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VMware Inc. (NYSE:VMW)

Q1 FY08 Earnings Call

April 22, 2008, 05:00 pm ET

Executives

Michael Haase - VP of IR

Diane B. Greene - President and CEO

Mark S. Peek - CFO

Analysts

Brent Bracelin - Pacific Crest Securities

Brent Thill - Citigroup

Kirk Materne - Banc of America Securities

Brent Williams - The Benchmark Company

Toni Sacconaghi - Sanford Bernstein

Heather Bellini - UBS

Kash Rangan - Merrill Lynch

Israel Hernandez - Lehman Brothers

John DiFucci - Bear Stearns

Operator

Good afternoon, everyone, and welcome to VMware's first quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period.

At this time, I would like to turn the conference over to Mr. Mike Haase, Vice President of Investor Relations. Mr. Hussey, you may begin your conference.

Michael Haase - Vice President of Investor Relations

Good afternoon, and welcome to VMware's first quarter 2008 earnings call.

With us today are Diane Greene, President and CEO; Mark Peek, Chief Financial Officer. Both Diane and Mark will present prepared remarks. And afterwards, we will open up the lines to take your questions.

Please note that this call is being webcast from our Investor Relations website. Our press release issued after the close of market is also posted on the website along with slides that accompany today's prepared remarks.

I'd like to remind you that statements made in today's discussion that are not statements of historical fact are forward-looking statements, subject to the Safe Harbor provisions under Federal Securities Laws. This includes, but is not limited to, statements regarding our financial outlook, future product offerings and projected demand. These statements are based on current expectations as of the date of this call and are subject to uncertainties and changes in conditions, significance, value and effect, as well as other risks detailed in documents filed with the SEC, including our quarterly report on Form 10-Q for the period-ending March 31, 2008 that may cause actual results to differ materially from those set forth in our statements.

In addition, during today's call, we will discuss certain non-GAAP financial measures. These non-GAAP financial measures, which are used as measures of VMware's performance, should be considered in addition to, not as a substitute for or in isolation from, measures of VMware's financial performance prepared in accordance with GAAP. You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP measures in our earnings releases for the period-ended March 31, 2008, and in the webcast slides available on the Investor Relations page of our website.

The slides and a telephone replay will be available for the next 30 days. To listen to the replay, please call 719-457-0820 and provide the following passcode, 4557344.

For your planning purposes, our second quarter quiet period begins at the close of business June 16. Finally, unless otherwise stated, all financial comparisons in this call will be in reference to our results for the comparable period of 2007.

With that, let me hand it over to Diane Greene.

Diane B. Greene - President and Chief Executive Officer

Good afternoon and thank you for joining our call. I've been looking forward to this call. Revenue this quarter was $438 million and growth was 69% year-over-year.

According to our research, only two other enterprise software companies have grown at or more than 50% year-over-year after they hit $1 billion in revenues. We are pleased to be heading this way. Through the leadership we have in the industry and the strategy and execution across all aspects of the business, we plan to continue at approximately this growth rate through 2008.

For 10 years now, VMware has demonstrated the ability to deliver superb quality and market-expanding solutions well ahead of the competition. We now have the benefit of a well-developed multi-tier distribution model. And with our new solution areas gaining traction, we can see our way to continuing this sort of growth well beyond 2008.

We're leading in virtual desktops and virtual data centers. We're leading and applying that virtualization to business continuity, automation and management, security and software application delivery via virtual appliances.

Moreover, customers are in the early stages of transforming their data centers ultimately into compute clouds that leverage both on-premise and off-premise resources. VMware virtualization is enabling this vision of cloud computing and we're making it a reality.

Many size today's virtualization market by just the consolidation opportunities and that is a very large market. This is good for VMware, because if service becomes consolidated through virtualization, customers progressively adopt more of our products. We see customers moving through five distinct stages of deployment with an even larger opportunity for VMware's higher-value products. And I'll discuss this later in the call.

While there could be short-term fluctuations, we're reaffirming our 50% guidance for the year, and in the interest of providing more transparency, are guiding for approximately 55% growth in Q2.

I'll now turn the call over to Mark. He will provide more details on our results for Q1 and our outlook going forward. And then I will close with the discussion of the business.

Mark S. Peek - Chief Financial Officer

Thanks, Diane. Good afternoon, everyone, and thank you for joining us today. This is another strong quarter for VMware and we are very pleased with our Q1 results. Our balance sheet remained strong. We ended the first quarter with $1.3 billion in cash, up $75 million from the prior quarter.

