Quest Software, Inc. Q4 2007 Earnings Call Transcript

Feb. 5.08 | About: Quest Software, (QSFT)

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 - AssistantTreasurer

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 QuestSoftware Q4 earnings release conference call. (Operator Instructions)

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

At this time, I would like toturn 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 Isaid, are Vinny Smith, Chief Executive Officer; and Scott Davidson, ChiefFinancial Officer.

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

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

Let me turn briefly to our Safe Harborstatement. Some of the statements we make today may be consideredforward-looking, including statements regarding our anticipated revenue andoperating margins in future periods, benefits we expect from recentacquisitions and areas we continue to invest in. The statements involve anumber of risks and uncertainties that could cause actual results to differmaterially.

Please also note that theseforward-looking statements reflect our opinions only as of the date of thispresentation, and we undertake no obligation to revise or publicly release theresults of any revision to these forward-looking statements in light of newinformation 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 ofrisk factors that may affect our results. Copies of these documents can beobtained from the SEC at sec.gov or by visiting the Investor Relations sectionof our website.

Also, please note that certain ofthe 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 andhave been adjusted to exclude various charges, including amortization ofintangibles, share-based compensation expense, and expenses of our stock optioninvestigation. We report our GAAP results, as well as provide a GAAP tonon-GAAP reconciliation, in our earnings press release.

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

Scott Davidson

Great. Thanks, Steven. Goodafternoon, everyone. Thanks for joining us. First, let me start by saying thatwe are really pleased to have the restatement behind us. I want to acknowledgeall the hard work that was put forth by the team in the process, andfurthermore, the support shown by our customers, employees and partners whowere patient as we worked through the issues culminating with our filings onDecember 31st.

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

So, let's start at the summarylevel. 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 revenuegrew by 7%. Non-GAAP operating income was $38 million and earnings per sharewas $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, totalrevenues were $631 million, representing a 12% increase. Non-GAAP operatingincome increased 2% to a $118.7 million, and earnings per share was $0.90.

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

Q4 services revenues increased17.8% year-over-year to $13.3 million. We noted continued success in ourmaintenance sales and renewal efforts, in addition to the benefit from the ScriptLogic acquisition.

Geographically, North American operationsgenerated 63% of total revenues in the quarter, with the rest of the worldgenerating 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'dlike to remind you that 2007 non-GAAP results presented today exclude theamortization of share-based compensation and process R&D charges,amortization of certain acquisition-related intangible assets, and costsrelated to the restatement of our prior-period financials.

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

The expense profile was impactedby 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 fromacquisitions, as well as higher costs related to foreign exchange.

Turning to the individual expenseitems, 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 revenuesin the year-ago quarter. Approximately three quarters of the increase can beattributed to headcount from acquired companies and on a core basis, as well asthe impact from foreign exchange.

Research and development expensesin 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 theincrease in R&D expense was attributed to higher labor costs from acquiredcompanies, and an increase in core headcount as well. Expenses were alsoimpacted by foreign exchange, as many of developers are located outside of the United States.

General and administrativeexpenses were $19.1 million, or 10% of total revenues in the quarter, ascompared to expenses of $12.5 million, which was 7.5% of revenues during Q4last year. Most of the dollar increase was related to increased headcount tosupport operations, cost from acquired companies, including the integration ofthese 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-GAAPoperating income was $38 million, which excludes $4.8 million in expenserelated to the restatement.

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

Other income net in the quarterwas $3 million versus $5.4 million in Q4 '06. The primary driver of the changein [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 balancesduring the quarter.

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

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

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

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

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

As we enter 2008, we continue tosee opportunities across several of our markets. And to capitalize on theseopportunities, our plan is to expand our investments in these markets to drivegrowth 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 andoperating margins for the year, as we believe that this is the bestrepresentation of the primary indicators of how to gauge our results. So, assuch, for the full year ending December 31, 2008, annual revenue growth isexpected to be in the range of $705 million to $720 million.

We are targeting GAAP operatingmargin of 11% to 12%. And, implicit in that guidance is 16.5% to 17.5% non-GAAPoperating 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 stockoption restatement.

