to be a strong focus point and important to our success. Our first global sales kick off meeting of the united team is taking place this week, here in Santiago.

There are a few longer term projects that we're working on, and I am pleased to say that we are on-track with these as well, but they continue to involve significant efforts and complexities. These include a combined CRM system we have decided to standardize on SurfControl system. We expect to have the first space of the new implementation completed in this quarter, and implementation will continue through the end of this year.

As for combined back end financial systems - again we actually like the SurfControl solution best and we'll be migrating to that system in Q2. Integration of the system used for our technical support function is schedule for early Q2 deployment. We've also made positive progress on the revenue to synergy front.

Earlier this month we entered into an agreement to sell the SurfControl CyberPatrol consumer focus business. Although the related amounts are small, this is another forward step in our plan. We expect this transaction to close in the current quarter.

In short, we are now one company with one sales force, one partner program, one product offering and one vision. I am very pleased with what I think is terrific progress for such a short period of time - really just four months since the transaction closed - and we've accomplished it while maintaining our customer and partner relationships. There is still much work to be done, but we are clearly and successfully executing the plan we laid out in October. Gene?

Gene Hodges

Thank you, Doug, and thank you for taking the time this afternoon to be with us. Q4 was a great finish to an important year for Websense. During the year we greatly expanded our footprint outside the U.S., built out our channels for both small and medium business and for large enterprise security offerings, dramatically expanded our product offering and associated core technologies and almost doubled the size of our global work force to organic expansion and acquisition.

Although, it was a year of difficult change, we believe we set the stage for higher profits in 2008, and for growth in 2009, beyond. We begin 2008 as a vastly different company, with a huge opportunity in front of us.

Through internal innovation and the acquisition of brilliant talent, we now have a strong product line and an amazing product release road map for the year. The available market that Websense sells to is now between three and five times larger than we addressed in 2007.

And we are squarely positioned in the sweet spot of the market with our web messaging and data security offerings that keep the good stuff in and the bad stuff out. We will brand, our new more sweet-like offering, essential information protection.

Our value preposition is simple; every organization is driven by the communication and management of information essential to the business. The essential information comes in all forms, from everyday e-mails, information brought in or sent out over the internet, to critical proprietary information.

Websense products provide the most effective and least costly way to protect all information, including essential information. In 2008 and 2009, you will see us increasingly focused on selling this integrated offering, first in large enterprises, then in medium, and lastly in small business.

Our experience and our guidance both reflect that this is a long and difficult process to branch from selling a single to multiple product lines. But we are very excited about this opportunity. For years Websense sales force has been hampered by not having enough to sell. In 2008 they finally will. Our plan is to execute this expansion strategy in the confines of stern cost management. We've demonstrated once again with SurfControl in Q4 that we manage costs well.

We want to keep our expenses in line with our growth and the projected loss of SurfControl customers dampens that growth in 2008. But while we have our foot firmly on the brake with regards to cost we'll be pushing the accelerator to drive future growth. We expect this growth to be offset by loss of SurfControl customers in 2008, but hopefully resulting in organic growth again by 2009.

These growth areas also represent potential upside to our 2008 plan. The largest potential areas of growth are first continued international growth, on-demand services, data loss prevention which we also talked about as data leakage or IOP and small to medium business around the world.

Q4 showed continued consistent performance in our business outside the U.S. Mexico and Latin America grew rapidly as did Asia and Canada. Solid growth continued across Europe including the more mature market in the U.K. We expect this growth to continue and to be a primary driver for Websense.

In 2008 we expect over 55% of our billings to come from outside the U.S. These non-U.S. markets have higher growth rates in our core web security filtering business that compliment the higher growth rates of the new segments we're entering. Eventually we believe this will result in higher overall growth for our company.

On-demand services are new from SurfControl and contributed $12 million in growth and $20 million in overall billings in 2007. On-demand was $5 million in Q4. Data loss prevention was $2.2 million in Q4 giving its $5.4 million for the year, almost all of this new business.

