Blue Coat Systems, Inc. F3Q08 (Qtr End 01/31/08) Earnings Call Transcript

Blue Coat System, Inc. (BCSI)

Q3 2008 Earnings Call

February 21, 2008, 8:00 am ET

Executives

Dan Levee – Director of FP&A

Kevin Royal - Senior Vice President and Chief Financial Officer

Brian NeSmith - President and Chief Executive Officer

Analysts

Samuel Wilson – JMP Securities

Ryan Hutchinson – WR Hambrecht + Co.

Jonathan Ruykhaver – Thinkequity Partners

Joshua Jabs – Roth Capital Partners

Erik Suppiger – Signal Hill Group

Richard Sherman – MKM Partners

[Jaret Sadiki] – Manny Napier

Rohit Chopra – Wedbush Morgan Securities

Rob Owens – Pacific Crest Securities

Chris – Merriman Curhan Ford

Scott Zeller – Needham & Company

Presentation

Operator

Welcome to the Blue Coat Systems Q3 Financial Results Conference Call. [Operator Instructions] At this point I’d like to turn the conference now to Mr. Dan Levee with Investor Relations.

Dan Levee

Good morning and thank you for joining us today. My name is Dan Levee and I’m the Director of FP&A temporarily filling in for Carla Chun, Blue Coat’s Director of Investor Relations. Kevin Royal, Blue Coat’s Senior Vice President and Chief Financial Officer will begin today’s call with an overview of financial results for the third quarter of fiscal 2008 ended January 31, 2008, and the current outlook for the fourth quarter ending April 30, 2008. Brian NeSmith, Blue Coat’s President and Chief Executive Officer will then follow with his commentary and other operating highlights.

As you know we will make forward looking statements during the course of this call. These include statements regarding expectations concerning market growth and business opportunities, expectations regarding future revenues, expenses, margins, tax rate and other financial metrics and other matters affecting Blue Coat’s financial outlook, prospects and future business. These statements are based on current expectations, they are subject to a number of risks, uncertainties and other factors that may cause industry and market trends where our actual results, level of activity, performance or achievements expressed or implied by these statements to differ materially.

We refer you to the risk factors referenced in our press release issued earlier today as well as the documents the company files with the Securities and Exchange Commission, including our annual report on form 10-K. These documents identify and discuss important factors that could cause our actual results to differ materially from those contained in our forward looking statements and projections. Now I’ll turn the call over to Kevin.

Kevin Royal

Today we are pleased to announce another quarter of record net revenue of $81.4 million for the third fiscal quarter of 2008 an 11% increase compared to net revenue of $73.4 million reported in the prior quarter. Included in the $81.4 million of net revenue is product revenue of $62.8 million which includes sales of appliances and Blue Coat WebFilter. Product revenue in the third quarter of fiscal 2008 reflects an 11% increase compared to $56.7 million in the prior quarter. As we disclosed last quarter we are seeing the Gateway Security market and the market for WAN Optimization and acceleration and products converge.

Consistent with last quarter we continue to observe a growing number of purchase decisions based on both security and acceleration functionality. As you are aware, competition in our market remains strong yet our differentiation continues to resonate with enterprises and is driving our success in this market. Because of this convergence we indicated last quarter we would no longer separate WAN application delivery bookings into two categories for discussion. Instead, as we manage our business through this period of growth we focus on the growth in appliance revenue which was $53.7 million in the third quarter a 13% increase compared to the $47.4 million in the second quarter.

As I mentioned, product revenue also includes revenue recognized on sales of Blue Coat WebFilter which decreased 2% to $9.1 million in the third fiscal quarter compared to $9.4 million in the second quarter. Approximately $7.9 million of the revenue recognized on the Blue Coat WebFilter this quarter is related to perpetual licenses compared to $7.7 million in the second quarter fiscal 2008.

Turning to service revenue, we recognize $18.5 million the third quarter an 11% increase over $16.7 million recognized in the prior quarter. On a geographic basis net revenue in North America was $35.4 million representing approximately 44% of total revenue. Net revenue in EMEA and Latin America was $33.6 million representing approximately 41% of total revenue. Net revenue in the Asia/Pacific region was $12.4 million representing approximately 15% of total revenue. Growth was very strong in EMEA which experienced net revenue growth of 40% in the quarter.

Gross margin on a non-GAAP basis decreased to 77.1% in the third fiscal quarter from 78.7% in the prior quarter. The decrease in gross profit as a percentage of net revenue was primarily attributable to slightly higher discounting, stronger sales in regions with slightly lower product gross margins and a reserve of $600,000 for potentially unusable inventory. On a GAAP basis operating expenses increased approximately $1.9 million to $48.2 million in the third quarter. However, as a percentage of total net revenue, operating expenses declined approximately 4%.