Now, let me turn it over toVinny.

Vinny Smith

Thanks, Scott. Let me take aminute and put a little bit of color into the performance in '07, and also whatthat 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 ofabout $630 million. Some of that was organic, and some was acquired. We alsoran with the pretax pro forma margins of about 18.8%. And you look at theestimates that were given to you, that will take us in '08 up to a little over$700 million.

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

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

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

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

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

And really, the only threat toour 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. Itdoesn't have a great deal of growth in it.

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

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

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

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

We compete, co-exist, andcomplement the biggest vendors in the market: the IBMs, the HPs, the CAs, theBMCs 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 sustainablegrowth that will be very dependable. So, that's why we view it as an importantkind of position for us to maintain. And so, we think we are going to have gooda '08, and allow us at some point in the future to break over intoprofitability.

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

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

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

The next area that we boughtthree companies in is in the client management space, and also happens to bevery SMB-oriented. ScriptLogic had a very strong position inthe 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 thirdcompany that we bought in the client management space is ProvisionNetworks. And this has some stunning technology, we thinkvery much a best-of-breed, clear leadership position, from a technology aroundVDI and terminal services. And likely competitors in the future in this marketare going to VMware itself, possibly. We are not sure exactly how diligentlythey are going to stay in that market; and also Citrix.

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

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 canleverage our existing sales force. We're very excited about that acquisition.

We brought two companies in theSharePoint 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 productsfor SharePoint.

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

And the last acquisition is inthe application monitoring space, a company named Magnum. What it is? It's abolt-on set of technologies, or feature sets, for our Foglight 5 offering inthe 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 inan existing family, that we need the technology, and the know-how, and thepeople, 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, these10 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 isthe second time in four years we won that award. We're only one of twocompanies 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, andit's nice that Microsoft appreciates that and recognizes it, as we go tomarket, making Microsoft the more adorable enterprise-worthy platform in manyareas. And so, we've built a great business around that market and thatrelationship.

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

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

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

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

Same for archive management, we releasedthe big products in '07. We have more to go in '08, but that's another deepmarket 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 dominantvendors, we'll be out to get growth. So, we try there. There are not that manycategories of areas of products that we have that are real deep, but those twohappen to be. So, that's why we are so persistent on our investment.

And our last point is, I havealready 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 fragmentedacross 50 or 100 vendors, but we are likely to be one of two large dominantvendors that are the best at innovating, best value for the customer, bring thebreadth of solutions that customers want, and offer a vendor that's just aknown company that delivers great results for its customers. So, we lock ourchances in that market. So, that's why we are so engaged to make sure we get aposition early.

Other factors at the company, weend 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 acharity fund inside the Quest, and this is a new thing we started. I think westarted at the beginning of '07, where it's entirely employee-controlled,employee-submitted, and employees decide on the charities. And we contributedcharitable dollars to over 150 organizations around the world. And it'ssomething 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 excitingto see what they doing with it.

As far as geographic trends, thisyear, 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 repairsome mistakes we made, and it's okay to make errors and mistakes. We’ve got totry new stuff.

But '08 through '09 will be atough 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 '08with the knowledge of what we learnt in '07. And so, we think we'll do betterin North America, and we are hoping that Europeand 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'thave the pipeline of companies that we're looking at. It's not because we don'twant to. It's just that we don't see the things that we saw in '07. But therewill be some deals, and they'll probably be the same types of deals that we didin '07.

Overall, though, in themarketplace, not Quest, but in general, we see a rapidly consolidatedmarketplace. And that, for me, spells opportunity, because there are fewvendors that have the same kind of focus on building rich, colorful, innovativesolutions for the customers, that have some scale and size that should reachthe customers, for the customers to trust them that they'll be there when timeare tougher.

And so, I am excited about beingpart of a marketplace that is consolidating. I think it's an opportunity for usto stand out and just focus on being great. For me, when I think about '08 andour focus and goals, they are broken into three branches. One is the financialobjectives, 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 andgood value, and to deliver great service to them. And the third is really goalsand 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 atdelivering on all three kinds of areas of goals and objectives.

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

And now, let's open the call upto questions.