Deferred revenue, representing revenue for future periods that we have not yet recognized, increased 88% from a year ago to $641 million and is up 16% from the end of Q4 2007.

We clearly have the resources to continue investing in the long-term growth plans we have to further secure our leadership in this exciting and expanding new industry. Let me emphasize once again that investing in our long-term leadership is exactly what we intend to do.

As we begin Q2, we have over 5,700 people around the world. Despite turbulence in the US economy and increased competitive noise, our operating results reflect strong customer demand across all geographies including the US. They reflect both an increased adoption of enterprise agreements by our large customers and an increase in the number of smaller transactions delivered through our strong channel partner network.

As you know, we measure our operating results both on a GAAP basis and on a non-GAAP basis. The non-GAAP results are what we use to measure our specific business operations. We reviewed the differences in these measures together on prior calls and are pleased with our results by either measure, but I will speak here in non-GAAP terms.

In our first quarter, revenue was $438 million; operating profit was $106 million; and diluted EPS was $0.22. These numbers represent increases of 69%, 62% and 38% respectively over Q1 of 2007.

In considering these percentages, let me remind you that EPS comparisons with quarters during which we were wholly owned by EMC do not take into account the dilution from the IPO sale of shares to Intel or dilution associated with our important employee equity programs, which now involved use of our own stock.

Geographically, US revenues for the first quarter were $225 million, representing 51% of total revenues, an increase of 65% over Q1 of 2007. International revenues increased 74% to $213 million. Our international markets were particularly strong for us this quarter with triple-digit growth in bookings in Australia, Brazil, Russia, India, China and others.

License revenue, revenue which is primarily recognized when we ship our products, was $294 million, an increase of 73% compared to the first quarter of 2007. Service revenue, revenue that we recognize over time and consisting of support maintenance and professional services, was $144 million, an increase of 62% compared to Q1 2007.

Our reported revenue is affected by changes in deferred revenues from quarter-to-quarter. At quarter-end, deferred revenues of $641 million consisted of $32 million of license and $609 million of services revenue. We're pleased with the increase in deferred revenues this quarter as it is consistent with our enterprise agreement strategy.

Our most comprehensive volume license offering, the enterprise agreement, serves the purpose of establishing and building long-term relationships with our customers as they commit to our infrastructure for their data center architecture.

We're pleased by the increased demand that we are experiencing for enterprise agreements. Over the course of the past year, we have changed how we structure these agreements to put more of revenue into services to recreate a recurring annuity.

A typical agreement includes the right to use a specified set of our products under a perpetual license. We use the support and maintenance, professional service credits and training. We generally limit the number of licenses which maybe deployed, and we expect the renewal of the agreement to result in further license and service revenue as customers extend virtualization in their data centers and on to their desktops.

Under an enterprise agreement, a portion of the revenue is attributed to the license and recognized immediately, but the majority is deferred and recognized over time, which we classify as deferred services revenue.

As this program gains momentum, you will likely expect to see some mix shift in our revenues from license to deferred service revenues. These agreements drive our recurring revenue, which provides us with greater visibility and predictability into our future revenue.

We also have future growth opportunity and renewals of service revenue, additional license revenue and up-sell of additional VMware value-added products. During Q1, enterprise agreements were approximately 20% of total bookings, more than triple a year ago.

Another area in which we see increasing momentum is our expanded channel network, which consists of distributors, resellers and OEMs and is now one of the largest in the industry. In February, we introduced new programs for these channel partners to help them quickly establish and expand their virtualization practices and drive new customer acquisition.

The programs provide channel loyalty, allow us to reach additional market segments and acquire new customers. We are seeing these programs gain traction, and we are encouraged by the long-term opportunity.

Turning now to non-GAAP expenses. Costs of revenues for the quarter were $56 million or 12.9% of revenues, up from 11.9% in the sequential prior quarter. This reflects a slight mix shift towards professional services as part of our enterprise agreement program.

Research and development was $102 million or 23.2% of revenues from 22.6% of revenue in the sequential prior quarter and reflects our continued determination to advance and improve our products.

Sales and marketing expenses were $137 million or 31.2% of revenues compared with 31.4% in the prior quarter and reflects the cost of our channel execution with which we are particularly pleased this quarter.

And general and administrative expenses were $37 million or 8.5% of revenues compared with 8% in the prior quarter as we continue to build our global infrastructure. Taken all together, we earned non-GAAP operating income of $106 million. This represents a 62% increase over the same quarter of the prior year, a result with which we are very pleased.