Our on-demand and data loss prevention segments both have a key asset and a key challenge with respect to geography. The asset in both cases is that we seem to have broken the code on how to sell these new offerings in a major region. The challenge in both cases is that we've not yet been able to duplicate the success globally. For example, in Q4, our $2.2 million in data loss prevention came largely from the U.S. Similarly, the $5 million of on-demand came largely from Europe and Australia.

Customer demand for both offerings seems to be strong globally and we need to replicate our successes around the world. It's very tough to get the right selling skills, channel partners, and compensation plans in place. We're clearly not done yet, but having a success model in one large region of the world is a big step towards global success.

In both Europe and the U.S., as Dudley mentioned, we're seeing increases in our SMB business with our established resellers and with large direct marketing resellers. We are continuing to invest to drive new SMB business through small resellers but we need to do more here.

Simultaneously, we're reducing investments in areas where SMB is not showing as much success as had been planned. These growth initiatives will be supported in 2008 by what we believe will be the strongest new private rollout in Websense history. Our plans for the first half include new debt DLP and on-demand functionality. Our plans for the third quarter include an additional major DLP released with our new DLP end point client product.

E-mail, web transfer, thumb drive, printing, CD transfers, you name it - Websense DLP will cover it all with a single powerful policy management platform. Our solution will deliver a comprehensive auto trail of who tried to move what information, via which specific transport medium, to what location.

We believe no other vendor in the industry will be able to do this. Simultaneously we plan to roll out the most important new releases of our web security products in the last three years. This will include major new functionality in web filtering such as real-time characterization of sites and security dangers through our on-demand clout. Some of our competitors talk about real-time web classification but they have no comparable technology for real-time security classification.

In Q3 we also plan to take our real time threat seeker security classification technology and put it in a box on the customers' site. This will deliver a new type of product, maybe it’s easy to think of it as a web content firewall, which will block spy ware and box in real time. We believe the combination of these two products will deliver the only effective web security for a web 2.0 world of user generated content.

Even our competitors are starting to admit that today's most important outside threats come from the web. Together these releases will comprise a powerful essential information protection suite for our customers with more than 500 employees. Spam, virus and phishing security on inbound and outbound e-mail protocols spyware brought an objectionable content security, inbound and outbound on web protocols, monitoring, auditing and real time leak prevention over any network including traveling laptops at a coffee shop Wi-Fi hotspot all from Websense.

We have lots of work to do to ship this enhanced product line and lots of learning to sell and support it effectively around the world. We are not forecasting overnight miracles and in fact expect this work to take place against the tough back drop of a darkening global economy a loss of some SurfControl customers, and the tough job of learning how to duplicate our success in selling DLP and on-demand from one part of the world to the global front.

It's a big challenge but not as daunting as the challenges we faced in 2007. Our confidence is improving as is evident by our raised guidance. Our 2008 plan targets increasing EPS by somewhat over 25%. Along the way we will also build a multi-product multi-geography sales force and channel to set the stage for 2009 growth.

Thank you and now let's turn the call over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions). First up we'll go to Samuel Wilson, JMP Securities.

Samuel Wilson - JMP Securities

Hi good afternoon everyone, just two very small questions for Dudley. I missed what the overall headcount at the end of the quarter was. And could you give us some expectations for CapEx for fiscal 2008?

Dudley Mendenhall

Sure. Let me start with the CapEx and then I will have our Doug respond on the headcount. Our depreciation expense is running at about $9 million to $10 million per year rate. And that is a good proxy for on going maintenance CapEx. We may spend a bit more than that this year with the new CRM system and new software systems that we're installing. But I think an on going rate of $9 million to $10 million commensurate with our depreciation expenses is a good proxy.

Doug Wride

And on the headcount Sam, I would say we're about 1250 at the end of year combined.

Samuel Wilson - JMP Securities

Perfect. Thank you very much gentlemen.

Kate Patterson

Next question please.

Operator

Next question will come from Alan Weinfeld, Henley & Company.

