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Quest Software Inc. (NASDAQ:QSFT)

Q4 2007 Earnings Call

February 5, 2008 5:00 pm ET

Executives

Vinny Smith - CEO

Scott Davidson - CFO

Steven Wideman - Assistant Treasurer

Analysts

Derek Bingham - Goldman Sachs

Kirk Materne - Banc of America

Mark Murphy - Broadpoint

Ken Wong - Cowen and Company

Aaron Schwartz - JPMorgan

Tim Klasell -Thomas Weisel Partner

Phil Winslow - Credit Suisse

Richard Sherman - MKM Partners

Brendan McCabe - Oppenheimer

Operator

Good day and welcome to the Quest Software Q4 earnings release conference call. (Operator Instructions)

With us today are Vinny Smith, Chief Executive Officer; Scott Davidson, Chief Financial Officer; and Stephen Wideman; Assistant Treasurer.

At this time, I would like to turn the conference over to Mr. Steven Wideman. Please go ahead, sir.

Steven Wideman

Thanks very much and welcome, everyone, to the Q4 conference call. On the call with us today, of course, as I said, are Vinny Smith, Chief Executive Officer; and Scott Davidson, Chief Financial Officer.

Scott and Vinny will give some thoughts on the quarter, and the year that ended December 31, 2007, and then we'll open up the call for Q&A.

Our call is being webcast from our Investor Relations website, and you can get a copy of our press release just issued a short while ago on this website as well. A replay of this call will be available on this site, or using the instructions noted in our release.

Let me turn briefly to our Safe Harbor statement. Some of the statements we make today may be considered forward-looking, including statements regarding our anticipated revenue and operating margins in future periods, benefits we expect from recent acquisitions and areas we continue to invest in. The statements involve a number of risks and uncertainties that could cause actual results to differ materially.

Please also note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events.

Please refer to our SEC filings, including our quarterly report on Form-10Q for the quarter ended September 30, 2007, and as always, our Q4 earnings release for a more detailed description of risk factors that may affect our results. Copies of these documents can be obtained from the SEC at sec.gov or by visiting the Investor Relations section of our website.

Also, please note that certain of the financial measures we'll use on this call such as EPS, net income, operating margin and operating income are expressed on a non-GAAP basis and have been adjusted to exclude various charges, including amortization of intangibles, share-based compensation expense, and expenses of our stock option investigation. We report our GAAP results, as well as provide a GAAP to non-GAAP reconciliation, in our earnings press release.

And with that, it's my please to turn the call over to Scott.

Scott Davidson

Great. Thanks, Steven. Good afternoon, everyone. Thanks for joining us. First, let me start by saying that we are really pleased to have the restatement behind us. I want to acknowledge all the hard work that was put forth by the team in the process, and furthermore, the support shown by our customers, employees and partners who were patient as we worked through the issues culminating with our filings on December 31st.

We've been looking forward to providing full operating results to our investors, and are now in a position to do so because of these efforts. So, thank you.

So, let's start at the summary level. And overall, our Q4 and 2007 results were good. Total revenues were $186.7 million for the quarter, a 12% increase over Q4 of '06. License revenue grew by 7%. Non-GAAP operating income was $38 million and earnings per share was $0.26. Cash flow from operations was $41.9 million. Deferred revenue, approximately $286 million, a $50.1 million or 21% increase over the last year.

For the 12-month period, total revenues were $631 million, representing a 12% increase. Non-GAAP operating income increased 2% to a $118.7 million, and earnings per share was $0.90.

So, now, I'll talk about the quarter in a little bit more detail. Q4 license revenues increased 7% to $98.9 million, and by 6% for the full year to $308.7 million. Looking at the revenue mix for the quarter, license revenues represented 53% of total revenues, while services generated the 47% balance. This compares to a 45% license services split in the comparable quarter last year.

Q4 services revenues increased 17.8% year-over-year to $13.3 million. We noted continued success in our maintenance sales and renewal efforts, in addition to the benefit from the ScriptLogic acquisition.

Geographically, North American operations generated 63% of total revenues in the quarter, with the rest of the world generating the remaining 37%. This compares to a mix of 66% North America, 34% rest of the world in Q4 of '06.

With respect to expenses, I'd like to remind you that 2007 non-GAAP results presented today exclude the amortization of share-based compensation and process R&D charges, amortization of certain acquisition-related intangible assets, and costs related to the restatement of our prior-period financials.

The earnings press release includes the reconciliation of the differences between the as-reported GAAP and the non-GAAP financial results. So, total expenses were $148.8 million, which represents a 26% increase, or $30.6 million over the December '06 quarter.

The expense profile was impacted by several acquisitions, including the first full quarter of ScriptLogic, which closed in August. Specifically, of the $30.6 million, over 40% of the increase was related to the impact from acquisitions, as well as higher costs related to foreign exchange.

Turning to the individual expense items, sales and marketing expenses for the fourth quarter were $79.4 million, or 43% of total revenues as compared to $65.4 million or 39% of total revenues in the year-ago quarter. Approximately three quarters of the increase can be attributed to headcount from acquired companies and on a core basis, as well as the impact from foreign exchange.

