McAfee Inc. (MFE)
Q4 2005 Earnings Conference Call
February 10th 2006, 4:30 PM.
Kelsey Doherty, Senior Director of Investor Relations
Eric Brown, Chief Financial Officer and Executive Vice President
George Samenuk, Chairman, Chief Executive Officer
Ed Maguire, Merrill lynch
Daniel Ives, Friedman, Billings, and Ramsey
Michael Turits, Prudential Equity Group
Sterling Auty, JP Morgan
Todd Raker, Deutsche Bank
Christopher Russ, Wachovia Securities
Peter Cooper, Morgan Stanley
Walter Pritchard, SG Cowen
Sarah Friar, Goldman Sachs
Alan Weinfeld, Kaufman Brothers
Rob Owens, Pacific Crest
Horacio Zambrano, Wedbush Morgan Securities
Gary McDaniel, Standard & Poor's
Philip Winslow, Credit Suisse
Robert Breza, RBC Capital Markets
Chris Hovis, Morgan Keegan
Gregg Moskowitz, Susquehanna Financial Group
Hello and welcome, thank you for holding for today's teleconference. I would like to remind all parties that your lines will be in a listen-only mode until the question-and-answer portion of today's call. Also this call is being recorded, should you have any objections you may disconnect at this time. I would like to hand the call over to Ms. Kelsey Doherty, Senior Director of Investor Relations at McAfee. Ma’am you may begin.
Kelsey Doherty, Senior Director of Investor Relations
Good afternoon and thank you for joining us. Today we will be discussing our results for the Fourth Quarter and Full-Year of 2005. Joining me for the call are George Samenuk, our Chairman and Chief Executive Officer; and Eric Brown, our Executive Vice President and Chief Financial Officer; Kevin Weiss, our Executive Vice President of Worldwide Sales, Service and Support; and Bill Kerrigan, our Executive Vice President of Consumer are also here and available to answer your questions. First, I ask for your attention while I review some cautionary language and then we will pass the call to Eric and George.
This conference call including the question-and-answer session may contain forward-looking statements. These statements include those regarding future operating margins and operating expense expectations, revenue and earnings guidance for the full-year 2006, expected revenue realization rates, future product introductions and shipments and the revenue opportunity associated with them, future partner opportunities for success of McAfee’s multi-channel, multi-partner distribution strategy, future subscriber and market growth expectations and other measures that may project future enterprise, SMB and consumer results.
Forward-looking statements are based on management's current expectations and are subject to risk and uncertainties including but McAfee may not achieve its planned revenue realization rates; succeed in its efforts to grow its business, build upon its technology leadership or capture market share. But the Company may not benefit from its strategic alliances or partnerships as anticipated, that customers may not respond as favorably as anticipated to the Company's product or technical support offerings, or that the Company may not satisfactorily anticipate or meet its customers' needs or expectations.
In addition, a number of operational and other factors from new product introductions the mix of product and services goals, the size of deals closed in the quarter, the amount of revenue deferred in a quarter, the charges we may take for acquisition, dispositions or stock-based compensations. The compensation we face in the market to the greater macro economic environment to name a few may cause our revenues, gross margins and operating results to fluctuate significantly from period-to-period.
We caution listeners that actual results may vary perhaps materially from the forward-looking statements referenced in this call including any forward-looking statements made during the question-and-answer session. And we encourage listeners to review the Company’s filings with the Securities and Exchange Commission including the Company’s third quarter 2005 10-Q filed November 4, 2005. For more detailed information on the risks and uncertainties related to the Company and its business. I would also would like to note that for your reference we have provided supplementary financial announcements including breakout of net revenue and bookings in to product groups, year-over-year and sequential growth rates and other financial metrics. You can find this supplementary information in our earning’s press release and on our Investor Relations website. A pro forma to GAAP reconciliation of the year-end financial numbers discussed in this conference call is attached to the press release issued by the Company this afternoon. I will now turn the call over to our Chief Financial Officer, Eric Brown
Eric Brown, Chief Financial Officer and Executive Vice President
Thank you Kelsey. Good afternoon and thank you all for joining us today. On January 23, 2006, McAfee announced that we would not be previously issued revenue and EPS guidance for the fourth quarter of 2005. The first question to be addressed is why, given the record bookings of 361 million in the fourth quarter of 2005 and the strong cash flow generation, was there a shortfall in the GAAP net revenue top-line and pro forma EPS bottom-line? When we constructed our internal forecast and external guidance for the forth quarter of 2005 we based on expectations for Q4 2005 revenue on a set of assumptions.
Two key drivers of our revenue assumptions related to the following A) the amount of revenue that we were expecting to rollup the balance sheet from the short-term deferred balances and B) the amount of new bookings in Q4 2005 that would be realized as in-period or upfront revenue. We referred to this metric as in-period realization. Revenues either recognized or realized in the current period are deferred on the balance sheet as short-term or long-term deferred revenue.
Our Q4 2005 results were consistent with what we were expecting in terms of deferred revenue roll-off, approximately 81% of total revenue came from prior period deferred revenue. However, we had a significant variance on the revenue realization rates and enterprise. Actual Q4 2005 realization rates were about half of what we were expecting entering the quarter. There were several variables involved in the realization rate computation. One, prior period actuals which formed the basis for the Q4 2005 percent realization forecast assumption. Two, forecast versus actual product mix, and three, large deal trends in Q4 2005 versus Q4 2004.