Our non-GAAP R&D expense increased approximately $700,000 but declined approximately 1% as a percentage of revenue. As we stated last quarter we expect R&D spending to continue to increase in absolute dollars. However, we intend to maintain our R&D spending as a percentage of net revenue at approximately 15% for the remainder of the fiscal year. Non-GAAP sales and marketing expense increased approximately $1.3 million but decreased approximately 2% as a percentage of net revenue.

The increase in non-GAAP sales and marketing expense results from increased headcount to expand our sales force. Our number of sales teams increased from 87 at the end of the second quarter to 92 teams at the end of the third quarter. Non-GAAP G&A expense in the third quarter decreased approximately $100,000 from the prior quarter and declined approximately 1% as a percentage of net revenue. On a non-GAAP basis the company reported net income of $15.3 million or $0.38 per diluted share in the third fiscal quarter 2008 compared to non-GAAP net income of $12.4 million of $0.30 per diluted share in the prior quarter.

For purposes of calculating non-GAAP earnings per share for the quarter ended January 31, 2008, our fully diluted shares were approximately $40.6 million. On a GAAP basis the company reported net income of $10.5 million or $0.26 per diluted share in the third fiscal quarter 2008 compared to net income of $7 million or $0.17 per diluted share in the prior quarter. As a reminder, a reconciliation of non-GAAP to GAAP financial measures is included in today’s press release.

Turning to the balance sheet, we ended the quarter with cash, restricted cash and short term investments of approximately $168 million, representing an increase of $15.5 million from the prior quarter. Our operating cash flow in the third fiscal quarter was $17 million compared to $19.2 million in the prior quarter. Capital expenditures were $2.7 million for the third fiscal quarter and depreciation and amortization was $1.8 million. In addition, the net proceeds from the issuance of common stock as a result of the exercise of stock options totaled approximately $800,000.

Our accounts receivable balance increased by $8.3 million during the quarter due to the increase in revenue. Our DSO’s increased to 54 days at the end of the third fiscal quarter. This increase is primarily due to the regional shift in revenues. The net increase in deferred revenue is $12.2 million for the quarter partially offsetting that increase was approximately $1.2 million in ratable revenue recognized on Blue Coat WebFilter.

Turning to our guidance for the fourth fiscal quarter 2008 ending April 30, 2008, the company currently anticipates net revenue in the range of $88 to $91 million. On a non-GAAP basis which excludes the amortization of intangible assets, stock based compensation expense and expenses associated with our stock option investigation. Earnings per share is expected to be $0.37 to $0.41 per diluted share. On a GAAP basis earnings per share is expected to be $0.23 to $0.27 per diluted share.

For planning purposes we are currently forecasting a tax rate of 5% for the remainder of fiscal 2008. As I mentioned last quarter in the future we may need to reverse the valuation allowance applied against substantially all of the company’s net deferred tax assets due to the company’s continued profitability. This reversal will cause a significant non-cash increase in earnings in the period the reversal occurs. Subsequent to the reversal of valuation allowance we are anticipating a higher effective tax rate of approximately 30% on an accrual basis.

As it is uncertain when it might be necessary to reverse the deferred tax valuation allowance we are using an effective tax rate of 30% for fiscal 2009 planning purposes beginning in the first quarter of fiscal 2009. We expect the cash basis tax rate to lag the accrual basis tax rate for several periods.

Now let me turn it over to Brian for his perspective on the quarter and our business going forward.

Brian NeSmith

Good morning and thank you for joining us. It’s been another good quarter for Blue Coat. This past quarter we received positive validation that our Proxy products and the WAN Optimization market are valued by customers as well as by industry analysts. As of December we are now positioned to leadership quadrant of Gartners Magic Quadrant for WAN Optimization controllers. Also, we hold the number one market share leadership in the WAN application delivery market for the first half of calendar 2007 according to the latest report for IDC.

In addition to our industry recognition we continue to gain new customers in the WAN Optimization space this quarter and several vertical markets such as transportation, financial, manufacturing, banking and healthcare. We had announced this quarter that the Proxy SG family of products are used by British Telecom to secure and accelerate their web based applications while managing the use of the web by employees.

Our leadership and success with customers results from our unique focus on delivering security and acceleration in a single platform. The WAN Optimization market is evolving as we predicted to one where customers need and want security and acceleration on a single platform. Customers are simply unwilling to indiscriminately accelerate any and all applications and content across their networks. Instead, they want to selectively accelerate mission critical applications an content and to block content that is unnecessary or potentially harmful to their business.