Report on operating results would not be complete without a word or two on our cash flow this quarter.

As a remainder, our non-GAAP operating cash flows, which exclude adjustments per calculation under FAS 86 and excess tax benefits from stock-based compensation, were $152 million for the quarter compared to $98 million for Q1 2007, a growth of 54%. On a trailing 12-month basis, these operating cash flows were $559 million compared to $258 for the 12 months ended March 2007 or growth of 116%.

Diane has provided our topline guidance, and I'd like to say a few more words about next quarter and the balance of the year.

In the first quarter, our operating margin of 24% was down from 25% for the same quarter of the prior year. Because our sales occur in US dollars, but we have operating expenses in local currency, the weakening US currency, which has declined 5% against the year or since our last quarterly update, was a significant factor here.

The effect of currency reduced our operating margins by approximately $10 million or 225 basis points compared to a year ago. While we are exploring strategies to mitigate this, these involve complex international implementations that will take time. You should not expect to see our operating margin exposure to the weakness of US dollar change very much in the next several quarters.

What we call net interest income and other this quarter was $2.6 million, a decrease from $6.8 million in the prior quarter. This decrease is due to $2 million left interest income on certain intercompany balances of EMC as well as a declining interest rate on our investment portfolio.

I expect a lower amount in the first quarter to be representative of what you might expect in the second quarter after taking the impact what interest rates may do into account.

First quarter average diluted weighted shares were 398 million, and we are expecting a similar number in the second quarter, somewhere around 400 million shares.

A number of factors affect our results, including an uncertain domestic economy; seasonality, particularly between the third and fourth quarters; customer demand for enterprise agreements and the rate at which we invest in our business, particularly products and channels.

We fundamentally believe and our supported in this belief by a variety of independent surveys that our products remain first choice as companies make their IT investment decisions. This we believe will continue to represent an advantage over our competitors. This does not necessarily mean however that our customers will not slow their spending if economic conditions continue to deteriorate, particularly in the US.

Considering these factors, we continue to expect that our revenues should grow approximately 50% in 2008. Right now, we do anticipate a solid second quarter based on our early view of global demand with revenues growing approximately 55% compared to Q2 '07.

Once again, we are very pleased with Q1. We delivered great results, have a strong balance sheet and are really looking forward to executing on the opportunity in front of us.

With that, let me turn it back over to Diane.

Diane B. Greene - President and Chief Executive Officer

Thanks, Mark. VMware's strategy from day one has been product and innovation driven. We focus on quality and partner-based delivery of the ultimate customer experience. The strategy is working very well. Our customer use phrases like, "It's just amazing, the kind of benefits" and constantly finding new uses for it all the time.

At VMware, we find these kinds of customer responses to be highly motivating. We like delivering this kind of value, and it is a strategic and competitive imperative for us. Our partners like VMware strategy as well.

I was recently on the East Coast meeting with partners. They were talking about why they value their VMware partnership. First, the brand value of VMware is significant. Customers know that VMware is the technology leader and far ahead of the competition that makes it easier for them to sell complementary products and services, and this drives our average deal size up.

Second, our partners see us continuing to distance ourselves from the competition. And third, they have a long-term view of how the partnership with VMware will help them continue to grow their own customer relationships and offerings, particularly in the services area.

We've been extending our hardware vendor partnerships, including the hundreds of certifications and also the co-development projects that deliver joint value in differentiated products to our mutual customers.

An example of this is in the announcement we made with IBM at VMware Europe, our first European virtualization conference held in February.

VMware and IBM announced a world record for exchange scaling. We were able to announce hosting 16,000 mail boxes on a single server, 50% higher we believe than any previous record. This is why customers like the University of Plymouth in the UK use VMware to virtualize their 50,000 exchange mail boxes. This is the largest virtualization of exchange resources that we are aware of

In order to transform their data center and move toward VMware architecture, customers are increasingly standardizing on VMware across all of their applications. This strong trend keeps us well positioned competitively.

Once the customer standardizes on VMware, our field and partners have the opportunity to grow with them. On an ongoing basis, they can help them get even more value from virtualization by integrating our steady stream of expanding data centre products and business continuity, desktop virtualization, delivery security and automation and management.

Let me now take you through how these opportunities generally develop. The adoption path generally maps to five stages that we call separate, consolidate, aggregate, automate and liberate. These five stages correspond to VMware innovations and also VMware offerings. Our field is working quite successfully with our partners to deliver on these stages as appropriate for the customer.