Alan Weinfeld - Henley & Company

Great quarter guys, really blew it out of the park. I was just curious in the dissynergy operations: what special programs were there to keep the SurfControl customers? And: what are some of the estimates that you have for 2008? And: how many you're going to keep for, might possibly give up because you did raise your revenue range? And I believe that might tell us something that you believe about the synergy or dissynergy.

Doug Wride

Well from a synergy standpoint I think our focus Alan was all about communication. We communicated with the customers, we communicated with our partners, we communicated with the former SurfControl employees. Everybody wants to know: where they stand? And I think we did that very well. We had programs whereby we did not discontinue any of their products. So, if you if you are customer or a bar, what you were using or selling didn't go away.

As we look forward to '08, we are optimistic and I'll let, Dudley speak to the forecasting aspect of it. But we are pleased with what we thought would be a greater dissynergy in Q4. Dudley?

Dudley Mendenhall

Sure, as you may recall to our December call, we spoke about 10% to 15% negative downward possibility in terms of loosing customers. We saw less than that as disclosed in the fourth quarter. But we are still adhering to a relatively conservative outlook for 2008. And till we gather one or two more quarters of information about the Surf customer migration.

Alan Weinfeld - Henley & Company

And: when might it be possible that you can buyback your stock? Because it’s sitting at this ridiculously cheap level if you are willing to be continuing to put up these results.

Dudley Mendenhall

Yes. As previously disclosed, we are going to reinitiate our stock repurchase program this quarter.

Alan Weinfeld - Henley & Company

Great! Thank you very much.

Kate Patterson

Next question please.

Operator

That's from Todd Raker, Deutsche Bank.

Todd Raker - Deutsche Bank

Hey, guys nice quarter. So just following up on Alan's question: You guys just had a quarter where it seen the SurfControl dis-synergies or ability to maintain the SurfControl customer base was rock solid. Why the conservatism? And: can you just comment from a competitive perspective: Is there anyone out there kind of targeting these accounts that you guys transitioned? Any special promotions that you're seeing competitively that's trying to disrupt the synergies?

Doug Wride

Hey, Todd this is Doug. I think that as you would expect and if you were a Websense competitor as you would do, all of our business has been targeted that's what you do you look for change and attack it and that certainly has been happening. We were very pleased with our success against those attacks. So we're optimistic that we can continue that success and to your first point about basically the SurfControl business was down less than 10% it was better than we thought. It's one quarter we think we've won a battle but we haven't won the war and we are just going to continue to be cautiously optimistic. We get a couple of more quarter to this under our belt at about the same range and we'll reflect that kind of performance in our guidance.

Todd Raker - Deutsche Bank

Okay then just one follow-up in terms of the billings guidance: are you guys willing to give us any sense for what we should be expecting around DLP in '08 and the hosts that are on-demand?

Gene Hodges

Todd, its Gene. No we're not going to guide to the sub-segments for '08, but we do intend to keep telling you what's the performance is. We do expect or we've targeted ourselves with above market growth rates performances in both of those areas. We obviously need to gain some on (inaudible) 21-1.48 and ManTech and on-demand we'll probably about 20% of message lab size, so we have some growing to do and then we think we can do that above market growth rate.

Todd Raker - Deutsche Bank

Okay and then just one follow-up on one of Dudley's comments. I just want to confirm on the cash flow side for '08. You guys said you would exceed your prior guidance range of what's $60 million to $75 million. Is that correct?

Dudley Mendenhall

That's correct.

Todd Raker - Deutsche Bank

Okay so it will north of $75 million now?

Dudley Mendenhall

Correct.

Todd Raker - Deutsche Bank

Okay thanks.

Kate Patterson

Next question please.

Operator

Sterling Auty, JP Morgan.

Sterling Auty - JP Morgan

Yeah thanks and guys couple of questions. Can you talk to us a little bit or give us a little color as to what the renewal rate was like on the core Websense site?

Doug Wride

Sterling it really didn't change from previous quarters we're averaging 75% to 80%.