When we were constructing our forecast for Q4 2005, we used the Q4 2004 results as the base line for our realization rate assumptions. Last year in Q4 2004, we saw a sequential increase in realization rates at year-end. After we consolidated the Q4 2005 results and realize that there was a significant difference between our current year results and last year’s Q4 results, we examined the deal mix. This examination revealed that in Q4 2004 we had a number of deals with higher realization rates due to conversions from legacy term licenses to our Perpetual Plus pricing model. These conversion deals produced new license sales, which generated more upfront or realized revenue in Q4 2004 compared to what we experienced in Q4 2005.
By Q4 2005 this conversion was substantially complete, in hindsight Q4 2004 had a realization rate that was not repeatable. We thus had an inaccurate baseline which was used in our Q4 2005 realization rate assumption.
The second factor relates to product mix. In Q4, 2005 we had a higher percentage of deals that involved either ratable revenue or multi-year support contracts. This is reflected in the high Q3 to Q4 sequential increase in deferred revenue. The sequential increase in long-term deferred revenue is greater than the 27 million that we added from Q3 2004 to Q4 2004, comparing final total deferred revenue at the end of Q4 2005 to our expectations; we had a positive variance of more than 30 million.
The third factor is large multi-product multi-year enterprise deals. We had a very solid year-end finish with very good deal metrics which I’ll discuss later. Our larger enterprise deals featured multi-year support commitments and a combination of products including new offerings such as our Foundstone Risk Management solutions. An analysis of the higher volume multi-element deals reveal several factors that reduce the amount of realized revenue versus our expectations.
Number one, Foundstone. Deals that included Foundstone were by default all treated as ratable with no upfront revenue. We purchase Foundstone at the end of 2004, changed the pricing model to confirm with the McAfee pricing model and thus throughout 2005 had not yet established VSOE or Vendor Specific Objective Evidence for the maintenance components of Foundstone. As a result, all Foundstone bookings were taken as ratable revenue as was all other product revenue in the multi-element transactions that included Foundstone. As a reminder, we are required to establish VSOE to support our maintenance contracts on bundled licenses.
Number two, higher mix of maintenance renewals. This finding related to the earlier observation that Q4 2004 was a strong quarter last year in terms of Perpetual Plus conversion deals. Q4 2005 represented the one-year anniversary of those transactions and thus a larger amount of business in Q4 2005 was in fact skewed towards the maintenance renewals which by definition are 100% ratable in terms of revenue recognition.
Number three, new products sold into large enterprise contracts. We were successful introducing new products into some of our larger deals in Q4 2005 which included maintenance renewals. Many of these deals are done on the basis of existing contract terms and conditions that include higher new accounts and higher discount rates. This causes a greater amount of upfront product revenue to be parked out and deferred versus a standalone sale.
It is important to note that the aggregate discounts on our systems business did not increase year-over-year. We were successful closing larger multi-year transactions indicating a willingness on the part of enterprise customers to make multi-year commitments to McAfee Security solutions.
Although the amount of revenue realized upfront was less than we expected. We believe that selling longer-term deals is the right thing to do from a customer perspective. Collecting cash upfront is positive from a net present value perspective and accretive to our stockholders given the pricing stability. This change in trends around large deals does however underscore the need for us to do a better job forecasting large deal trends and expected realization rates.
As a secondary order impact, we realized higher than expected freight procurement and logistics cost in Q4 2005, which increased per unit costs versus expectations. This adverse impact contributed to an increase in our cost of good and a decline in our reported gross profit margins for this quarter. We have identified the cost of goods variances, which were in part related to a change in our European fulfillment model and we’ll be taking corrective actions in the first half of this year. The combination of lower realized revenue and higher than expected cost of goods resulted in a gross profit margin dollar shortfall versus our expectations.
At the operating expense level, we indicated in Q3 2005 that we were expecting to ramp up spending, we did in fact ramp up spending as planned in Q4 2005. The sequential increase in operating expenses was approximately $9 million. This operating expense increase combined with the gross profit margin dollar adverse variance resulted in the shortfall at the EPS bottom-line. We did not recognize the adverse revenue realization trend line in time to make any intra-quarter adjustments to operating expenses to mitigate the bottom-line impact.
The balance sheet reflects the strong operational results in deferred revenue and cash generation. Deferred revenue grew by $90 million exceeding our expectations and reaching a total of $746 million, an all-time high for McAfee. This was also one of the strongest quarters of operating cash flow generation in the Company’s history at approximately 125 million compared to $87 million in operating cash flow for Q4 2004.
Having walked through the cause of change versus expectations, I will now turn to the operational review. Fourth quarter 2005 consolidated net revenue was $253.3 million representing 4% growth year-over-year. For the full-year 2005 excluding divested businesses revenue was $985.4 million representing 22% growth over 2004.
On a GAAP basis, net income for the fourth quarter of 2005 was $40 million or $0.23 per share on a diluted basis. Please note that this amount is outside the $0.16 to $0.20 GAAP range that the Company provided during its earnings pre announcement. This was primarily due to a change in the Company’s Q4 2005 GAAP tax provision from an original estimate of 24 million to an actual Q4 amount of 16 million.
GAAP net income for the fourth quarter of 2004 was 39 million or $0.23 per share on a diluted basis. Pro forma net income for the fourth quarter of 2005 was 45.4 million or $0.27 per share, pro forma net income for the fourth quarter of 2004 was 37.1 million or $0.22 per share. Year-over-year pro forma net income at EPS for the fourth quarter grew 23%. North American GAAP revenue of 143.3 million accounted for 57% of Q4 2005 revenue compared to 60% in Q4 of 2004. International GAAP revenue of 110 million accounted for 43% of fourth quarter 2005 revenue compared to 40% in Q4 2004.