Research and development expenses in the fourth quarter were $33.3 million or 18% of revenues. This compares to $25.3 million, or 15% in the year-ago quarter. A predominant amount of the increase in R&D expense was attributed to higher labor costs from acquired companies, and an increase in core headcount as well. Expenses were also impacted by foreign exchange, as many of developers are located outside of the United States.

General and administrative expenses were $19.1 million, or 10% of total revenues in the quarter, as compared to expenses of $12.5 million, which was 7.5% of revenues during Q4 last year. Most of the dollar increase was related to increased headcount to support operations, cost from acquired companies, including the integration of these acquisitions, and ongoing legal tax and consulting projects.

The GAAP operating margin was 12% for the quarter, and the GAAP operating income was $22.8 million. The non-GAAP operating income was $38 million, which excludes $4.8 million in expense related to the restatement.

This generated an operating margin for the quarter of 20%. As noticed before, during Q4 of '07, we acquired several companies and have a full quarter’s impact from ScriptLogic. The operating margin profile of these companies was lower than Quest's core business, thereby compressing our margins from the quarter from the prior year.

Other income net in the quarter was $3 million versus $5.4 million in Q4 '06. The primary driver of the change in [OIN] was related to strengthening of the dollar late in the year, causing $1.1 million loss resulting from the re-measurement of our foreign balances during the quarter.

The non-GAAP tax rate was 32.2% for the year, compared to 27.1% in 2006. The increase is primarily the result of tax effective booking valuation allowances, and certain historical and current net operating losses in foreign jurisdictions.

GAAP net income for the quarter was $24.1 million, and GAAP EPS was $0.23. Non-GAAP net income was $27.8 million, and non-GAAP EPS was $0.26. Fully diluted weighted average shares outstanding was 105.9 million shares.

Now, turning to the cash flow and the balance sheet, at year end, cash and investment balances totaled $365.7 million. Please note that this includes $48.9 of restricted cash, which was expended on January 2, 2008, for the PassGo acquisition. In addition, we expended approximately $39 million on acquisitions, net of cash acquired during Q4.

CapEx for the quarter was $2.9 million. Cash flow from operations was $42 million, totaling $137 million for the year. Comparatively, operating cash flow was $58 million, and totaled $148 million for Q4 and full year 2006 respectively.

Operating cash flow was impacted by higher expenses as discussed earlier, related to the impact from foreign exchange and acquisitions. In addition, we paid out $11 million more in cash taxes during the year, based on a higher rate, and expended approximately $11 million in restatement-related charges during the year. Deferred revenues were $286 million, up $50 million year-over-year. DSOs for the quarter were 73 days versus 72 days in Q4 2006.

As we enter 2008, we continue to see opportunities across several of our markets. And to capitalize on these opportunities, our plan is to expand our investments in these markets to drive growth in both our core business and our newly acquired entities.

Now, let's talk about guidance. On a go-forward basis, we'll be providing guidance for total revenue and operating margins for the year, as we believe that this is the best representation of the primary indicators of how to gauge our results. So, as such, for the full year ending December 31, 2008, annual revenue growth is expected to be in the range of $705 million to $720 million.

We are targeting GAAP operating margin of 11% to 12%. And, implicit in that guidance is 16.5% to 17.5% non-GAAP operating margin for the year. The non-GAAP guidance excludes approximately $39.1 million of amortization of acquisition-related intangible assets, share-based compensation expense, and additional costs related to the stock option restatement.

Now, let me turn it over to Vinny.

Vinny Smith

Thanks, Scott. Let me take a minute and put a little bit of color into the performance in '07, and also what that means for '08 from my perspective.

At summary level, as Scott spoke about, we did about 12% growth overall in '07, which took us to a company size of about $630 million. Some of that was organic, and some was acquired. We also ran with the pretax pro forma margins of about 18.8%. And you look at the estimates that were given to you, that will take us in '08 up to a little over $700 million.

So, when I look at that business and how we did in '07, first thing that I am looking at is, when we look at the deal bands over $100,000, over $0.25 million, over $0.5 million and over $1 million, we really didn't gain any growth by doing large transactions.

We drove all the work that we achieved through smaller deals, which I think is a good thing in that, if the recession becomes more prevalent in the software industry, being able to execute and survive on small deals is healthy.

We did do 50 deals in the year over $0.5 million, and 16 deals in the year of over $1 million. In Q4, we did five deals over $1 million, but none were greater than $2 million. And that compares to doing six over-$1 million deals in 2006 in Q4.

The customers we did business with in Q4 for over $1 million, two were technology companies, one was a telecommunication provider, and two were banks, which is a little concerning, just because the banks are probably not spending a lot of discretionary money on IT. As far as the breakdown in price in those large deals, three were driven by Windows, one database, and one application management products.

Moving on to just thinking about our core markets, which we consider our core markets to be database, Windows and then applications, the database area was kind of a star of the company. We still flourish in these markets. We have phenomenal products. We have great customers. We have tens of thousands of customers. We have, we think, maybe up over 1 million users if we aggregate them all together. And so, we have done a wonderful job of delivering great value to our customers, wining in the market, competing.

And really, the only threat to our position in the market is the evolution of the database platform itself, whether that's Microsoft or Oracle. And so, it's a steady business, though. It doesn't have a great deal of growth in it.