Question-and-Answer Session

Operator

(Operator Instructions)

And we'll hear first from DerekBingham with Goldman Sachs.

Derek Bingham - Goldman Sachs

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

Vinny Smith

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

Derek Bingham - GoldmanSachs

Okay. Great. And then --

Scott Davidson

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

Derek Bingham - Goldman Sachs

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

Vinny Smith

Yes, we basically tried to havetoo many senior field reps selling all of our products across Windowsapplications and databases. And what we learned was it was too much and we wereleaving many accounts undersold to, and it was just difficult for reps toreally carry that breadth of products. Our company has just gotten too broad.

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

Derek Bingham - Goldman Sachs

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

Scott Davidson

Each of these companies, as Vinnysaid, there is 10 of them, right? And a lot of them are smaller typeorganizations. So, the profile is sort of all over the board, but none of themhad operating margins in 2007 that approached our core operating margin ofroughly 19%. If you strip those out and you look at the sort of core businessfor Quest in '08, I'd say our operating margin would roughly be similar to whatit was in '07.

Derek Bingham - GoldmanSachs

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 KirkMaterne 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 alittle bit -- I mean the core business being flat, say '07 to '08, I canunderstand the acquisitions -- but given that you're building up a much largerbase of maintenance revenue; one, would think as that makeshift changes, moreof that should follow the bottom line. So, I guess from where are you investingin your core business and why does that make sense given someone's business isin terms of their maturation rate now and their growth rates?

Scott Davidson

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

At the sametime, 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 ifyou will. So, there is inherent in that some level of duplication on the costside, as they do their own order processing, film and [revrak] and everythingelse that's there on sales organization. There will be some benefits of uscross selling each others products, but there's some cost associated with thatas well.

The reason forthat is because they typically sell to a different market, they sell to an SMBand they sell through a channel where there's a little bit difference from therest 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 aremoving into. Any talk about the VMware and the support for ESX server throughVizioncore and some of the technology that Invirtus has as well.

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

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

Kirk Materne - Banc of America

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

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

Vinny Smith

I can tell you that we evaluatethis all the time, because the cost to go to market is so high. What we aretrying to do is, build more agility into our product areas so that we can meetthe market faster because we've found ourselves struggling with becoming amid-sized software company and not always been the leader in innovation whichwas all typically our advantage. So we are struggling some. So one the topchallenges of that is how to go to market.

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

One of the challenges to thecompany in general is, we plan markets that might be several $100 million insize 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 sizechunk of it but we have not been able to get into the markets that are measuredin billions and we are we are getting a big chunk of it. And that's just wherewe are as a company and we've not been fortunate enough to be in that type ofsegment.

Kirk Materne - Banc of America

Last question for Scott. Giventhat 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 ofthe margin targets for the overall business were still in that low 20% range orsimilar around that. Given that you are incubating Vizioncore and some of theseother, is that margin profile still intact or do we need to think about something lower than that going forward?

Scott Davidson

Yeah. I mean I think, if you lookat the guidance that we set on a non-GAAP margin basis; that was 16.5% to17.5%. So we finished the year on a non-GAAP basis of about 19, a shade under19A, 18A to be exact. Within that Q4 number we had five of the acquisitionsthat Vinny talked about actually took place in Q4, and the sixth wasScriptLogic which took place in August. So six of the 10 acquisitions happenedfrom August through December, so we haven't seen a full year of the impact ofthose acquisitions yet and we finished at [18.8] on the off margin side. Sothat's what our guidance reflects probably, if you take the high end of thatrange about a 100 basis points down from that, so 17.5 is how to get to thatdata point.

Kirk Materne - Banc of America

Okay thanks I'll let someone else.

Operator

And we will hear next from MarkMurphy with Broadpoint.