For the year, GAAP net income was 139.9 million or $0.83 per share on a diluted basis compared to 255.1 million or $1.31 per share on a diluted basis for 2004. Approximately $0.90 of the GAAP net income in 2004 was related to the extraordinary gain on the sales of Sniffer, and Magic. Pro forma net income for 2005 was 205.5 million and pro forma earnings per share were $1.21 compared to 103.4 million or $0.58 per share for 2004. Year-over-year pro forma earnings grew by 109%.
Bookings in the fourth quarter were $361 million representing 14% growth year-over-year and 23% growth sequentially. Booking were solid across all geographies. We saw a significant increase in the number of large deals closed in the fourth quarter with our largest deal coming in at over $5 million. We closed 323 deals over $100,000 including 24 deals over $0.5 million and eight deals over $1 million. For comparative purposes, we closed 285 deals over $100,000 in Q4 2004. We continue to spend money to align our marketing and sales efforts with those of our partners both in the consumer and SMB channels. Funding for these programs is accounted for us contra-revenue not operating expense and comes directly off of the top-line.
Examples of contra-revenue include rebates, market development funds, co-funded marketing and promotional programs. This type of spending is very typical for channel centric company and remains a growing area of investment for McAfee as we transition to being a more channel focused and partner driven organization. We will continue to make investments in our partners but remain mindful of the expenses and conscious of the returns, such investments required to be sustainable.
Pro forma gross margins for the quarter were 81%, a decline from recent quarters and lower than our anticipated margin levels of approximately 85%. Gross profit margins in the quarter were affected by the lower in-period revenue realization and higher than expected cost associated with freight and procurement. Due to the anticipated hardware growth and increased channel revenue sharing payments in 2006, we expect that our pro forma gross profit margins in the first quarter will be in the 82% to 84% range and 81% to 83% for the full-year of 2006. The low gross profit margin operational results go in-line with our expectations in the guidance we issued in October 2005.
Total pro forma operating expenses were 152 million or 60% of revenue in the fourth quarter of 2005, compared to 66% in the fourth quarter of 2004. Pro forma sales and marketing expenses were 75 million or 29.7% of net revenue representing a dollar increase of approximately 3.9 million from the third quarter of 2005. The increase reflects sales commission expenses on record bookings as well as increased marketing program spend. Pro forma research and development costs were 46.7 million or 18.5% of net revenue representing a slight increase over the third quarter of 2005. As we’ve told you in October, we continue to invest in research and development in McAfee, the security technology leader. One example of the benefit of our investments in R&D is our patent portfolio. In 2005 alone McAfee was awarded 53 patents bringing our total to 184 patents.
Pro forma G&A expenses were 29.9 million or 11.8% of net revenue, consistent with our guidance issued in October we saw a sequential increase in G&A expense due to a SOX related expenditures as we near our filing deadline.
While operating expenses for the quarter were consistent with expectations on an absolute dollar basis with total operating expense increasing by 8.8 million sequentially, the pro forma operating margin for the fourth quarter was 21% reflecting the shortfall on the revenue line and the gross profit line. In the fourth quarter, we repatriated $350 million in foreign earnings under the American Jobs Creation Act of 2004. The bulk of this tax expense was accrued in our Q3 2005 results so the true-up in Q4 2005 was nominal.
Total head count increased by 150 people to end the quarter at 3290 employees. DSOs for Q4 2005 were 56 days. Deferred revenue was 746 million at the end of Q4 2005, the split between short-term and long-term on the incremental deferred revenue was roughly equal. Short-term grew by 48 million to 570 million and long-term grew by 42 million to $176 million.
We ended the fourth quarter with cash, cash equivalents, and restricted cash and investments of 1.308 billion, a net increase of $110 million over the third quarter. Our business model continues to generate a significant amount of cash, which we intend to use to buyback stock, reinvest in our business and keep available for potential security acquisitions. Please note that 50 million of this balance is restricted cash allocated for the settlement with the SEC.
During the quarter, we generated approximately 125 million in cash from operations on a GAAP basis. The cash flow summary breakdown is as follows. First, starting with GAAP net income of $39.7 million, we add 15.3 million back for depreciation and amortization. We add 1.1 million back for deferred taxes stock op and other. We add 68.9 million back for changes in working capital, deferred revenue and other items. This nets out to a total of approximately 125 million in GAAP operating cash flow. Below the operating cash flow line we used 3.8 million for capital spending in the quarter and we generated 13.8 million in cash from stock option exercises and ESPP purchases.
During the fourth quarter, we used approximately $21 million to repurchase 765,000 shares of our common stock. As of today, we have a total of approximately $213 million in authorization available for share repurchases though August 20, 2006.
Now some comments on metrics changes. Starting with our Q1 2006 results we’ll no longer being reclassifying 1 to 10 new transactions from our SMB business into our consumer results and we’ll include these transactions in our enterprise segment reporting. While we’ll continue to provide enterprise, SMB and consumer bookings metrics during 2006, we will be incorporating SMB revenue into our enterprise revenue results effective immediately.
Guidance, the following updated guidance replaces or supersede any previous guidance with respect to future periods and is valid as of today only. I would like to remind listeners that guidance is based upon management’s current expectations and that actual results may vary perhaps materially from those results anticipated in this guidance.
For the first quarter of 2006, we expect net revenue between $250 to $280 million, representing approximately 12.5% year-over-year growth at the middle of the range. We expect first quarter pro forma earnings per share between $0.28 and $0.32 per share on a diluted basis and a pro forma operating income margin of approximately 24% to 26%. We expect our diluted share accounts to range between 172 and 174 million diluted shares in the first quarter. We assume a pro forma tax rate of 27% for the first quarter of 2006 and the full year of 2006.