Turning to the Windows marketplace, we made a really sharp move six years ago, betting that we could break into the Windows market when the market was transitioning from NT to Windows 2000, and we transitioned in well. We have enormous business now in Windows, and we have been able to drive a great deal of growth over the last several years out of that Windows franchise growing bigger and bigger.

Last couple of years, we have been adding on adjacent, still Windows, business where we have gone from tier Windows management up into AD management, into exchange management. And now, we are prying our way into things like identity management, security, SharePoint management.

And by adding on not just products within the areas, but also new areas within Windows, we think we can maintain growth, although this year we did see some flattening out in some of our bigger Windows areas, and that stalled some of the overall growth of the company, because we have been relying over the last couple of years on the Windows growth to drive the overall growth of the company.

In the application area, it's been a long road for us, and it's been an investment, which is kind of quote for "we have not been making money". But we feel like we've done some really great things with our products, and we feel like we are going to continue to be able to grow this business. And so, we've maintained the investment orientation.

We compete, co-exist, and complement the biggest vendors in the market: the IBMs, the HPs, the CAs, the BMCs of the world. And so, it's a hard market, but it's one that we feel like, if we get a good position in, we'll be able to have long-term sustainable growth that will be very dependable. So, that's why we view it as an important kind of position for us to maintain. And so, we think we are going to have good a '08, and allow us at some point in the future to break over into profitability.

Let me now roll over to talking about acquisitions. We had a very active '07 in the acquisition world, doing all types of acquisitions which were different than many other types of acquisitions that technology vendors are doing. We bought 10 companies. Most were pretty small.

And I'd categorize them in this way. One was a completion of an acquisition we actually did in '05, and that was in the VMware ESX management space, to manage the servers that are being virtualized and running the virtualized guests, and that's Vizioncore.

The second deal is another server virtualization company named Invirtus that we are actually putting through Vizioncore's channel, rolling them together. And so, we're trying to build a very complete suite of products for managing the virtualized environments. So, our internal development efforts, plus buying those two companies, allow us to go get the expertise and market knowledge we need to go and create a new business. Both the new business within Quest, and those acquisitions, are key components to that.

The next area that we bought three companies in is in the client management space, and also happens to be very SMB-oriented. ScriptLogic had a very strong position in the desktop management space, and had a very strong SMB channel. And with that, we acquired a company named Kemma, which was an SMB helpdesk place. And so, those two companies are very SMB and very client-focused.

The third company that we bought in the client management space is Provision Networks. And this has some stunning technology, we think very much a best-of-breed, clear leadership position, from a technology around VDI and terminal services. And likely competitors in the future in this market are going to VMware itself, possibly. We are not sure exactly how diligently they are going to stay in that market; and also Citrix.

So, we think with the technology purchases we made and then are taking into market, that we're going to be able to carve out a good position for ourselves in that marketplace.

Other acquisitions we did in '07, we bought a company named PassGo, which is in the identity management space, which is coupled well with our other identity management products, so we can leverage our existing sales force. We're very excited about that acquisition.

We brought two companies in the SharePoint space, Workplace Architects and Proposion, small tiny companies. We're in a meeting today, actually, going through the SharePoint marketplace, and that's somewhere between a 50 and a 100 tiny small companies doing products for SharePoint.

Now, I don't see that as a sustainable market situation, and that will evolve to being two or three. And so, what we're doing is building internally, as well as through small acquisitions, a robust product family, where we want to be the market leader like we are in the other markets that we compete in. And so, we made those two small acquisitions around SharePoint.

And the last acquisition is in the application monitoring space, a company named Magnum. What it is? It's a bolt-on set of technologies, or feature sets, for our Foglight 5 offering in the BSM space. And so, we were very busy this year, but it was in [such a] deals that we do, which tend to be very technology oriented.

They tend to be the products in an existing family, that we need the technology, and the know-how, and the people, or to move into an adjacent market and really move in with strength. And we'll use the acquisitions plus internal development to do that. And so, these 10 acquisitions, all fit into that strategy around acquisitions.

Other highlights in 2007 were: First of all, we were Microsoft Global ISV Partner of the Year again. This is the second time in four years we won that award. We're only one of two companies to be actually a multi-year winner, which is really exciting for us. And we deliver a great deal of value to the ecosystem around Microsoft, and it's nice that Microsoft appreciates that and recognizes it, as we go to market, making Microsoft the more adorable enterprise-worthy platform in many areas. And so, we've built a great business around that market and that relationship.

Second notable item for inside Quest is we entered the SMB marketplace with some force. The Script acquisition really put us into a place where we could go to market with a deep, deep channel in North America. We are actually able to take additional Quest products that are worth good value, but we didn't have a way to get to them, and we are putting them into the Script channel. And we think we are going to be able to gain growth by taking Quest products in preliminary SMB channel.

Other events in '07, we continue to thrive with Dell. We want to tell Dell's top 10 ISVs we do tens of million of dollars of business through Dell. And we think that '08 will continue to enhance and magnify that relationship.

Another thing, I think, about the highlights in '07, we got Foglight 5 out the door. And right now, we are in the process of hardening and studying it, and running it maturely, but this is a big technology chasing a big market opportunity. And so, it's not something that could stand quickly, but we got the products out in '07. We're hoping to see some of the rewards from that hard work from '07 earlier in '08.