Sterling Auty - JP Morgan

And I missed if it was in the prepared remarks and the press release. What was the average contract duration on the Websense side?

Doug Wride

Again, we aren't breaking out Websense and SurfControl any longer, because of the obvious migration issues and the difficulty with tracking that. We went up slightly in contract duration about half a month. We sold a few more three year subscriptions this year, but nothing material in terms of the movement in that metric.

Sterling Auty - J.P Morgan

Okay, and usually at this time of the year is about the time that you make any pricing changes or decisions. Can you give us an update as to what's being decided? I know on SurfControl you've had some previous announces but, just as a whole: is there any pricing changes for 2008?

Gene Hodges

Sterling, its Gene, we do not plan to change either web security or DLP pricing. We are going to get more aggressive in on-demand pricing in the US and that's going to be still accretive as our sales are so low in the US.

Sterling Auty - J.P Morgan

Okay and last question Gene for you. Can you just characterize for us how you feel about the BlackSpider on demand results in the fourth quarter? What's the initial kind of color from the channel that you are starting to expose? And: what do the training programs that help push that more aggressively North America look like?

Gene Hodges

Well, I think the performance by Jeff Haggard and the Surf team that remained with us were miraculous. This is Europe and the labor laws are complex and the team was performing in the middle of working out all of the various labor issues, which is immensely difficult. And to be able to bring that number home it was I think slightly down from Q4 the year before after bluntly the pipeline had been shall we say well ridden in Q3 as the Surf reps did a good job of bringing the business in, you know that's dynamite.

Sterling Auty - J.P Morgan

Alright thank you.

Kate Patterson

Next question please

Operator

From Jefferies, Katherine Egbert

Katherine Egbert - Jefferies

Hi, I have a couple of questions regarding SurfControl revenue. You recognize $25 million out of $97 million written down. Is that right?

Dudley Mendenhall

Yes, in terms of our non-GAAP add back, that's correct.

Katherine Egbert - Jefferies

It seems like a high ratio. What was the rationale behind that?

Dudley Mendenhall

Well we used the accounting roll out practice of daily revenue recognition that we use for Websense. We would be happy to spend some time offline with you on the exact formula, but it's completely consistent with the Websense revenue recognition practice that we have.

Katherine Egbert - Jefferies

Okay and: how much does the December revenue upside was there the conversion? If it's to GAAP.

Dudley Mendenhall

A few million.

Katherine Egbert - Jefferies

Okay. Also you mentioned Doug, you mentioned about merging your systems. Did you say when you are going to merge the order management systems of the two companies?

Doug Wride

Which system?

Katherine Egbert - Jefferies

Auto management

Doug Wride,

Order management. So that I did say that, we begin that roll out in Q2 of this year and it will continue to roll out functionality throughout the entire year.

Katherine Egbert - Jefferies

Okay so we are getting in Q2. And then last question: How many SurfControl customers have taken you up and your offers to upgrade to the Websense policy, 10% to 20% upwards? How much penetration do you expect to get from that over the course of '08?

Doug Wride

Well, truly it was only a few customers that actually purchased the migration based on the number that were up for renewal. I mean: we are talking in a matter of 100s, low 100s. It isn't something that we were trying to sell. It was more we were willing to take that order, because we wanted first and foremost the customer to stay with us. Now we have a program that we've rolled out, that number should increase we believe in Q1 and as we go through this year. But it's not a big billings promo push, it's all upside if we can do it.

Katherine Egbert - Jefferies

Okay good job.

Doug Wride

Thank you

Kate Patterson

Next question please.

Operator

Philip Rueppel, Wachovia

Philip Rueppel - Wachovia

Yes. A Couple of question on the DLP product: Kind of looking at '08: what do you think it's going to take to drive the growth rates up in that arena? Is it really the new products that you talked about in Q1 and Q2? Or: is it really just renewed focused and being able to pay attention and execute especially outside of the U.S.?