On a pro forma basis for the first quarter of 2006 we are expecting the following in terms of operating expenses. G&A expenses to range from 11% to 13% of revenue, R&D expenses to range from 17% to 19% of revenue, sales and marketing expenses to range from 30% to 32% of revenue.
We are updating financial guidance for the full year 2006. We expect 2006 full year net revenue to range between approximately $1.015 billion and $1.150 billion. We expect pro forma EPS excluding stock-based compensation expense under FAS 123R to range between approximately $1.25 and $1.35 per diluted share. This EPS range assumes a higher full-year 2006 pro forma tax rate of 27% at an average of approximately 174 to 176 million diluted shares for the full-year of 2006.
We expect full-year pro forma operating income margin to range between 23% and 25%. On a pro forma basis for the full year 2006, we are expecting the following in terms of operating expenses. G&A expenses to range from 9% to 13% of revenue, R&D expenses to range from 15% to 19% of revenue, sales and marketing expenses to range from 28% to 32% of revenue. For 2006, we are assuming the following key FX rates, 1.81 U.S. dollars to the British pound, 1.24 U.S. dollars to the Euro, 104 Japanese yen to the U.S. dollar. Guidance under FAS 123R, our current best estimate for pre-tax stock compensation charges under FAS 123R is a total 2006 expense ranging from $48 million to $58 million. This takes into account existing year-end 2005 equity instruments and estimated that net new issuance in 2006. I would now like to turn the call over to George.
George Samenuk, Chairman, Chief Executive Officer, Chairman of the Board
Thanks Eric. McAfee’s focus for the last year has been solely on security and improvements in execution of our business plan. This focus has delivered record results. McAfee bookings for the year excluding divested businesses totaled 1.25 billion and grew 19% year-over-year. Our year-over-year pro forma revenue growth was 22% excluding divested businesses. Pro forma operating margins improved dramatically from 14% for 2004 to 25% for 2005 and met our June 2004 Analyst Day commitment. 2005 pro forma EPS are $1.21, grew 109% year-over-year. Our business model has driven record deferred revenue as Eric mentioned which provides visibility into future results and continues to add cash to our balance sheet immediately.
McAfee’s enterprise business had a very strong fourth quarter. Bookings were 136 million, growing 13% year-over-year and 44% sequentially showing strong fourth quarter seasonality in our largest enterprises. McAfee secured content management solutions introduced late in the third quarter are gaining traction in the marketplace. Just as we, our Secure Web Gateway solution was reviewed by eWEEK and said that it easily surpassed the other products in our detection tests. McAfee was selected by the Greek government provide a total solution for securing email and web browsing for tens of thousands of government users.
Our growth in enterprise continues to be driven by customers deploying multiple layers of proven McAfee security across their infrastructures. For example in the first quarter AT&T chose McAfee Secure Content Management solutions and our Foundstone Consulting Services to round out their security infrastructure. Continental Airlines selected and implemented McAfee VirusScan and ePolicy Orchestrator. And one of the world’s largest financial institutions chose to deploy Intercept along with a renewal of McAfee Systems Protection and ePO in the largest deal of the quarter for McAfee.
Large scale displacement of incumbent anti-virus providers is typically where as the switching cost for customers can be higher than the license cost. However, in the fourth quarter McAfee did see a number of significant competitive displacements that deserve mention. Some examples are, a large international diversified manufacturing and technology company which chose McAfee VirusScan, Secure Content Management appliances and Group Shield over an entrenched incumbent. And a large international car manufacturer which displays the key competitor in favor of McAfee VirusScan, desktop firewall and other McAfee security products.
Discounting will not win competitive business of this scale, you need superior solutions. McAfee solutions make our customers much more secure, McAfee provides a more comprehensive set of system security solutions including enterprise Anti-Spyware, Host Intrusion Prevention, Application Firewall, Anti-Virus and the upcoming Policy Enforcer. And McAfee provides superior integration and manageability with the ePolicy Orchestrator. No other vendor can provide this breadth of solutions.
We are especially proud that the annual CIO Insight Vendor Value Survey recently named McAfee, the vendor with the most improved scores since 2003 overtaking the competitor to the first place in this important security category. And just last week TechTarget’s information security magazine announced it’s 2006 products of the year awards with IntruShield and Foundstone both won gold at the intrusion prevention and vulnerability management categories. Our award winning McAfee Anti-Spyware solution continues to exceed our original expectations and it’s well underway to achieving blockbuster status.
We have additional products ready for launch this spring for which we have high expectations. Our new McAfee Policy Enforcer will be generally available this quarter. This product which delivers an enterprise ready approach to mitigating the risk to corporate assets caused by non-compliant endpoint systems is McAfee’s entry into the network access control business.
Throughout 2005 we told you that we are focusing on our channel partners, products and process in SMB. The smaller segment on SMB 25 nodes and below saw 19% increase in bookings year-over-year. Overall SMB bookings grew 3% year-over-year and 12% sequentially.
On the partner side of our business we continue to gain momentum. As you may recall we receive recognition from Tech Data and Ingram Micro in 2005 and earlier this year Softchoice, one of North America’s largest SMB resellers name McAfee as their software vendor of the year in the United States and Canada. We are proud of this recognition that we’ve received and we look forward to continuing the progress in 2006. Our product offerings for the SMB segment were strengthened in the fourth quarter when we added our award wining McAfee Anti-Spyware Solution to our Managed VirusScan online solution.