And what I think about Foglight is, as we really start to acknowledge, there is a multi-year opportunity of growth. So, that's why we have been such a steady investor there.

Same for archive management, we released the big products in '07. We have more to go in '08, but that's another deep market category that, if we hit it right, we can have lots of growth for many, many years, because the category is so thick. And if we're one of the dominant vendors, we'll be out to get growth. So, we try there. There are not that many categories of areas of products that we have that are real deep, but those two happen to be. So, that's why we are so persistent on our investment.

And our last point is, I have already mentioned SharePoint. We think that this market is going to grow to $100 million in the next couple of years. Like I said, it's going to be fragmented across 50 or 100 vendors, but we are likely to be one of two large dominant vendors that are the best at innovating, best value for the customer, bring the breadth of solutions that customers want, and offer a vendor that's just a known company that delivers great results for its customers. So, we lock our chances in that market. So, that's why we are so engaged to make sure we get a position early.

Other factors at the company, we end the year with 33,150 employees. That's up about 500 heads from a year ago '06. A lot of that growth came from the acquisitions. We're also investing in a charity fund inside the Quest, and this is a new thing we started. I think we started at the beginning of '07, where it's entirely employee-controlled, employee-submitted, and employees decide on the charities. And we contributed charitable dollars to over 150 organizations around the world. And it's something that our employees are very proud of, and we’re happy to pass the (inaudible) B014, 1.32 and then let them control that, and it's just exciting to see what they doing with it.

As far as geographic trends, this year, in '07, it was a tough year in North America. We tried some things. We thought we're doing the right thing to go to market, and they didn't all work. And so, we are finding ourselves having to repair some mistakes we made, and it's okay to make errors and mistakes. We’ve got to try new stuff.

But '08 through '09 will be a tough year. In Europe, we didn't make as many changes in Europe, just molded along. They also got benefit from the dollar. So, we go into '08 with the knowledge of what we learnt in '07. And so, we think we'll do better in North America, and we are hoping that Europe and the rest of the world maintain some momentum, which should be great.

As far as acquisition activity in '08, we do not expect to be nearly as active as we were in '07. We just don't have the pipeline of companies that we're looking at. It's not because we don't want to. It's just that we don't see the things that we saw in '07. But there will be some deals, and they'll probably be the same types of deals that we did in '07.

Overall, though, in the marketplace, not Quest, but in general, we see a rapidly consolidated marketplace. And that, for me, spells opportunity, because there are few vendors that have the same kind of focus on building rich, colorful, innovative solutions for the customers, that have some scale and size that should reach the customers, for the customers to trust them that they'll be there when time are tougher.

And so, I am excited about being part of a marketplace that is consolidating. I think it's an opportunity for us to stand out and just focus on being great. For me, when I think about '08 and our focus and goals, they are broken into three branches. One is the financial objectives, and living within the financial boundaries we've set for ourselves.

The next is customer objectives, and being able to allow them to reach their successes and obtain good ROIs and good value, and to deliver great service to them. And the third is really goals and focus around on how to make Quest a great place for our employees. And so, I am excited about rolling into '08. I think we've got a really good shot at delivering on all three kinds of areas of goals and objectives.

And last point I want to make before we open up for questions is, we obviously went through a tough time during the stock option thing for the last 18 months or so, and then we shot ourselves in the foot in '07, it feels like, in a couple of places. But we have great employees here, and I appreciate them very much. We have new ones from acquisitions. We have new ones from us hiring them, and they make this company fantastic and great. So, I just want to thank them.

And now, let's open the call up to questions.

Question-and-Answer Session

Operator

(Operator Instructions)

And we'll hear first from Derek Bingham with Goldman Sachs.

Derek Bingham - Goldman Sachs

Hi. Thank you very much. I wonder if you could give us some color, maybe a little more detail on what exactly flattened out in the Microsoft business in 2000 and then your thoughts on what you think is going on again this year; any key Microsoft cycle this year that you think you can capitalize on?

Vinny Smith

Just a second here. The growth that we are going to experience in '08 is by realigning our sales force in North America, and that should help across our big segments at Windows migration to AD and exchange. And then we are anticipating the adjacent newer market categories like identity management, security and SharePoint to contribute on top of that. So, it's not as much a macro-Microsoft cause. It is also doing a better job of aligning our sales force and then also bringing us richer product sets into some new areas.

Derek Bingham - Goldman Sachs

Okay. Great. And then --

Scott Davidson

Hi, Derek, I'd add to that. One of the things with respect to the Microsoft products -- we did see good growth in EMEA particularly. And as Vinny said, EMEA was one of those regions where we didn't change the sales orientation.

Derek Bingham - Goldman Sachs

Okay, got it. Could you just give a little more detail there on realigning the sales force in North America? What actually is happening there?

Vinny Smith

Yes, we basically tried to have too many senior field reps selling all of our products across Windows applications and databases. And what we learned was it was too much and we were leaving many accounts undersold to, and it was just difficult for reps to really carry that breadth of products. Our company has just gotten too broad.

And so, in the past, we went with more of a striped sales force, and we kept that striping in Europe and it did well in '07. And so, we're rolling back to more of a striped sales force where we were more effective in '06.