The first stage is separate. VMware workstation let's one computer do the job of multiple computers by separating the logical function of a device from the physical device itself. One computer connects with many different computers and run in multiple OSs. Workstation is sold principally to the channel and the web and it opens up data center opportunities by giving people the VMware experience.

The next stage, stage two, is consolidate. Clearly, server consolidation has been our initial killer app. It began with another VMware innovation, GSX Server, which was the first virtualization software that enabled businesses to logically partition their Windows-based servers and the multiple virtual servers.

Seven years later, VMware ESX hypervisor is the runaway market leader and is the core VMware virtualization technology and used by more than 100,000 customers, including 92% of the PRO/1000.

We're taking aggressive measures to proliferate the high-quality ESX hypervisor through a new ultra-small and secure footprint in our ESXi hypervisor. ESXi is expected to ship with all the major x86 vendors this quarter, eventually enabling every new server to arrive supporting server consolidation and giving VMware and our partners the opportunity to up-sell to VMware infrastructure a much more customer value along with again a higher deal size.

If you really want to optimize your data centers, then you need stage III, which is to aggregate your servers and pull the resources and deliver capacity on demand. Many of our customers at this stage also discover that with a virtualized data center, they have the best insurance policy for business continuity and disaster recovery.

Some customers work towards it in stages, but others are moving right to it. We see mid-market customers move immediately to this phase. They are smaller and more agile. So, they can just deploy a virtualized architecture from day one. In fact, this last quarter, we further segmented our field to address this opportunity.

The same is true in emerging countries. I was recently in India and also China where companies are definitely in a hurry. What this translates into for VMware is that they are skipping the early stages and just moving directly to deploying of VMware architecture as fast as they can roll it out. This includes both desktop and server.

Security manageability, reliability and minimum power usage for desktop deployments have very high value to our customers in the emerging countries. Moreover, the legacy physical and social structures are just not an issue. So, we see this as a large growth opportunity. In fact, in Q1 we had triple-digit growth in 15 countries that would fall into the emerging category.

Increasingly, customers across the geographies are extending virtualization and adding desktop resources to the pool. Workers using VMware virtual desktops get a full PC experience, both online and offline. This allows them to work from anywhere and on multiple devices. They also get the highly manageable, scalable and reliable VMware infrastructure backing the productivity of their PC users.

The desktop is an area that VMware is investing in heavily, and we are innovating at a rapid pace. We plan continued leadership in this area.

Stage four is the automation phase. This is an exciting and perhaps moving opportunity. Automation is the next transformation area in the virtual data center. This quarter, we are shipping an automation menu [ph] that includes products for managing virtual machines across their entire lifecycle, automating the lab environment for test and dev, automating the application life cycle and automating disaster recovery processes, bring disaster recovery to applications before just weren't candidates.

These products work on top of VI and work with all of our major storage partners. The interest in them has been very high.

Our partners are excited about the opportunity that the automation products provide to them to deliver more services offerings to their customers. We're excited about how together with our partners these new products and services will increase VMware's momentum.

The fifth and final stage is liberate. This means as virtualization becomes pervasive, it will be available across corporate boundaries with virtual machines distributed both on and off-premise, well secured and well managed. It is the age of the cloud, and this presents another opportunity for VMware. The first points can be seen in our increasing traction in hosting and with service providers.

We're continuing to execute on other fronts as well. SMB is an area where we already do a significant amount of business. The foundation in standard additions of our VMware Infrastructure 3 suite provides the best TCO for small and medium businesses embarking on virtualization.

Our newly introduced SMB-targeted Virtual Infrastructure Acceleration bundle is getting great traction in Q1.

And finally, we complement our innovative product strategy with our also innovative multi-tier distribution strategy with partners. VMware has a unique win-win approach to partnering, and we're in the fortunate position of having products that complement and interoperate with hundreds of offerings from our partners. Q1 was another solid quarter of strong execution with our technology, consulting and channel partners.

So, to wrap up, let me reiterate the key strengths driving VMware's strong position in the marketplace

VMware is doing what a few companies have achieved in terms of revenue growth, and we are clearly maintaining our excellent product and go-to-market execution as we grow on all these fronts.

Demand for VMware solutions across all geographies is very strong as is our customer and partner following. Our partners don't hit customer objections when selling VMware, and they appreciate the growing suite of services resulting from our broadening VMware portfolio, particularly in management and automation.

VMware has more than 6,000 employees passionate about making our customers and partners successful. And VMware has more virtualization expertise than any other company on the planet. VMware has a lead in virtual desktop business continuity, automation and management, virtual security and software applications as virtual appliances.