Our fourth quarter results show that we are in track with our managed offering as bookings grew 21% year-over-year. We will continue to enhance our offerings to satisfy this fast growing segment.
Finally, our Partner Relationship Management system continues to deliver value to our partners while making McAfee easier to do business with. In the first half of this year, we will deliver full function e-commerce and technical to support capabilities to our partners around the world and our strategy is working. And we believe that we have built ourselves a solid foundation for continued growth.
Our consumer business continues to be a significant contributor to McAfee’s results. Overall consumer bookings in the fourth quarter were 151 million and grew 21% year-over-year. Our online consumer bookings were $116 million, up 41% year-over-year. This is the 9th quarter in a row where we’ve seen year-over-year revenue and bookings growth in our online business of more than 25%. The consumer market has moved to online delivery. McAfee has been offering security as a service online since 1999, and we are the proven leaders providing daily updates and versionless software to over 17 million subscribers directly or through partners. Ours is the model that competition is trying to duplicate. Others call this the future, McAfee has been doing it for seven years.
Retail bookings were 36 million, down 17% year-over-year. The decrease in retail bookings is consistent with the weakness seen in this segment as many consumers had migrated to online delivery for their security needs. McAfee continues to win awards for our consumer products. In the United States McAfee VirusScan 2006 won Smart Computing's "Smart Choice" award, and McAfee’s Internet Security Suite was named "System Security Product of the Year" by Small Business Computing, an award voted on by the users. In addition McAfee was honored by PC Magazine when it named our VirusScan 2006 the best of the year.
We generated 2.2 million net new paid subscribers in the fourth quarter bringing our total number of consumer online subscribers to 17.2 million. The average number of subscriptions per subscriber grew to a new record high of 1.68, up from 1.56 in the third quarter. This underscores the shift in consumer purchasing patterns from buying single security products of buying multiple layers of protection for McAfee. Even in our retail channel the McAfee Internet Security suite has become our highest unit volume retail product. Our relationship with Dell continues to be strong.
From August 1, 2005 though January 31, 2006 McAfee enjoyed Dell recommended status in North America. Beginning on February 1st through April 30, 2006 McAfee moves to default status with Dell meaning that all Dell computers in North America will automatically ship with a 90=day free trial of McAfee security products if a user chooses not to buy security products at point of sale. We are very pleased to announce that McAfee will be both Dell recommended and Dell default for all regions worldwide from May 1st through July 31st of this year.
In November 2005, we launched our multi-year partnership with Gateway eMachines where we will be featured exclusively as both recommended and default. We expect to ship and over 4 million Gateway’s PC’s in 2006. In the fourth quarter we standard our relationship with MSN, in addition to MSN’s premium subscribers McAfee now provides virus scan and personal firewall plus to MSN’s dialup subscribers.
On Monday we announced the partnership with Sony Ericsson, a leading global provider of mobile multimedia devices, provide mobile security solutions and tool of Sony Ericsson’s smartphones. Trials of McAfee virus scan mobile and McAfee firewall mobile will be included with the Sony Ericsson phones. We are the global leaders in mobile security technology and continue to work with handset manufacturers and service providers to extend our reach into this growing market. As we enter 2006 McAfee remains focus solely on providing world-class security solutions to our customers. We continue to strike for the ultimate goal of operational excellence. The business is strong with double-digit year-over-year increase in revenues, all-time high deferred revenue and very significant cash generation.
In 2006, we remain focused on building the momentum in the consumer online market increasing revenue from all segments, continuing to streamline the business and delivering exciting new products to our customers.
Thank you and now I will turn the call back over to Kelsey and we will open it up for Q&A.
Kelsey Doherty, Senior Director, Investor Relations
Before the operator pose for questions I would like to remind you that McAfee will have a build at RSA next week. We will be presenting at the American Growth Conference in San Jose on February 13th, the Goldman Sachs Conference in Phoenix on February 28th, the Wedbush Morgan Conference in New York on March 2nd and the Deutsche Bank Conference in Miami on March 13th. Please note McAfee’s Analyst Day 2006 will be held on June 6th in New York City. Details will be posted on our website and invitations will be forthcoming. Operator, you may now poll for questions, in the insisted time we ask that each caller limit themselves to one question and dial back again for follow-up. Please proceed.
Thank you. Operator Instruction. We will proceed with our first question it comes from Ed Maguire of Merrill lynch.
Q - Ed Maguire
Yes, question for Eric, could you drill down a little bit more in to the expected decline in gross margins just give us the sense of what the elements were there, with a little bit more detail and also your expected operating margin assumptions for the year, is that really just reflecting the impact of the lower gross margins?
A – Eric Brown
Yes, it’s a combination of two things. First of all in regards to the gross profit margin line, we’re getting more traction with our hardware products, so I think mix is going to be a factor here as we look at the growth in 2006 versus 2005 so that needs to be incorporated. In terms of the overall operating income margin for 2006 versus 2005, we’re expecting to continue to invest in sales and marketing as well as R&D and so there will be a slight uptick there as well, those two factors lead to a slight reduction versus the operating income margin levels we experienced in 2005.
Thank you. Our next question comes from Daniel Ives of Friedman, Billings, and Ramsey.
Q - Daniel Ives
Thanks, Eric, you are in the MBA with that first five minutes. In regards to the timing of the preannouncement 23 days after the quarter and that move to out of investors, can you kind of walk us through what happened there, what was your rev rec going to the autos that way came out so we? And then just last question on, in regards to ‘06 guidance, because of the nature of multi-year larger deals, would you see that some revenue you initially thought was coming into ’06, now it looks like its in ‘07 type of event? Thanks.