Derek Bingham - Goldman Sachs

All right, perfect. And just one follow-up if I could on margin. Could you maybe give us a sense for how different these acquired companies' margin structures are currently from the rest of the company? I guess, that is to say, how is the profitability of the underlying company trending if you were to strip out those acquisitions?

Scott Davidson

Each of these companies, as Vinny said, there is 10 of them, right? And a lot of them are smaller type organizations. So, the profile is sort of all over the board, but none of them had operating margins in 2007 that approached our core operating margin of roughly 19%. If you strip those out and you look at the sort of core business for Quest in '08, I'd say our operating margin would roughly be similar to what it was in '07.

Derek Bingham - Goldman Sachs

Okay, great. Thanks very much and good to have you back.

Vinny Smith

Thank you. It's good to be back.

Operator

And next we'll hear from Kirk Materne with Banc of America.

Kirk Materne - Banc of America

Yes, thanks very much. Scott, maybe just a follow-on to that last question about margins. Can you talk a little bit -- I mean the core business being flat, say '07 to '08, I can understand the acquisitions -- but given that you're building up a much larger base of maintenance revenue; one, would think as that makeshift changes, more of that should follow the bottom line. So, I guess from where are you investing in your core business and why does that make sense given someone's business is in terms of their maturation rate now and their growth rates?

Scott Davidson

Well, there are a couple of different things as far as where we are investing in the business. We're setting up an R&D facility in China for example. We have significant operations from an R&D prospective in UK with PassGo. We have Israel, we have Canada, and we've always had Russia since Aelita acquisition. So now we're making an investment in China because that's more of a lower cost profile. So there's investment going on there. From a support side in the last year we've actually increased investment in our APAC support center, which is in Singapore, just so to build up some of our APAC revenues which have historically been less than 5% to 6% of the total company.

At the same time, one of the things that we've done with several of these acquisitions, most notably ScriptLogic, is to keep it as a separate self contained entity if you will. So, there is inherent in that some level of duplication on the cost side, as they do their own order processing, film and [revrak] and everything else that's there on sales organization. There will be some benefits of us cross selling each others products, but there's some cost associated with that as well.

The reason for that is because they typically sell to a different market, they sell to an SMB and they sell through a channel where there's a little bit difference from the rest of core Quest as we know it. So there's some level of duplication there. Incrementally we've got other businesses in other markets that we are moving into. Any talk about the VMware and the support for ESX server through Vizioncore and some of the technology that Invirtus has as well.

Again those are channel markets for us, different route to markets, different customers to buy our products. And so that will take investments to sort of move those channels along and continue to develop them. Again they are all investments that we need to make.

Another area is ScriptLogic, in general, most of their revenue, the lion share that revenue, was derived from the United States. They had some revenue in EMEA, primarily to the UK, and little bit in Australia as well. So, we will need to expand some of the work they have done, and we can leverage our existing infrastructure, but again there will be some cost to sort of push some of that out as well.

Kirk Materne - Banc of America

That's really helpful. And maybe just one follow up. Vinny, you talked about earlier that you are having a really broad array of products and clearly some of the acquisitions you've made have been maybe more in gentle than synergistic with some of your core businesses. I guess, how do you guys view having all these businesses sort of running on a stand-alone basis? Clearly you are not getting as much leverage as you would if you brought them all internally.

I mean are you guys doing a portfolio review constantly to make sure that it makes sense to have this broader product portfolio, given say some of the different revenue growth trajectories of each the businesses? I am just trying to get a sense of it; does it make sense to be this broad or should you be more narrow and go deeper in certain areas?

Vinny Smith

I can tell you that we evaluate this all the time, because the cost to go to market is so high. What we are trying to do is, build more agility into our product areas so that we can meet the market faster because we've found ourselves struggling with becoming a mid-sized software company and not always been the leader in innovation which was all typically our advantage. So we are struggling some. So one the top challenges of that is how to go to market.

But I don't think the three product families and having sales force two of them or share sales force and one has more of it's own unique sales force, doesn't seem like too many, and what we are doing is, we are trying to incubate products, companies, on the side to see if any one of them could become a high growth one that we could add in the internal side of Quest. And so there is a reason for us to keep them somewhat independent when they are smaller, to allow them that agility and speed, but we also want to get them to a certain size. So we are trying to strike the balance, there is no set formula.

One of the challenges to the company in general is, we plan markets that might be several $100 million in size and we will go out and do it. Some times we'll start with the market worth $20 million and then will grow into 100 to200, and we will get our fair size chunk of it but we have not been able to get into the markets that are measured in billions and we are we are getting a big chunk of it. And that's just where we are as a company and we've not been fortunate enough to be in that type of segment.

Kirk Materne - Banc of America

Last question for Scott. Given that your are doing some more incubation in some of these smaller companies, when we went into sort of the [backup] -- last time you talked you knew some of the margin targets for the overall business were still in that low 20% range or similar around that. Given that you are incubating Vizioncore and some of these other, is that margin profile still intact or do we need to think about some thing lower than that going forward?