Mark Murphy - Broadpoint

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

Vinny Smith

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

Mark Murphy - Broadpoint

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

Vinny Smith

My take is I look at it then Ialso see how I think it affects us. I think Microsoft's position is onlygrowing and it's strengthened directory management, email management, documentmanagement and collaboration earning all of that within SharePoint. It justseems 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 orsometimes put functionality that it clips our products. And so we've got toplay the innovator race with them, and not so much in a negative way, but theyare just going to evolve those platforms and take out market opportunities fromus. So it's a bit of a mixed bag. The market opportunity grows but it alsoshrinks 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 forScott. Could you comment on the recent growth rates for a couple of theacquired businesses, particularly ScriptLogic and Vizioncore to whatever extentthat you can or perhaps where do they stand as a percentage of revenue today?

Scott Davidson

We're not breaking out the growthrates 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 hasbeen - we've so much expense overseas it’s been a difficult situation where youhave a major kind of employment wage inflation cost associated with that. Sothat's something that we've eaten in '07 a lot more than we expected and that'salso a driver on these numbers.

Mark Murphy - Broadpoint

Thank you.

Operator

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

Ken Wong - Cowen and Company

Hi, guys. This is Ken Wong forWalter Pritchard. Can you help us better understand the profitability profilein the three major businesses? You mentioned APM is losing money. How muchdisparity 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 makesomething work, but we don't spilt out any margin contribution.

Ken Wong - Cowen and Company

Okay. And in terms of thedeclining operating margins in '08, can you tell us what your target headcountmight be?

Vinny Smith

That's a good question. I don'tknow. We're at 3,450 today. Scott?

Scott Davidson

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

Ken Wong - Cowen and Company

Okay. And lastly, could you guysclarify 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 fromAaron Schwartz with JPMorgan.

Aaron Schwartz - JPMorgan

Good afternoon. I was wonderingif you could talk about potential synergies with the indirect distribution. Iknow you gained a lot of indirect distribution both through the Script andVizioncore acquisition. Is there a potential for revenue synergy through thosechannels with your core Windows products?

Vinny Smith

Core revenue synergies betweenVizioncore Script and our Windows business?

Aaron Schwartz - JPMorgan

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

Vinny Smith

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

And here, we are trying to stickin 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'sentirely new for us. It's all additive. And there might be other things for usto buy in this category. So, we're learning and watching and we're trying tofigure out what products and messages really work.

Aaron Schwartz - JPMorgan

Okay. And then I had a questionabout the Foglight 5.0 release. It seems like it was a methodical releasethrough the year. I am not sure if you've already covered this. If you have, Iapologize, but could you update us on sort of the uptake there and then maybewhat your expectations are for sustainable growth in the APM business goingforward?

Vinny Smith

We had a good Q4, and we havebeen methodical, and then we've been punching out releases about every twomonths. And it's been really well done. Our engineering and private managementgroups have done a phenomenal job, and we're going to continue that pacethrough '08.

I think that there is a good shotthat we could grow that business and to sustain that growth. It's a prettydecent sized business right now, but I don't like that we're sitting heretalking about 12% corporate growth, which is frustrating for me, and then I amused to going faster.

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

Aaron Schwartz - JPMorgan

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

Vinny Smith

Well, it'll be nice to get anymargins, because it's not churning off any cash flow, while the otherbusinesses 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 orhigher, even. So, we are not there now. We won't be there in '09, but we willget pretty close.

Aaron Schwartz - JPMorgan

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

Scott Davidson

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

Aaron Schwartz - JPMorgan

Okay. Thanks for taking myquestions.

Scott Davidson

Sure.

Operator

And we will move next to TimKlasell with Thomas Weisel Partners.

Tim Klasell -Thomas Weisel Partner

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

Vinny Smith

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

And the thing about the IT shopsof today are, their environments are becoming very dynamic, so you needadaptable solutions. And so, we think over the next couple of years, we've gotan opportunity to realize the promise of monitors, but now in a more complexenvironment which is a very dynamic environment where people are sweeping poolsof resources around through virtualization techniques to better utilize theirstuff, and we are going to be the vendor that knows how to adapt and monitorand deliver end-to-end analysis of why your users and your applications areexperiencing what they are.

That's never really been donebefore. 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 areintensely frustrated with them. And so, we are small vendor, so the marketdoesn’t have to grow a lot, we need to just be good, but we also think themarket will grow because of their dynamic situation that they are putting intotheir shops. A lot of it on the back bone of the VSX.