A - Eric brown
I’ll answer these questions in the reverse order. One of the things that change, we updated the revenue guidance versus what we gave 90 days ago, but if you go back, when you look at what we had as our embedded assumption for end of 2006 deferred revenue, in our latest revision to guidance, that number is up significantly in the $90 million or so dollar range versus what we are thinking say 90 days ago. So, in fact what you have there is effectively a shift from realized revenue into either short-term or long-term deferred revenue at the end of 2006. In regards to the question, the timing of the pre-announcement, why was it so late? It’s important to note that, well in advance of the quarter close, we set the date and the time for the earnings call, so we had this February 9th date on the books for quite sometime anticipating that we were going to have an elongated and carefully constructed quarter-end and year-end close process. So, effectively, we went through and, every single process reconciliation exactly as we had it mapped out and effectively, it did not alter our time line in terms of, closing the books and getting to the level of certainty that lead to the decision to pre-announce our Q4 2005 results.
Thank you. And our next question comes from Michael Turits of Prudential Equity Group.
Q - Michael Turits
Hi Eric, you go into - it looks like 6% to16% revenue growth, can you give me some idea of whether or not deferred revenue should grow at about that same level and whether cash flow should grow at that same rate also?
A - Eric Brown
Yeah, to give you a sense of what we expect for cash flow, very round numbers. Operating cash flow, 350 to 400 million for the full-year; deferred revenue, we expect to, increase as well and as I noted on the earlier question. If we look at the change in our thinking for 2006 today versus where we were 90 days ago, we were expecting comparable levels of activity i.e. overall bookings but we’re expecting less of it to be realized in 2006, and we’re expecting more of it to be on the balance sheet as deferred revenue at the end of 2006.
Thank you. Our next question comes from Sterling Auty of JP Morgan.
Q - Sterling Auty
Thanks, George when I hear things like an increased amount of maintenance renewals and multi-year support deals, it seems to me like, what I worry about is there is not a lot of new seek acquisition or not a lot of new product acquisition going on, is there a fall-off in demand here in enterprise security that we should be worried about?
A - Eric Brown
Not at all Sterling, we did a record $361 million in bookings in the fourth quarter. We got many large deals as we describe, some of the larger deals included the renewal of their support maintenance contract Foundstone, IntruShield and some cases Anti-spyware. So what we’re seeing is many more larger deals in the fourth quarter and potentially in 2006 we’re seeing multi-element products and we are seeing customers locking in the renewal of maintenance or support for a year or two years and they pay us the cash upfront. So what we would like to do is follow the cash, we are seeing record bookings, record cash generation, and we see our customers boarding the McAfee way and locking us in for the long-run, which I think as investors out there, you should love because we’re getting the cash upfront in all of these transactions. So we saw a no spike downward in demand, in fact we had record bookings in the fourth quarter.
Thank you. Our next question comes from Todd Raker of Deutsche Bank.
Q - Todd Raker
Hey George, I was just wondering if you just speak to the similar opportunity here both Microsoft and Symantec are starting to roll out a pretty broad vision in terms of what the consumer products should be. Can you talk about your plans to move into backup and data recovery or any kind of expansion beyond the security phase? Thanks.
A - Eric Brown
Todd, it’s a great question, for years we have been perfecting the art of security as a service. We clearly understand the consumer requirements going into this year backup and recovery is a function that consumers are looking for and especially as they had more on to their digital asset phase whether it be music or photos. I turned your attention back to our discussion at Analyst Day in November - in last June, where we commented Todd very specifically on the change of the threat environment around content effective base threat anti-spam, we’ve already delivered functionality in our subscription model against those two new threat areas, we’ll continue to add additional features and functions to our subscription model as they go forward. But clearly backup and recovery, quite in standard on consumer minds as our anti-piracy proactive block in to the anti-spyware protection of their home based or WiFi based networks, protection of other devices that they are starting to use more frequently in their consumer digital life around things like their mobile phone or the USB device. So there is no disagreement in terms of the trend or the nature of the threat environment that has emerged, we have been talking about that for the last three quarters now and our capability of adding on new services in delivering them seamlessly to our subscribers.
Thank you, sir. And our next question comes from Christopher Russ of Wachovia Securities.
Q - Christopher Russ
Yeah, good afternoon. Eric, you mentioned cash flow in ’06 of perhaps 350 to 400 million, I know it was sort of a rough ballpark number but it looks to me like in ’05 the number is 418 million based on the 125 million in the fourth quarter and you are still guiding at about 11% revenue growth in ’06 at the mid-point of the guidance. Does that imply that bookings will be weaker than 11% or deferred revenue growth will flow considerably in ’06, I’m just trying to understand why cash flow would decline in ’06 relative to ’05?
A - Eric Brown
That’s a good question. Bear in mind, we are expecting an extraordinary operating cash flow –outflow when we release the Escrow of the SEC settlement that’s $15 million is going to show up as negative operating cash flow when that’s settled in 2006 and so to get a fair apples-to-apples comparison you would need to take that $15 million into account.
Thank you. And our next question comes from Peter Cooper of Morgan Stanley.
Q - Peter Cooper
Hi, thanks, I am still little confused and Chris’s question actually made me more confusing here. So couple of things that Foundstone which you guys closed end of ’04, you have got a year of experience, you have some revenue clarification issues there, why part of this what I’m missing here in Q4. Guidance means basically you have erased $100 million of incremental sales for ’06, but you also said you are getting more deferred yields in last quarter especially adding more revenue rec anyway, so you are talking about even less more incremental growth here, so I don’t know maybe two way question I ask here but you know, where we seem a slowdown here, is there a certain part of enterprise or its got to be a little more two of them just a change in posturing of longer term deals, isn’t it?