Scott Davidson

Yeah. I mean I think, if you look at the guidance that we set on a non-GAAP margin basis; that was 16.5% to 17.5%. So we finished the year on a non-GAAP basis of about 19, a shade under 19A, 18A to be exact. Within that Q4 number we had five of the acquisitions that Vinny talked about actually took place in Q4, and the sixth was ScriptLogic which took place in August. So six of the 10 acquisitions happened from August through December, so we haven't seen a full year of the impact of those acquisitions yet and we finished at [18.8] on the off margin side. So that's what our guidance reflects probably, if you take the high end of that range about a 100 basis points down from that, so 17.5 is how to get to that data point.

Kirk Materne - Banc of America

Okay thanks I'll let someone else.

Operator

And we will hear next from Mark Murphy with Broadpoint.

Mark Murphy - Broadpoint

Thank you. Vinny, from what you've seen historically, is the EBIT flow of your Microsoft business -- does it feel like it’s triggered more by Microsoft's new product releases or actually by Microsoft's end-of-life activity for the older products?

Vinny Smith

I think its end-of-life is sometimes a much smaller effect than the new major trends. For instance, take SharePoint, is the market going to like adopt it the way people talk about it today? If they do, it's going to create 100 million plus market opportunities for us to go and compete in. So it's more around the future and the movement of what you're moving toward, is where you tend to spend money versus the tail end of it.

Mark Murphy - Broadpoint

And so Vinny, how do you characterize Microsoft's recent success with those products that SharePoint, Windows server or SQL server in exchange? Moving into '08 and '09, do you see kind of an ongoing wave of market share gains for Microsoft that you can play into and maybe resume the strong growth that you had at the Microsoft business, or from your perspective has Microsoft holding the market either strengthened or weakened at all?

Vinny Smith

My take is I look at it then I also see how I think it affects us. I think Microsoft's position is only growing and it's strengthened directory management, email management, document management and collaboration earning all of that within SharePoint. It just seems to be a very clear that Microsoft is going to continue to do very well. The challenge we face, however, is as Microsoft evolved their products or sometimes put functionality that it clips our products. And so we've got to play the innovator race with them, and not so much in a negative way, but they are just going to evolve those platforms and take out market opportunities from us. So it's a bit of a mixed bag. The market opportunity grows but it also shrinks as they embed product categories that we sell into the base platform, many times for free.

Mark Murphy - Broadpoint

And then just a final one for Scott. Could you comment on the recent growth rates for a couple of the acquired businesses, particularly ScriptLogic and Vizioncore to whatever extent that you can or perhaps where do they stand as a percentage of revenue today?

Scott Davidson

We're not breaking out the growth rates or the percentage of revenue for any of those deals.

Vinny Smith

Let me just make a comment too. Another thing that's eating us up on the margins is the dollar devaluing has been - we've so much expense overseas it’s been a difficult situation where you have a major kind of employment wage inflation cost associated with that. So that's something that we've eaten in '07 a lot more than we expected and that's also a driver on these numbers.

Mark Murphy - Broadpoint

Thank you.

Operator

And we'll hear next from Walter Pritchard with Cowen & Company.

Ken Wong - Cowen and Company

Hi, guys. This is Ken Wong for Walter Pritchard. Can you help us better understand the profitability profile in the three major businesses? You mentioned APM is losing money. How much disparity is there between the profitability or database and Windows?

Vinny Smith

We don't break that data out. I'll just let you know that we want to invest for a long time to try to make something work, but we don't spilt out any margin contribution.

Ken Wong - Cowen and Company

Okay. And in terms of the declining operating margins in '08, can you tell us what your target headcount might be?

Vinny Smith

That's a good question. I don't know. We're at 3,450 today. Scott?

Scott Davidson

I'd say that if you look at what the increase in the headcount was last year, which was about 460 people, 75% of that was acquired. Again, assuming that we are not making any acquisitions at this point, which we probably will during the year, and you just look at the core run rate of that and, say, you add it give or take about 100 heads during the year last year, so I would say we will probably additional give or take another 75 heads during the year, core.

Ken Wong - Cowen and Company

Okay. And lastly, could you guys clarify expectation for tax rate in '08?

Scott Davidson

I'd say for the '08 tax rate, just you see the '07 rate right now and roll it forward. So, use 32.2.

Ken Wong - Cowen and Company

Okay, great. Thanks, guys.

Vinny Smith

Thanks.

Operator

Our next question will come from Aaron Schwartz with JPMorgan.

Aaron Schwartz - JPMorgan

Good afternoon. I was wondering if you could talk about potential synergies with the indirect distribution. I know you gained a lot of indirect distribution both through the Script and Vizioncore acquisition. Is there a potential for revenue synergy through those channels with your core Windows products?

Vinny Smith

Core revenue synergies between Vizioncore Script and our Windows business?

Aaron Schwartz - JPMorgan

In terms of maybe moving some of your Windows-based products through that in direct channel?

Vinny Smith

Okay. We're going to see when it tests us. In that, we've got products that we think fit the SMB channel, and we want to give it a run. And it's been started already. We started it basically on the beginning of the year. And so, that's though on the Script, because they've already got a business that they are trying to grow.

And here, we are trying to stick in X number of more products, but we're excited to really test that out, because we want to see how big we can take this SMB market, because it's entirely new for us. It's all additive. And there might be other things for us to buy in this category. So, we're learning and watching and we're trying to figure out what products and messages really work.