Thank you for listening. And now, Mark and I would like to take your questions.

Michael Haase - Vice President of Investor Relations

Okay. Before we go to Q&A, I'd like to ask everyone to try to limit yourself to one question. Thanks a lot for your corporation. Operator, let's open up the lines, please.

Question And Answer

Operator

Thank you, sir. [Operator Instructions] And we'll take our first question from Brent Bracelin with Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

Thank you. Diane, first question I have for you really is tied to kind of the trends and what your customers' feedback was in the quarter. Obviously, there is a lot of concerns on the economy, obviously increasing concerns on competition.

As you'll think about kind of the feedback from customers, your long-time customers and new customers, what was the general kind of commentary on why they were buying or why they decided to pause their plan of virtualization in Q1?

Diane B. Greene - President and Chief Executive Officer

Well, Brent, as you know, our product suite has a very high ROI. And so that puts us in a really good position for getting valet share as the economy gets a little more uncertain. And I would say that we see that in our customers where they are going ahead. We increase the number of big deals we did.

We were able to close big deals in the financial sector. People are definitely talking about the economy, but we don't see hesitation with our customers. They are pretty eager to deploy the VMware Infrastructure as an architecture.

Brent Bracelin - Pacific Crest Securities

Okay. Now, on the desktop side, was there any kind of acceleration there or a pause on the desktop side?

Diane B. Greene - President and Chief Executive Officer

No. The desktop, as we've thought for some time, is a major infrastructure change. And so we don't see that happening immediately, but we were pleasantly surprised to see a big uptick in the number of pilots. So 2008 seems to be the year of the pilot, and we've got hundreds or thousands deployments in pilots that we're starting to see. But we believe 2009 is going to be the year they roll these things out.

Brent Bracelin - Pacific Crest Securities

Thank you.

Operator

And we'll take our next question from Brent Thill with Citi.

Brent Thill - Citigroup

Thanks. Mark, on the operating margin decline this quarter, can you just give us a sense is that something we should except at a trough level and how to think about the rest of the year with the 24% base you set up in Q1?

Mark S. Peek - Chief Financial Officer

Well, Brent, as I mentioned on the call, we were hit pretty hard with currency. We have consciously gone to invest globally as a business, and we are selling only in local dollars. And so, we were hit hard this quarter and we see that continuing on for the next couple of quarters.

I think the important point as we have always said is that we are really looking to invest in this business, and we are not trying to optimize for quarter-to-quarter operating margins. Now that said, we still think the mid-20s is the right intermediate place to think about our operating margin.

But regardless of troughs that we might see, be it from revenues or increases in costs or whatever the reason, we are not going to optimize for operating margin. We are going to continue to invest in the business, in our products, in our channels and in the infrastructure to support it.

Brent Thill - Citigroup

Thanks.

Operator

We will take our next question from Kirk Materne with Banc of America Securities.

Kirk Materne - Banc of America Securities

Yes, thanks very much. Mark, last quarter you noted that the November and December OEM revenues obviously flow into the first quarter. And I think last quarter the deferred license number was something in the area $54 million. I think you noted as $32 million this quarter.

Can you give me some, I guess, just background, is that what we should expect sort of normally from the seasonal point of view? Did you see any sort of deceleration? I mean it didn't seem that way, but did you see any deceleration in February, March, because that obviously doesn't show up to the second quarter? Can you just try to frame that for me just so I understand some of the volatility in that number?

Mark S. Peek - Chief Financial Officer

Sure, Kirk. And you need to disconnect deferred revenue from the recognition on the OEMs, because the OEM revenue that we recognized isn't on the balance sheet. And so, we see some seasonality from the x86 system vendors.

We are recognizing their shipments towards the end of the fourth quarter and our first quarter. And then seasonality that they have in the first quarter will be recognized in our second quarter. Now, with respect to deferred revenue overall, we look at the number in total. And we are really pleased with the growth that we had, 88% year-over-year in total deferred revenue.

The deferred license revenue is really based on product shipment. And so, it's going to have a certain amount of volatility to it. But the deferred service revenue is part of our strategy with entering into long-term enterprise agreements, and it's much more predictable and gives us a lot of visibility into the quarter and the year ahead.

Kirk Materne - Banc of America Securities

Thanks for your clarification.

Diane B. Greene - President and Chief Executive Officer

Yeah. If I can just reinforce that, we made our conscious decision about a year ago on these big deals to

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