The approach to WAN Optimization demands a more comprehensive solution to address the challenges of managing applications in a decentralized environment. Blue Coat’s unique WAN application delivery solution first provides visibility into the traffic on the WAN and then applies a robust set of policies to accelerate business critical traffic while stopping the threat of malware and unwanted applications. This good combination of acceleration, security and control that leads to the ability to stop the bad and accelerate the good, as we like to say.

An additional benefit of our integrated solution is that it enables enterprises to allow their branch offices to access the internet directly, rather than back hauling it across the WAN. Prerequisite to manage and secure direct internet access by the branch office is that it has available the same security and policy control as the corporate headquarters. With Blue Coat the same Proxy SG appliances that provide WAN Optimization at the branch office can also provide the security and control necessary for direct internet access.

It is a fully integrated solution for both acceleration and security. On appliance, one set of policies and one management infrastructure. Unlike our competitors we believe that security should never be an after thought. It is not an accessory it cannot be bolted on to a product instead security needs to be engineered from the ground up. Security and acceleration are different sides of the same coin and the ability to offer both on one platform comes from Blue Coat’s core technology competencies of proxy architecture, caching and content architecture.

Our Proxy SG appliances are built both for security and for acceleration. Our emphasis on security starts with our SGOS operating system. This is a custom operating system, not a Linux or Windows derivative. Any knowledge about our operating system is carefully controlled. It is tightly closed and for good reason. You may have noticed that we recently acquired common criteria certification for the latest version our SG appliance.

This is indicative of a very high level of security, functionality and our certification will be accepted in 24 major countries around the world. Common criteria certification is essential for many government and military purchases. Including purchases of security products made by the United States Government and is well respected by many large enterprises. The ability to manage and distribute video is another key competency where Blue Coat’s products excel.

No different than other contents some video’s good is important to a business and some are more likely more is not. In fact, enterprises and organizations currently are being overwhelmed with video from external sources that can consume huge amounts of bandwidth. Sites such as You Tube stand out. Last year You Tube represented some 4% of worldwide web traffic. One can suspect that this year it will be considerably higher. Rather than blocking or controlling external video usage many of our customer simply want to mitigate its affect on WAN, on internet gateway bandwidth.

Blue Coat’s granular policy allows customers to set rules for managing video. At the same time, enterprises are quickly embracing the use of video for training employees, are communicating to all employees at once. Managing and distributing on demand and live video is increasingly seen as a key new requirement of WAN Optimization. We believe that our Proxy SG is the best product in the market today for video distribution in the enterprise whether it is live or on demand.

As our market continues to develop and new requirements emerge it is imperative to have a solution that can solve application delivery challenges securely over an increasingly distributed complex environment. The platform that we have evolved over the past 11 years provides just such solution. We are in the right place at the right time with the right architecture and experience to meet these new challenges and to deliver the solutions that our customers demand.

Most importantly we remain the only company in the market that can deliver on our promise of stopping the bad and accelerating the good. With that I will turn the call back over to our moderator for questions.

Question & Answer Session

Operator

[Operator Instructions] First to the line of Samuel Wilson of JMP Securities.

Samuel Wilson – JMP Securities

Just a few small questions for you and I’ll just list them off and then you can fire away at them. First, any change in the competitive environment in particular, I’m a little less concerned about you versus Riverbed but you versus the big goliath Cisco, any changes in terms of pricing or how they are behaving in the market? Second, can you describe linearity a little bit throughout the quarter? Third, can you give us an update, I know financial services is not your largest vertical but it’s an important vertical, maybe the tone of the customers throughout the quarter?

Kevin Royal

Linearity was fairly comparable with other quarters. We tend to see about 20% the first month, 30% in the second month and 50% in the last month of the quarter. This quarter was fairly similar with what we experienced over the last few quarters.

Brian NeSmith

The part I guess I’d add to that is while I’m sure most people have thought of that but that also is the first month of this calendar year. Which I think there was a lot of concern about it but we didn’t see much of a change from the standpoint of our business as far as that distribution of revenue across the three months. Competitively I don’t think there’s any significant change from what we’ve been seeing historically from Cisco or from Riverbed. There have been some recent product announcements from both companies but the dynamics I’ve not seen a lot of change.

The financial services environment I don’t think there’s anything that I would point to that shows a dramatic change in the demand. There’s been a little bit here and there with certain customers but in our largest customers we did have a number of financial services customers that we closed business over $1 million with a number of those customers that were clearly in the financial services sector. There’s a little bit of activity there. I read the same things you do, so I have the same concerns but we haven’t seen much as far as a change in the demand and what those customers are looking for.