Aaron Schwartz - JPMorgan

Okay. And then I had a question about the Foglight 5.0 release. It seems like it was a methodical release through the year. I am not sure if you've already covered this. If you have, I apologize, but could you update us on sort of the uptake there and then maybe what your expectations are for sustainable growth in the APM business going forward?

Vinny Smith

We had a good Q4, and we have been methodical, and then we've been punching out releases about every two months. And it's been really well done. Our engineering and private management groups have done a phenomenal job, and we're going to continue that pace through '08.

I think that there is a good shot that we could grow that business and to sustain that growth. It's a pretty decent sized business right now, but I don't like that we're sitting here talking about 12% corporate growth, which is frustrating for me, and then I am used to going faster.

And that APM business should be able to grow at twice that rate for a sustainable period of time. And then because it's such a thick market category, it'd be nice if we could get that to happen. We've just been really challenged getting enough critical mass and size and right technology, but it seems like we're getting really close.

Aaron Schwartz - JPMorgan

Okay. And then I know you've been investing quite a bit in that business over the last couple of years. I mean what do you think about the growth opportunity you just talked about, and maybe the margin expansion there longer term over the next couple of years, relative to maybe a corporate margin target?

Vinny Smith

Well, it'll be nice to get any margins, because it's not churning off any cash flow, while the other businesses are. In the software business, it's really awesome when it's good, because once you get over the expanding number, it's 80% gross margins or higher, even. So, we are not there now. We won't be there in '09, but we will get pretty close.

Aaron Schwartz - JPMorgan

Okay. And the last question, Scott, this is probably for you. Do you have an estimate for either the potential exposure or timing on a payment for the section for '09 adjustment?

Scott Davidson

We are in process of rolling out a plan as we speak, but it's not fully baked yet. But if you go back and look at the last filing that we had through the first three quarters of 2007, we had accrued about 600,000 in an exposure for that. It probably won't be until a couple more months, so we can roll that out. But the good news is it affects a small group of people within the company. There are people who have been communicated to. And we think at this point, we've got about 600K reserve at this point.

Aaron Schwartz - JPMorgan

Okay. Thanks for taking my questions.

Scott Davidson

Sure.

Operator

And we will move next to Tim Klasell with Thomas Weisel Partners.

Tim Klasell -Thomas Weisel Partner

Yes. Just a quick question on the Foglight business. You seem rather confident that you can get that to high double digit, 20%-some growth. And if I look sort of across the space of other companies trying to compete in here, nobody seems to be really growing that quickly. What has to be done to Foglight to be able to break this market opening to get that faster growth that you would like?

Vinny Smith

My take on this market is, it's been a difficult market for last 15 years, there’s been a lot of phases to it and there has been a lot of failed projects. But we are finally getting to a place where people can realize kind of the promise of what you wanted to do in enterprise monitoring and application monitoring, where it can go in relatively quickly and yield value. And so, when you look at what Foglight's going to be able to do as far as deliver value quickly, to be adaptable to your environment, it's even more so important when you are talking about in a virtualized world, and Foglight fits that need. It can be – it's highly adaptable to the environment.

And the thing about the IT shops of today are, their environments are becoming very dynamic, so you need adaptable solutions. And so, we think over the next couple of years, we've got an opportunity to realize the promise of monitors, but now in a more complex environment which is a very dynamic environment where people are sweeping pools of resources around through virtualization techniques to better utilize their stuff, and we are going to be the vendor that knows how to adapt and monitor and deliver end-to-end analysis of why your users and your applications are experiencing what they are.

That's never really been done before. In the past we've had very static systems that were not very adaptable, and the market is pretty large with those static systems, but customers are intensely frustrated with them. And so, we are small vendor, so the market doesn’t have to grow a lot, we need to just be good, but we also think the market will grow because of their dynamic situation that they are putting into their shops. A lot of it on the back bone of the VSX.

Tim Klasell -Thomas Weisel Partner

Okay, great. And then, sort of chipping on to the indirect side, you sound like you really want to be pushing rather cost or more of a volume market? Are you going to be able to share with us what percentage of revenues come from the indirect channel or something to that effect?

Scott Davidson

You know historically on [core Quest] it's been roughly 10% without sort of giving you a way to back into what the script numbers are, because Vizioncore's a piece of that as well. I think if you aggregate that script in Vizioncore, you'd probably be approaching double that.

Tim Klasell -Thomas Weisel Partner

Okay. And then that channel has a tendency particularly at scale to be a much higher margin business. As that continues to grow faster than the over all business, what will you think your margins could approach?

Vinny Smith

We don't even model that. First we have to kind of achieve success than we can think about it. Your margins are pretty easy when things are going good, because once you get through your expenses, you have a very low variable cost in this business. So we know where the Promised Land is on both the SMB channel side but even the direct business once you get over then that it's pretty good. So we haven't even thought about what the margins could be there.

Tim Klasell -Thomas Weisel Partner

Okay. Then one final one here. Share repurchases -- I don’t know if you've already covered this -- is there any thinking or any announcements that we could expect on our share repurchase plan?

Scott Davidson

Not presently.

Tim Klasell -Thomas Weisel Partner

All right, great. Thanks, guys.

Scott Davidson

Thank you.

Operator

And we'll move next to Phil Winslow with Credit Suisse.