Tim Klasell -Thomas Weisel Partner

Okay, great. And then, sort ofchipping on to the indirect side, you sound like you really want to be pushingrather cost or more of a volume market? Are you going to be able to share withus what percentage of revenues come from the indirect channel or something tothat effect?

Scott Davidson

You know historically on [coreQuest] it's been roughly 10% without sort of giving you a way to back into whatthe script numbers are, because Vizioncore's a piece of that as well. I thinkif you aggregate that script in Vizioncore, you'd probably be approachingdouble that.

Tim Klasell -Thomas Weisel Partner

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

Vinny Smith

We don't even model that. Firstwe have to kind of achieve success than we can think about it. Your margins arepretty easy when things are going good, because once you get through yourexpenses, you have a very low variable cost in this business. So we know wherethe Promised Land is on both the SMB channel side but even the direct businessonce you get over then that it's pretty good. So we haven't even thought aboutwhat 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 thereany thinking or any announcements that we could expect on our share repurchaseplan?

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 PhilWinslow with Credit Suisse.

Phil Winslow - Credit Suisse

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

Scott Davidson

Phil, we're not going to breakout the segment growth rate or so the market expectations on the growth ratefor us. We just gave aggregate guidance; we’re not going to give it by productarea.

Phil Winslow - Credit Suisse

Okay. And then I guess, when youdo look at just the virtualization products and particularly, what type ofrevenue run rate would you expect to see there, the possibility raised, startto 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, whereyou actually start to hit those leverage points from revenue perspectiveparticularly on the APM side?

Vinny Smith

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

Phil Winslow - Credit Suisse

Okay, thanks guys.

Vinny Smith

Thanks.

Operator

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

Richard Sherman - MKM Partners

Hey, Good afternoon. I just havea couple of clean up questions and some clarification. The headcount was it3350 or 3450?

Scott Davidson

To be exact, it was 3346.

Richard Sherman - MKM Partners

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

Scott Davidson

It’s a combination of differentcomponents, if you go back to the last page of the press release, it will sortof back into it. But the details is amortization, tangible assets, share basedcomp. There’s a piece of it which is related to a professional service feeswhich 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 Ithink, Vinny may be you made this comment about it being kind of complimentaryout in the market. And I’d always thought of it sort of competitive with theother APM vendors. Maybe you could you give us some insights into how you seethat or what you were implying in that comment?

Vinny Smith

Sure. Like when we view themarket, as we go to market with a very comprehensive database monitoring, manytimes application monitoring, looking at the multiple component that make upapplication and be able to do three hours analysis and get to the point in theapplication where the problem is, there are solutions that tend to focus in adifferent way from and think of it is like device management, NOC managementlooking 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 willintegrate into those solutions and customers will run those. And most bigcompanies 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 thosecompanies also are trying to get over where we are on the applicationmonitoring, but there is a lot of technology to that. So, we many time co-existvery well with Tivoli,MOM, OpenView.

Richard Sherman - MKM Partners

Great, all right. Thank you.

Operator

And we will hear next fromBrendan McCabe with Oppenheimer.

Brendan McCabe - Oppenheimer

How are doing, guys? Can you hereme?

Vinny Smith

Yes.

Brendan McCabe - Oppenheimer

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

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

Vinny Smith

Okay, I'll do the stock optionpiece. 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 dealwith. It was very de-focusing for many, many management members and also theemployees restricted from exercising their options.

So, it was a kind of a broad,just general distraction. The company kind of showed its strength by weatheringthrough it, but it was painful. And so, we are through it. And to answer yourquestion 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 inplace, and people are moving to it. It's already done. We are beginning inFebruary. It's been done for several weeks, and we think that's good and thatwill hopefully bode well for '08 and get off to a good decent start.

Scott Davidson

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

Brendan McCabe - Oppenheimer

Okay, thank you.

Operator

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

Vinny Smith

Okay. Well, I just wanted to saythanks for bearing with us for the last 18 months. It's been a long time sincewe 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 patiencewith us over the last 18 months. And we are excited about going into '08 andgoing after our objectives for the year. Take care and have a nice day.

Operator

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

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