Operator

The next question is from Ryan Hutchinson with WR Hambrecht + Co.

Ryan Hutchinson – WR Hambrecht + Co.

In terms of operating margins moving forward, how should we be thinking about the margin expansion over the next couple of quarters and I think is it fair to assume that we should continue to see modest improvements to operating margins given a sustained top line growth?

Brian NeSmith

We gave guidance for one quarter so I think you can see that the picture for one quarter. Obviously recent history has shown some steady improvement here but also to qualify that, we operate in a fairly volatile market. We’ve given the guidance for the next quarter but I don’t think we can give you much past that.

Ryan Hutchinson – WR Hambrecht + Co.

To put it another way, with the top line growth are we going to see another round of significant investments that could pressure operating margins a couple quarters out? Is it the stance of management to continue to march toward the 25%?

Brian NeSmith

We’ve highlighted that we want to gradually move to that 25% operating margin. Any one quarter we can’t guarantee that it’s going to be in a nice linear manner that we are going to make the steps to that. The guidance we can give you is for next quarter and then what happens in the following quarter since we don’t give guidance there I can’t really give you any prediction of what’s going to happen. Not much more I can add to that unless Kevin there is anything you want to add.

Ryan Hutchinson – WR Hambrecht + Co.

In terms of not breaking out the WAM Optimization bookings, I understand the rationale for not providing that number. Having said that, could you provide some additional color in terms of how the initiative is progressing in terms of your internal plans. Maybe number of new customers, win rates, anything that the street can get a better sense of how you are progressing in that market would be helpful.

Brian NeSmith

Broadly what I would say is that more and more so our traditional market at the gateway we are going to see some growth there but I don’t think its going to be significant. Probably on the order of 10% to 20% annually. The bulk of our growth is going to come out of customers that are looking for WAN Optimization functionality whether that’s what they are looking for exclusively or whether its both WAN Optimization and security its hard to break out.

That’s why we have some difficulty breaking that out. Substantively speaking the bulk of our growth is going to come from WAN Optimization. Even harder for us sometimes to categorize it there’s the simple for something is pure security or pure WAN Op but actually it turns out increasingly that a larger and larger percentage of our total is actually both when you look at our business. As far as customer penetration, we continue to see the same kind of success we were seeing the previous quarters.

I don’t think the dynamic has changed a lot. It’s a very competitive market; I would say we are starting to see a higher percentage of our deals are competitive with at least someone in the market. That’s probably the only thing we are seeing a slight change on over the last quarter.

Ryan Hutchinson – WR Hambrecht + Co.

Last question on gross margin came in within expectations that you highlighted on last quarters call. How should we be thinking about gross margins moving forward in the fourth quarter?

Kevin Royal

The guidance for profitability and earnings per share contemplates our gross profit will remain relatively flat with the third quarter.

Operator

Our next question is from the line of Jonathan Ruykhaver with Thinkequity Partners.

Jonathan Ruykhaver – Thinkequity Partners

You are looking at growth and sustainability of growth over the next 12 or 18 months is the lever here still elated in your mind to broadening the channel is sales footprint for WAN Optimization. Have you seen a need for new capabilities that are complementary outside of core WAN Optimization?

Brian NeSmith

There are a couple questions in there actually and maybe I’ll broaden it out to answer a few other things that I think are worth talking about. The motivation for a lot of customers in deploying the Proxy in the branch environment is driven by a need to want to take the servers out of the branch. We are starting to see announcements from some competitors where they are basically talking about putting the server back in the branch.

Call it, package it whatever way you like, in the end the motivation is that I don’t want to deal with the administration, the management of a box that’s running a lot of different applications on the platform and then suffer some of the reliability and the manageability issues that come as a result of that. The answer is yes, there are some things we view as good incremental functionality to add to our platform that are relevant to the branch environment. Not to the extent that we become a server.

That is an important distinction a lot of cases customers may think they are getting something for free. They took their servers out of the branch; they consolidated those devices to a few data centers and then if they correspondingly look to redeploy them packaged a different way they are going to run into the same issues that they talked about before. Yes, there is room for review some incremental functionality but as an appliance based solution which we are, we are very careful about understanding what we can add value on and what we can’t.

If it’s just simply the amalgamation of different applications on the platform that’s the job of the server. We’d recommend if customers want that they buy a Dell server or HP or an IBM server or whatever they want for deploying that branch. We would look at applications where it’s very clear that we are adding value to the transaction not just simply serving as a platform where those applications need to run.