Gene Hodges

I think there are four things. In the US we will have more sales capacity I believe and will be able to apply a good portion of that to DLP and some to the new OD products as well. Outside of the US I think it's learning we have some role models from the Israeli team and they are helping teach our European and Asian teams. Worldwide we need to build better services capability with our partners. Most of the deployment services are delivered through partners. We're not going to go in to that business. And this is a very service intensive business and we did find [gate] fourth quarter. So we're working pretty hard to get that service capability online with our partners. Pipeline looks very strong for the year. We continue to acquire world class customers and in fact had our first more [markey] named customers in the fourth quarter.

Philip Rueppel - Wachovia

Okay. And a quick question just on you had mentioned that you had good hopes at the Surf channel will move over and sell Websense products going forward. Do you have examples of that already happening in the fourth quarter?

Doug Wride

Absolutely! I mean: we have not seen a flight of SurfControl bars they now have a broader product offering to sell to their installed base. So that's all good.

Philip Rueppel - Wachovia

Okay, great. And then one clarification from Dudley, regarding the non-GAAP quarterly revenues that should decline slightly sequentially: was that each of the four quarters in '08 or was it really just the first quarter?

Dudley Mendenhall

No. It's modestly in each of the fourth quarters, because of the way the revenue rollout or works from the billings.

Philip Rueppel - Wachovia

And: is that something that it would be just one year or so before the discontinued products anniversary and then we're back in a more normalized revenue schedule?

Dudley Mendenhall

That's correct.

Philip Rueppel - Wachovia

Great! Thank you very much.

Kate Patterson

Next question please.

Operator

From Credit Suisse this is Phil Winslow.

Phil Winslow - Credit Suisse

Hi guys. I was just wondering: if you get back to the synergies obviously much stronger renewal rates and you have anticipated on the SurfControl side. When you do look at your '08 guidance as implied by your billings, it used to be sort of potentially 20%. What's the level that you are looking for now give or take?

Doug Wride

I am sorry, Phil but I didn't understand …

Phil Winslow - Credit Suisse

Well, basically: just churn rates that you are expecting now? Given that you have at least one quarter of data.

Doug Wride

Well, the churn rate on the renewals, we continue to hope to move that up, particularly when you look at the combined rate, SurfControl typically was a lower renewal rate than Websense was, so to the degree we can stabilize their renewals, we should be able to pull that up, which would move our combined rate. All of that said, you continue to try and drive towards another five points there and it works very positively to the top line. But with the years and years of making that effort, we have been in the 75% to 80% renewal rate for at least five years may be longer.

Phil Winslow - Credit Suisse

And then also just may be you have said earlier on the call, but: could you give the breakout of one, two and three year deals with the percentage of billings?

Doug Wride

No. We don't have that it was 24, 24.3 months and I think it was 9% two years.

Phil Winslow - Credit Suisse

And still about 30% being one year?

Doug Wride

No, 50% being three years like 49% three year. But I don't have that breakout.

Phil Winslow - Credit Suisse

That's great. Alright thanks guys.

Kate Patterson

Next question please.

Operator

Peter Kuper from Morgan Stanley.

Peter Kuper - Morgan Stanley.

Great, thanks. I think people touched in the call, but: if you guys give us a little more color on discontinued ops in two angles here? One is: what that magnitude may be? I have a suspicion that people are going to run that amortization models and club with a pretty wide range of what the impact on a per quarter basis is which is said it will lead to a sequentially decline, like they can may be clear that up a little bit on the call. And then as part of that what are some of these discontinued ops looking like, are they from a product perspective if you can't give that on the call. Is there a margin lift from these? Or: little more thinking of what these areas would entail?

Gene Hodges

Peter its Gene here. We are undoing several unprofitable OEM deals that SurfControl did that did not result in the discontinuation of any technology, but those were dilutive deals. We are maintaining couple of handfuls of profitable OEM deals those are with the largest OEMs as you would expect with the Junipers and Cisco's and checkpoints of the world.