A – Eric Brown
No, I mean just bear in mind, there is the change in kind of realization and, what goes to deferred, the disconnect or change in assumptions in our part is reflected from Q4 activity only. We made the comment during the call that we ended the year 2005 with about $30 million more deferred than what we had expected and so that’s not a that dealt in and of itself even assuming that its all short-term incremental deferred revenue is not going to fully account for a fraction of the change in the revenue estimate. Now what’s more important here is that, we’ve taken a very close look at a couple of things. We’ve taken a look at mix for 2006 and we revised that based on the best information. We’ve integrated all the available information in the marketplace regarding other competitors Symantec, Microsoft and others. And we’ve also refined our estimates regarding realization rates throughout each of the four quarters of 2006. And those realization rates again comparing them to what we were thinking 90 days ago are indeed lower.
Thank you. And our next question comes from Walter Pritchard of SG Cowen.
Q - Walter Pritchard
Hey Eric, it seems like the investors are going to be guessing about these things like realization so forth on the bookings number, wondering if it maybe makes more sense to just guide to more bookings and lesser revenue fall out of that, if that’s the case any quantification of bookings do you think you may do in ‘06 to go along with that revenue number?
A – Eric Brown
No, we are not going to guide to bookings, it was a metric here, so we are just, we’ve kind of addressed this question in previous quarter, we are not going to introduce that as a new guidance metric at this point in time. We’re going to stick with GAAP net revenue, the OpEx detail and the gross profit and the operating income margin.
Thank you. And our next question comes from Sarah Friar of Goldman Sachs.
Q - Sarah Friar
Good afternoon everyone. One quick one and then a little bit on the new updated question, so just firstly, can you give us a sense for average contract length and how those look in trend rate? And then secondly can you just give us a little bit more color on the pricing environment given that your larger competitor has talked a lot about pricing issues particular in the SMB area. Is that one of the reasons why SMB bookings performance fell off in the quarter?
A – Eric Brown
Okay, I’ll take those in the following order. First of all, average content duration, there was a slight, very slight increase in contract length, we took a close look at it but nothing significant, so nothing extraordinary there. In our systems business year-over-year no change in discount levels, no difference whatsoever. In certain geographies and certain product lines, certain types of hardware we did see some year-over-year discounting, increases but again nothing that would have significant overall impact on the business. One of the things that is going to new and different for us in the fourth quarter of 2005 is the number of large transaction, so we did one of the largest deals ever, right over 5 million total bookings in the fourth quarter of 2005 and we gave the staffs and the deal count over 100,000 versus Q4 2004. And so what we’re seeing is, as we expand the breadth of the McAfee Security Solutions portfolio we’re becoming more successful overtime selling in multiple components, our two customers are the new customers or our existing customers would reach out to them for the annual maintenance renewal. And so, Foundstone is now starting to factor-in some of the mix more and so that’s certainly helping the enterprising business, but otherwise, we see this as a stable enterprise, in a pricing in the economic environment.
Thank you. And our next question comes from Alan Weinfeld of Kaufman Brothers.
Q - Alan Weinfeld
Hi, so you are basically saying that every deal that includes Foundstone as it grows throughout 2006 is going to be put into deferred revenue before comes onto the income statement either in late’06 or ’07?
A – Eric Brown
Well, good question, just to be clear throughout 2005 our Foundstone product transactions were treated as ratable, and again this has to do with the fact that we acquired them back in late 2004, we changed the pricing model at the time of acquisition and we basically operated the entire year without having the firmly established foundation of VSOE for Foundstone. We expect that to change and in 2006 we believe we are approaching the point where we have sufficient data points in a stable pricing model. And so we think that 2006 will be different with respect to the Foundstone product line.
Thank you. And our next question comes from Rob Owens of Pacific Crest.
Q - Rob Owens
Yeah, what are your implications or what are your around DSO’s as we look forward in 2006 because we saw the expense here with the growth and deferred? And then as a function of that I think you mentioned the cash flow from operations if we add back in the 50 million being 400 to 450, I don’t understand why that wouldn’t imply kind of flattish bookings for 2006? Thanks.
A – Eric Brown
Just to clarify the one-time extraordinary operating cash flow event I mentioned is going to be a reduction of operating cash flow by 50 million for the Escrow’s released. Not in from one-time extraordinary increase. So you need to put the signs on that one. In terms of the DSO’s, again the DSO at the end of Q4 2005 was 56 days, the comparable DSO metric for the fourth quarter of 2004 was 54 days. So a slight increase but nothing significant, we’re still expecting the same general range of DSOs 40 to 55 days, that we’ve articulated in the past several quarters.
Thank you and our next question from Horacio Zambrano of Wedbush Morgan Securities.
Q - Horacio Zambrano
Thank you, most of my question have been answered, but I do want to dig in a little bit on the decision to not breakout SMB revenues going forward, I know you sort of decided to bring IntruShield in. Can you give us more color on that decision?
A – Eric Brown
Sure, we actually have spent some time taking a look at the way other metrics and segment details are reported by our competition, and so the change that we’ve made by folding SMB revenue into enterprise, it’s we believe its consistent with our peers.
Thank you. Our next question comes from Gary McDaniel of Standard & Poor's Equity Research
Q - Gary McDaniel
Hi, I think I just go back to the cash flow guidance, even though with the $50 million dollar adjustment as an outflow, the guidance is essentially flat despite 11% revenue growth increase in your guidance. Do you think bookings aren’t going to be soft, how is the cash going?