Jonathan Ruykhaver – Thinkequity Partners

A follow up, some of your competitors suggested a growing market opportunity in the data center market related to data replication and other storage issues. Do you see that as an area Blue Coat might go into, or is the focus going to remain more on the reload office issues for applications delivered?

Brian NeSmith

We as a company have a product that could service that application. We have chosen to focus on the branch. We think that’s were we add the most value that the combination of security and acceleration and the risk policy control that we bring to the table is most relevant to the branch. Data center to data center is a bulk data transfer problem, there’s just not a lot of policy in control and security issues there. We do have a product that could service that market, we just don’t feel like we bring anything that unique and we’ll leave that to other players.

Jonathan Ruykhaver – Thinkequity Partners

One final question, do you have any sense as to the percent of net cash customers that have migrated to the Proxy SG platform?

Brian NeSmith

The last time I looked at it, which was at the end of December, we were roughly around two thirds of the way through there. That’s definitely an estimate.

Jonathan Ruykhaver – Thinkequity Partners

It sounds like the conversion rate is definitely fallen off and you’ve gone through the bulk of those transfers to the new platform.

Brian NeSmith

I think that the remainder are just waiting for the depreciation cycle on their existing equipment. They’ll make a transfer; I’m not really worried about customers not making the transfer. Fundamentally for a lot of those customers they are happy with the solution they’ve got and they are just going to wait until they’ve depreciated what they purchased from Network Appliance previously.

Operator

Our next question is from Joshua Jabs with Roth Capital Partners.

Joshua Jabs – Roth Capital Partners

Can you talk a little bit about the pipeline specifically what you are seeing internationally versus domestically? As a follow up, there are few additions to the sales team, where were those additions?

Brian NeSmith

The growth we saw in the sales team is consistent with everything we’ve seen in the past. It’s occurring all over the world, it’s not concentrated in North America or Europe or Asia. That’s the same thing I suspect going forward as well. In any one quarter we’ll see a particular region surge but generally has not been a trend and we look for something going across a couple of quarters. As far as the pipeline, it’s grown consistent with what we’ve seen the past quarters and we look at it and we track it but I wouldn’t say there is anything of note that I would point to that was unique in this quarter compared to previous quarters.

Joshua Jabs – Roth Capital Partners

On the unusable inventory can you give us a little color there?

Kevin Royal

The reserve that we took in the quarter relates to third party pre-paid license inventory that we currently estimate will not be sellable in the future is about $600,000 and impacted gross margin by about 0.7%.

Operator

Next we’ll go to Erik Suppiger from Signal Hill Group.

Erik Suppiger – Signal Hill Group

What is the deferred revenue component for the WebFilter at this point?

Kevin Royal

It’s roughly $5.5 million.

Erik Suppiger – Signal Hill Group

You recognized about $1.2 million for the quarter can you give us any sense, is that going to change much in the April quarter?

Kevin Royal

We expect about $1 million of the remaining balance to float through in the fourth quarter.

Erik Suppiger – Signal Hill Group

Does it trail down slowly from there or does it go forward and drop?

Kevin Royal

It trails off over the next year.

Erik Suppiger – Signal Hill Group

On SG are there any noted security enhancements or additions that you are going to be making, what is the roadmap from a security perspective for the SG appliance at this point? Is there any noted enhancements coming?

Brian NeSmith

There are, I don’t think we’ve actually announced any specifically. Broadly speaking what we are seeing take place in the internet in general is things that we are going to respond to obviously new types of content be it XML, Web 2.0, Blogs, are things that we obviously want to provide rich policy controls. In a broad trend I’d say that there are investments that we’ll be making in those areas for both acceleration and security.

The other aspect that we are dealing with is a growing trend of customers that were back hauling traffic across the WAN and then going out a few centralized locations distributing that across the enterprise. There’s a fairly significant investment on the management of our platform where you are going to direct the net in a highly distributive manner. How do you keep policy control? How do you monitor that scenario? That’s a fairly significant investment for us as well.

In every release there are incremental features that we add that improve how we monitor or control things. I don’t believer there is anything we specifically announced in the upcoming release. As we look to 2009 I expect our WAN Optimization investment to start to tail off as a percentage and that our security investment will grow substantially. We are rapidly getting to the point where there’s not much more you can do in WAN Optimization to make things run faster.

It will still be a continued investment in acceleration features but I definitely think the security features you are going to see a resurgence from the standpoint of things that we are going to need to do and what our customers are looking for us to do.

Erik Suppiger – Signal Hill Group

What about Mal security or reputation based security for Malware?