Phil Winslow - Credit Suisse

Hi guys, most of my questions has been asked, but I just wanted to focus a little bit on just the revenue growth potentially of your various sub segment side. Wonder if you would comment on what you do think of the Windows business can grow at? And obviously on the virtualization side from a dollar perspective, where do you think they can get to in '08 or maybe over the next couple of years?

Scott Davidson

Phil, we're not going to break out the segment growth rate or so the market expectations on the growth rate for us. We just gave aggregate guidance; we’re not going to give it by product area.

Phil Winslow - Credit Suisse

Okay. And then I guess, when you do look at just the virtualization products and particularly, what type of revenue run rate would you expect to see there, the possibility raised, start to tick higher on those and also on the APM side too?

Scott Davidson

Could you ask that one more time?

Phil Winslow - Credit Suisse

What Benny was talking about, sort of just the inflexion point of the fixed cost, the software model, where you actually start to hit those leverage points from revenue perspective particularly on the APM side?

Vinny Smith

We got about a year and half worth of growth before we get there.

Phil Winslow - Credit Suisse

Okay, thanks guys.

Vinny Smith

Thanks.

Operator

And next, we’ll hear from Richard Sherman with MKM Partners.

Richard Sherman - MKM Partners

Hey, Good afternoon. I just have a couple of clean up questions and some clarification. The headcount was it 3350 or 3450?

Scott Davidson

To be exact, it was 3346.

Richard Sherman - MKM Partners

3346, okay. And then Scott, you had mentioned $39.1 million in the Delta between GAAP and pro forma. What does that all include, is that all in amortization and stock comp?

Scott Davidson

It’s a combination of different components, if you go back to the last page of the press release, it will sort of back into it. But the details is amortization, tangible assets, share based comp. There’s a piece of it which is related to a professional service fees which are whether a statement, which will still have a little bit more of that, that will be trailing in, [mainly] in process R & D.

Richard Sherman - MKM Partners

Okay, great. And then Foglight I think, Vinny may be you made this comment about it being kind of complimentary out in the market. And I’d always thought of it sort of competitive with the other APM vendors. Maybe you could you give us some insights into how you see that or what you were implying in that comment?

Vinny Smith

Sure. Like when we view the market, as we go to market with a very comprehensive database monitoring, many times application monitoring, looking at the multiple component that make up application and be able to do three hours analysis and get to the point in the application where the problem is, there are solutions that tend to focus in a different way from and think of it is like device management, NOC management looking across thousands of devices and just making sure everything is okay.

And Tivoli opened to you or MOM fits that bill, we don't tend to focus there. We focus on the application side that we will integrate into those solutions and customers will run those. And most big companies will buy an application-oriented monitor and tied into a NOC level, device level monitor, and we are one, and many times the others. And those companies also are trying to get over where we are on the application monitoring, but there is a lot of technology to that. So, we many time co-exist very well with Tivoli, MOM, OpenView.

Richard Sherman - MKM Partners

Great, all right. Thank you.

Operator

And we will hear next from Brendan McCabe with Oppenheimer.

Brendan McCabe - Oppenheimer

How are doing, guys? Can you here me?

Vinny Smith

Yes.

Brendan McCabe - Oppenheimer

Three quick questions. Just on the large deals, Vinny, you noted that they were down. I was just wondering how much of that would you kind of attribute to your credit? You didn't mention anything about the options investigation. But do you think that held any consumers at bay or it was the kind of result of that change in the sales force?

And as it relates to that sales force change, and you talked about kind of going back to the old model, how long you think that will take if there is any disruption? And then lastly, on the acquisitions, you talked a lot about their impact on margin. Just trying to figure out kind of what would the organic growth rate in this quarter and what's implied in your guidance for a core growth rate?

Vinny Smith

Okay, I'll do the stock option piece. Some customers were given a little bit of [grief] over the stock option, but not really too many. It wasn't as much of an internal issue we had to deal with. It was very de-focusing for many, many management members and also the employees restricted from exercising their options.

So, it was a kind of a broad, just general distraction. The company kind of showed its strength by weathering through it, but it was painful. And so, we are through it. And to answer your question about the sales force, we are moving back to the model that we had in '06. So, we pretty much know how to do it in North America.

The changes have been put in place, and people are moving to it. It's already done. We are beginning in February. It's been done for several weeks, and we think that's good and that will hopefully bode well for '08 and get off to a good decent start.

Scott Davidson

And to your last question about sort of implied organic rate, in the 12% or 14% growth rate that we've got there and if you go back to sort of what 2007 was, approximately half of that is purchase accounting versus organic. And I think that will hold true in 2008 as well.

Brendan McCabe - Oppenheimer

Okay, thank you.

Operator

And that is all the time we have for questions. I'd like to turn the conference back to our speakers for additional or closing remarks.

Vinny Smith

Okay. Well, I just wanted to say thanks for bearing with us for the last 18 months. It's been a long time since we did one of these calls. We're a little bit out of practice, but it was fun. And thank you, all our employees listening, very much appreciate your patience with us over the last 18 months. And we are excited about going into '08 and going after our objectives for the year. Take care and have a nice day.

Operator

That does conclude today's conference. We thank you for your participation.

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Source: Quest Software, Inc. Q4 2007 Earnings Call Transcript
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