A – Eric Brown
I think that, again we are not going to provide granular full-year 2006 cash flow guidance. The broad range that we’ve given here is meant to be more direction as opposed to precise and its intended to give you a sense of cash flow remaining, strong and consistent with the levels that we’ve experienced over the past 10 to 12 months.
Thank you. And our next question comes from Phil Winslow of Credit Suisse.
Q - Philip Winslow
Hi guys, couple of quick questions here. First you mentioned the, we call the out performance in deferred revenue by 30 million, if you exclude the, the lengthening of contracts, how and – and basic folks are going to look at, pushed out of the quarter versus your expectations, could you quantify that in a dollar value? And then also as far as gross margins can you provide the little more detail as far as exactly what the pro forma change was, why it’s in ongoing sort of semi permanent change and where you expect to see gross margins standing overtime?
A – Eric Brown
Okay, I think the first question is, one of – perhaps backlogging, you know what was kind of left at the end of Q4 into that kind of play into the change in deferred, actually we had a pretty good strong and efficient close to the quarter. So, nothing unusual to report there, and again the, the difference that we are looking to isolate here is the amount of, based on the amount of bookings that we’ve achieved which was consistent with our expectations going into the quarters, how did it parse between revenue recognized in period versus revenue that flow to the balance sheet is either short-term or long-term deferred. And again what we found is that less of the revenue was recognized upfront for the reasons we previously articulated, and more of the bookings flowed to the balance sheet is either as short-term or long-term deferred. And so, it was a push from one side of the equation to the other as opposed to there being any significant change in how we finish the quarter bookings and, backlog that remained.
Thank you. Our next question comes from Robert Breza of RBC Capital Markets.
Q – Robert Breza
Hi good afternoon, I was wondering if you could talk a little bit about how we should think of, the quarter relation I guess of the yearly revenues, at least normally we expect Q1 revenues to be down at least at the mid point, you got them going up sequentially. I mean, should we normally expect I mean at least based on 2005 numbers about 24% is normally Q1, and then it kind of ramps from there on up. How do you – do you expect the similar pattern or how should we be thinking about that given that’s your mid point is up sequentially over Q4?
A – Eric Brown
Yeah, in terms of looking at the quarter’s trend line for revenue in 2006, we are expecting it to be relatively flattish with an uptake in the fourth quarter of ’06 relative to the third quarter of ’06 and again I make that comment here because having just closed out 2005, we effectively had flat GAAP revenue Q3 to Q4.
Thank you. Our next question comes from Chris Hovis of Morgan Keegan.
Q - Chris Hovis
Hi, I have couple of quick questions. One, if I understood Eric your response to a prior question around Foundstone, it sounds like you’ll recognize more deferred revenue upfront throughout 2006? And then the second question for George is, I think we heard a lot of talk about Intrushield, can you give us a sense of what’s your stand in Intrushield prevention business?
A - George Samenuk
Well, Intrushield has strong fourth quarter, we are pleased with the Intrushield results on a global basis. We haven’t broken out Intrushield as I described in a couple of quarters calls ago, because three years ago Intrushield was doing one million a quarter, now we’ve done well over 100 million or 125 and looked in more Intrushield revenue in the last 8 or 9 quarters, 10 quarters. So we’re pleased with the Intrushield results in 2005 and look for a good Intrushield performance in 2006.
A - Eric Brown
And this Eric, to your question about the Foundstone products, yes the reason we touched upon Foundstone is that what we’re finding is that we’re being more successful bundling Foundstone into multi-own the transactions than what we had anticipated say 90 days ago. And given the strong finish to the fourth quarter of 2005, what we found were a number of large deals involving multiple product sets as well as Foundstone. And with Foundstone being a pure ratable product with new no VSOE, introducing Foundstone and, upsizing deals while it’s a very good thing to do from a bookings perspective and a cash flow perspective. What it did was, introduce an unexpected element of ratability basically the multi-element Foundstone transactions, we are all ratable and that is frankly something that we have not anticipated or forecasted going into the fourth quarter of 2005.
Kelsey Doherty, Senior Director of Investor Relations
We will be taking one more question after that, thank you.
Thank you. And our final question will come from Gregg Moskowitz of Susquehanna Financial Group.
Q - Gregg Moskowitz
Hi, thank you. Looking at the Q4 cost of goods sold increased 15 million sequentially on flat revenues. How significant of an impact in absolute dollar terms was the higher freight fulfillment and unit cost in Europe? And what gives you the confidence you’ve been fully corrected in the first half. And then secondly, going back to Foundstone quickly since the timing of when you establish VSOE we would clearly impact revenue recognized in ‘06 just wondering what you’re assuming in guidance, does that more of a first half issue or second half issue just wondering if you could put a final point on that? Thanks.
A – Eric Brown
Yeah we are expecting that the Foundstone VSOE issue taking care of in the first half as opposed to the second half of the year. In regards to the cost of goods variants essentially what we had is we alluded to this in the opening remarks of we had a change in the European fulfillment model logistics partners in one geography. And we had some unexpected implementation, difficulties and so we are confident that we will work through that in the first half of 2006.
Kelsey Doherty, Senior Director of Investor Relations
Thank you very much for joining us this afternoon. We do recognize that there are still several in the queues who either have not had an opportunity to ask a question or else queued after for follow-up questions, we will be getting back to all of you in our follow-up calls. So I appreciate your patience and we look forward to talking to you later this evening. Take care, bye.
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