Brian NeSmith

We do things with web mail, we deal with that environment. Generally speaking in the environment we play with the majority of large enterprises e-mail and the web are separate infrastructures. There no question it’s an ongoing debate here. It continues to rage in any one month about adding e-mail to our platform or not. We don’t see a lot of demand for it. There is a debate, we have seen noise from some competitors about doing things in an integrated manner but our customer base is in general not really requested that in a significant way.

Over the next couple of years will we probably at some point add e-mail, there’s a reasonable chance that we will. There is also no small probability that we still would find it’s a separate part of our infrastructure and we wouldn’t do it. It’s a tough one, you are welcome to join the debate among the different employees here as we do debate and argue about it. Whether at some point it becomes critical to us to do that.

As to the second issue, we already and have for a long time dealt with spyware, malware and those types of challenges in our platform. Some aspects of reputation based things; I’m not a big believer especially when you look at malware because malware tends to come up and go away very rapidly in sites and so the reputation isn’t as much of a use. Security is valid in certain contexts and where it is we do use it. We do use a lot of other techniques to try to help companies manage the spyware, malware problem.

Erik Suppiger – Signal Hill Group

Last question, if I’m doing the math right it looks like your guidance reflects slightly higher, if I use the mid point of your guidance this quarter compared to the last quarter I think your guidance for sequential growth was slightly higher this quarter than last quarter. Any commentary as to why you may be suggesting an acceleration relative to the guidance you had last quarter?

Brian NeSmith

We don’t quite look at it that way. What we do is we look and make an assessment given our pipeline and our sales management and the forecast that we have and what we try to give you guys is the range of what we think that is as reasonable as we can the outcomes we are going to end up with. We don’t, as much, look to tracking whether we are up or down slightly from one quarter to the next. There a range and we want to be clear about that range. We don’t look at mid point whether we grew or not.

In any one quarter compared to the previous quarter I wouldn’t draw a trend line based on two data points. You have to look over a longer period of time to get a sense of whether we are seeing things accelerate or slow down in that quarter. I don’t draw any conclusion from it.

Erik Suppiger – Signal Hill Group

Do you see a seasonal strength from a Q4 perspective or anything like that typically?

Brian NeSmith

It’s our fiscal year end so we definitely see a little bit of activity related to that. That’s probably more relevant as we go into next fiscal year. Generally speaking we’ve not experienced a huge amount of seasonality. It’s a little bit of a factor but I wouldn’t say a huge factor for us in our business. Sometimes when you look at the opportunities and the approximate time they are going to close we’ll see things bump up a little bit or bump down a little bit. The trend line in general we haven’t seen a significant shift.

Operator

Our next question is from Richard Sherman from MKM Partners.

Richard Sherman – MKM Partners

My questions are around the gross margin number and the discounting comment that you made. Maybe you could give us some more insight why discounting increased in the current quarter and what your plans are for discounting and by how much did the discounting increase?

Kevin Royal

The discounting was a small factor in the quarter. It’s wasn’t really all that significant. The larger impact to gross margin was the shift in revenue to regions other than North America that typically have slightly lower product gross profits.

Richard Sherman – MKM Partners

Back to the discounting question, are there discounting differentials that are higher discounts also overseas or lower price points overseas? Is that what you are indicating?

Kevin Royal

That’s correct.

Richard Sherman – MKM Partners

Is that shift in the overall revenue towards Europe a little bit more here in this quarter?

Kevin Royal

During the third quarter.

Richard Sherman – MKM Partners

Did you have total headcount number?

Kevin Royal

Yes, the total headcount at the end of the quarter was 874 regular full time then we had another 58 temp employees that we track.

Operator

Next to the line of [Jaret Sadiki] from Manny Napier.

[Jaret Sadiki] – Manny Napier

I have a couple questions. First, I was wondering if you could give the rough split between your WAN Optimization customers, how many of those are new wins versus selling into the traditional install base?

Brian NeSmith

I don’t know exactly. It’s so difficult to tell in that picture. We don’t really think about it that way. The point worth highlighting here is I don’t feel like it represents a special challenge for us to close an Optimization customer that’s not a current customer than it is for one that is a current customer. It’s nothing material from the standpoint of how we look at the customer. We don’t actually track that that closely.

[Jaret Sadiki] – Manny Napier

You guys are having good traction outside the installed base of selling this?

Brian NeSmith

Absolutely, we see that along two dimensions. Both with net cash customers as well as with customers that have some other competitive solution in place. In some cases don’t do anything for internet security; they are just looking for an optimization solution.