We have discontinued and sold though we have sold not discontinued the consumer offering. As Doug mentioned its small moneys but that was a real defocusing item. We are obviously not geared up to be a consumer company. We discontinued the endpoint security clients, we will replace that client with our own capability for the customers that want it, so we think we can staunch significant revenue loss there but that was probably a diluted product and we are focusing our geographic coverage on one of the email appliance products in China for majority of the sales would be made in any case. So that one will go forward, but we won't try to sell and support it outside of China.

Peter Kuper - Morgan Stanley.

Okay, so all that in, is it fair to say that the 28% to 30% operating margin target for this year is a conservative estimate?

Gene Hodges

Well you know the C word, gosh.

Peter Kuper - Morgan Stanley.

That will be: “the G word”.

Gene Hodges

Yes, it's a number that we think we can deliver and we get there predominantly by cost control. Our P&L is a little weird in that if we had for example the happy situation of billings being very positive in the second half of the year we would pay those commissions, but not see much revenue that can actually, potentially, be dilutive to margins but boost the top line. Wouldn't mind seeing that either and I am sure you guys wouldn't because we'd get it back in '09.

Peter Kuper - Morgan Stanley

Right, and then I'll wrap up this last thought. I think you just met me there. Given that the discontinued ops in that last comment Gene, it sounds like the second half of the year we could see some renewed momentum here from a billings point of view and then of course and that would set up for a nice '09 revenue outlook, I would imagine?

Gene Hodges

Yeah. We certainly believe that we will reduce the customer loss rate over the course of ‘08. We actually saw a small uptick from Q3 to Q4 in terms of SurfControl customer retention, and we take that very positively. Although, Q1 is a new quarter, and the competitors are going to get even nastier, as well as what should be a big help from this new product set where we should see some modicum of orders obviously for enterprise products, you don’t see a big hit in products that are only six months old.

Peter Kuper - Morgan Stanley

Got it. Great, thanks very much ,and congratulations.

Kate Patterson

Next question, please.

Operator

Rob Owens, Pacific Crest Securities.

Rob Owens - Pacific Crest Securities

Yeah, good afternoon, everyone. So, as I look at your billings guidance for 2008: is that all predicated on a better realization of this dissynergy? Or: if you changed your underlying markets growth assumptions?

Gene Hodges

Rob, it's Gene. Predominantly, it was other businesses than Surf that drove more positive billings guidance. We still see a lot of work to do, as Doug mentioned, in the integration and we had one good quarter, but we are not there yet.

Rob Owens - Pacific Crest Securities

So Gene, if we rewind a little bit. I think, last year, you gave a 5% outlook for industry growth. And…

Gene Hodges

Right.

Rob Owens - Pacific Crest Securities

Looking at Websense in Q4, I think, you said it was up 15%, if I heard your comments correctly, so…

Gene Hodges

That’s correct.

Rob Owens - Pacific Crest Securities

Does that cause you to revise your thinking here whatsoever or was that somewhat just a Q4 aberration and we should see more normalized 5%?

Gene Hodges

Well, when we look at the whole year, I think, in fact we see if the combined Websense and SurfControl proxy for the market as a whole, it was at around 5%. Surf had significant portions of its growth driven by on-demand, and we had a portion of our growth driven by DLP, a couple of percent, and when you put those together combined company was 7 or 8%. And you subtract out OD and DLP, you get back at around 5%. Now the quarter-by-quarter number has certainly jerked around a lot, and that makes it difficult for all of us to call, but the rearview mirror says 5% is the peg, but it’s much faster outside the US.

Douglas Wride

Yeah. That – Rob, that 5% is, as Gene just said, is the US Web Filtering opportunity, and everything else other than that should grow faster and that’s what influenced the 15% in Q4.

Rob Owens - Pacific Crest Securities

Great. Thanks.

Kate Patterson

Next question, please.

Operator

No other questions holding.

Kate Patterson

Okay. Thank you all very much. We will talk to you soon, and hope to see you on April 9th at our annual analyst briefing.

Operator

Thanks again for joining, ladies and gentlemen. That will conclude the conference call. Again, have a good day.

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