[Jaret Sadiki] – Manny Napier

The next question was can you go through the differentiation between how you guys handle FSL and how Riverbed handles it. There has been some noise out there regarding multiple instances of certificates and then whether the traffic is offloaded or not and is still accelerated?

Brian NeSmith

I know that Riverbed tries to portray what we are doing as less secure that what they are doing which I think is patently incorrect. We’ve lived the security space now for over 10 years. We sit in front of the worlds largest corporations helping management secure that infrastructure. We’ve lived security from the beginning of what we’ve had to do as a company. We do it differently, and I don’t want to bore everyone here with all the details of this but broadly speaking the biggest difference between the two companies approach is that we allow you to secure FSL based applications when those applications come from the public internet and Riverbed does not.

As far as how the certificates get distributed, we actually provide a lot of flexibility. There are several different ways that customers can do that and manage how they do that. We encrypt on the disk anything related to the certificates and the management of the certificates so there’s no issue with that. With that we are also very proprietary OS to the extent that people want and they are worried about a theft in the box, all these things are not issues.

We have provided at the gateway and in the branch for customers the support for SSL acceleration and we’ve gotten the certification from the federal government around common criteria. That is marketing that doesn’t seem to have any validity. For customers, I know the biggest point of differentiation is if you are depending on something like sales force or aruba or you are depending on some trading application or something else you are getting from FSL from the public internet Riverbed can’t touch that traffic, they can’t accelerate it, they can’t do anything with it.

We have a very unique and we applied for a number of patents around the solution around how we provide support for SSL acceleration.

[Jaret Sadiki] – Manny Napier

Also regarding Riverbed, they’ve talked about a 90% win rate out there on competitive bids and obviously you guys are doing quite good as well. Is it just a case that you guys aren’t in a lot of the same head to head competitions? Do you think they are overstating their win rate?

Brian NeSmith

I don’t know, I can’t speak to what is in their head. The only thing I can give you on our side is that our focus generally remains on large enterprise and helping the customer not just with pure line optimization but with video distribution with content distribution with policy based control, authentication and typically we look to focus on customers that aren’t just simply trying to accelerate an individual application but want to deploy an application delivery infrastructure that allows them to secure and accelerate. It ends up being that we end up focusing on customers with a slightly different solution set.

Operator

You next question is from Rohit Chopra with Wedbush Morgan Securities.

Rohit Chopra – Wedbush Morgan Securities

I want to get an idea on the sale cycles, have you noticed any change in the sale cycles as you look out over the last four months?

Brian NeSmith

No. Nothing I can add there, no change.

Rohit Chopra – Wedbush Morgan Securities

Can you talk about the size of the deals, have they been increasing recently, do you want to talk about last quarter versus the quarter before?

Brian NeSmith

In general we continue to see a trend of deal sizes getting bigger. WAN Op in general the deal sizes tend to be on average larger than we saw in our Gateway. I couldn’t tell you exactly whether from Q3 to Q2 whether we saw it go up or down or not. I think in general we’ve seen a general trending of the opportunities we are facing being larger.

Rohit Chopra – Wedbush Morgan Securities

How has the client been helping your sales recently, or has it not been?

Brian NeSmith

We haven’t done a lot in that area as a part of our solution set for customers. We’ve introduced it and we’ve had good success with the customers that have deployed it to date. It’s a feature, is the best way of putting it of our product. Like any other feature its relevant as part of the sale but I wouldn’t call it out as something special in that regard. I think the one thing that again is unique is that similar to what we do with our Proxy products that security and acceleration is a critical part of what we would do in the client and that will remain thematically and everything that we do is how can you both accelerate but do it intelligently where you can secure and control what people are doing.

Rohit Chopra – Wedbush Morgan Securities

I know this question has been asked in a number of different ways and I know the guidance is out there. Have you seen any type of caution on the part of some of your clients as far as spending or where they want to spend or when they want to spend?

Brian NeSmith

I read all the same magazine and reports that all of you do. We are obviously a bit sensitive to it from the way we build and look at our business and the forecast that we’ve produced we haven’t seen a significant change. It doesn’t mean that it couldn’t happen but we haven’t seen it.

Operator

Next from the line of Rob Owens with Pacific Crest Securities.

Jake Rossman – Pacific Crest Securities

I had a few questions around the federal government space with the common criteria certification. Is that going to be a boon for business? What has the government business looked like historically and what do you guys see in your pipeline coming from the federal space?

Brian NeSmith

Common criteria certification is the price of doing business when you are selling security products. It has been a significant investment in getting this certification for several years. I don’t think it is going to change fundamentally how much business we are doing in the government. We’ve gotten other certifications the government has required and other companies have required in this area. It’s necessary but I don’t think it changes what we are doing in that area.

Federal is a bit lumpy as far as a business consistently delivering every quarter because of the budget cycles associated with the government. It s a very good business area for us, we’ve had a lot of success in governments throughout the world, not just the federal government but a lot of foreign national governments as well as a lot in State and local governments. It represents a good market for us and all we do is highlight that common criteria certification to help investors understand how much we continue to invest in security and making sure that our platform is one that serves as a security solution for our customers.

Rob Owens – Pacific Crest Securities

Could you provide any sense of a range of what typically the federal space represents on a quarterly basis?

Brian NeSmith

I’ve seen as low as probably 2% or 3% and as high as 7% or 8% in any one quarter.

Rob Owens – Pacific Crest Securities

Getting back to the gross margins here in the quarter. Was any of the strength in EMEA or Asian markets driven by larger deals this quarter and then looking at this upcoming quarter would you expect the mix to shift back towards North American sales and see either gross margins flatten out or kick back up here in Q4?

Brian NeSmith

As Kevin highlighted the guidance is that we expect gross margins to basically stay flat roughly speaking. As far as sizes of deals, I think we are seeing a gradual trending up but there is nothing different between the different regions I don’t think. As far as what happens, I don’t think we have guidance to how the split is going to occur across the different regions. We are not that particular about where the opportunities are and we look to invest in the business and the growth where we see things.

Operator

From the line of David Duley with Merriman Curhan Ford.

Chris – Merriman Curhan Ford

I was wondering if you thought North American revenue was going to be troughing as a percentage of revenue this quarter. Typically it’s been around 40% to 50% and its 30% I believe you said.

Brian NeSmith

If you look past, this is something that is really important, if you look over the last couple of years at our business you will see in any one quarter sometime a regional surge in advance of another in that area. I don’t see a trend at this point in time. Troughing, I don’t know it’s hard to get too predictive here. I would expect in general our North American business is going to continue to grow. Our European business may grow faster it may grow slower but I don’t know see a fundamental trend there.

We had good growth in the previous quarter in the North American business and I don’t see a fundamental change there.

Chris – Merriman Curhan Ford

When you talked about enabling internet access at the branch via your solution are there some numbers around that that gives you an advantage there?

Brian NeSmith

Technically the way I understand it is the way most companies deliver internet access to users that are in a branch have to travel back across the private wire network to go out to the public internet. The most powerful thing you can get in using your bandwidth more efficiently in our wide area network is to simply just not back haul that traffic. The challenge for companies is you don’t want to do that unless you have the same kind of policy and control.

For customers sitting in the branch if they want to go directly to the net, one of the things we look to differentiate us, we do sell our WAN Optimization solutions is the flexibility that we provide. Uniquely for customers where they can get the security control and go direct to the net in the branch and not have to back haul that traffic. That capability is one that we offer you don’t really see from a lot of the other WAN Optimization companies in the same platform.

Chris – Merriman Curhan Ford

Is that a bigger advantage for a larger enterprise or a small enterprise or does it matter?

Brian NeSmith

I don’t think it matters. Generally it’s probably more relevant for the larger companies but small companies care about saving money on the WAN just as well.

Chris – Merriman Curhan Ford

On the net cash customer base I believe one of your competitors has been talking about some wins there. Are you not seeing any significant market share loss there? On the security side.

Brian NeSmith

I’m sorry; who was saying they were seeing wins there?

Chris – Merriman Curhan Ford

Secure Computing.

Brian NeSmith

I haven’t seen a lot that would indicate any fundamental change there. Secure Computing, they web wash their product, we see a little bit of noise. IronPort, Cisco we see a little bit of noise I would view it a bit more as marketing than reality as far as what we are seeing competitively. Without a doubt today Blue Coat Proxy SG is the best solution for large enterprises and I look to say that the success that Secure has been more in the medium business side of things.

Chris – Merriman Curhan Ford

Is the WebFilter included in your secure product outlook of 10% to 20% annual growth?

Kevin Royal

Yes, WebFilter is part of the security products.

Operator

Our final question will come from the line of Scott Zeller with Needham & Company.

Scott Zeller – Needham & Company

My question has been answered.

Operator

I’ll turn it back to the presenters for any closing comments.

Dan Levee

We’d like to thank you for joining us on today’s call. A replay of today’s call will be available. Have a great day and we look forward to speaking with you again soon.

Operator

Ladies and gentlemen this does conclude your conference. Thank you for your participation you may now disconnect.

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