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McAfee, Inc. (MFE)

Q1 2008 Earnings Call Transcript

April 24, 2008 4:30 am ET

Executives

Kelsey Doherty – VP, IR

David DeWalt – CEO and President

Keith Krzeminski – Chief Accounting Officer and SVP of Finance

Todd Gebhart – SVP and General Manager, CSB

Analysts

John DiFucci – Bear Stearns

Rob Owens – Pacific Crest

Todd Raker – Deutsche Bank

Daniel Ives – Friedman Billings Ramsey

Walter Pritchard – Cowen

Sterling Auty – JP Morgan

Philip Rueppel – Wachovia Securities

Sarah Friar – Goldman Sachs

Phil Winslow – Credit Suisse

Katherine Egbert – Jefferies

Brent Thill – Citi

Presentation

Operator

Good afternoon ladies and gentlemen. My name is Tina and I will be your conference operator today. At this time, I would like to welcome everyone to the McAfee Q1 2008 earnings conference call. (Operator instructions) Miss Doherty, you may begin your conference.

Kelsey Doherty

Thank you very much. Good afternoon and thank you for joining us. Today's conference call is being recorded and will be available for replay on McAfee's Investor Relations home page at investor.mcafee.com. On today's call are our Chief Executive Officer and President, Dave DeWalt; and our Senior Vice President of Finance and Chief Accounting Officer, Keith Krzeminski.

Dave will open the call with an overview of the quarter and a review of our business model. Then Keith will provide the financial details and guidance and Dave will close the call with a quick wrap-up and then we'll take your questions. You will find in our press release and on the Investor Relations section of our website a GAAP to non-GAAP reconciliation of the first quarter 2008 financial results discussed in this conference call. The link is investor.mcafee.com and our results are posted under quarterly results. We will post our prepared remarks to the Web site following the conclusion of today's call.

This conference call, including the question and answer session, will contain forward-looking statements. These statements include, among others, those regarding market trends, our strategic positioning, guidance on revenue, operating income margins and earnings levels for the second quarter of 2008 and full fiscal year, expectations regarding the benefits of our acquisitions of SafeBoot Holding BV and ScanAlert, Inc., the expected level and scope of security threats in future periods, expectations regarding the industry shift to security suites, expected industry growth rates of the market segments in which McAfee participates, expected new and future product introductions and the revenue opportunity associated with them, expected integrations of products from recent acquisitions with existing McAfee product lines, expectations regarding McAfee's business momentum, market position, business segments, statements regarding future partnership opportunities, specific growth initiatives and strategies outlined for 2008 in McAfee's business, and plans regarding future strategic acquisitions and other uses of cash by McAfee, including our stock repurchase program

. Forward looking statements are based on management's current expectations and are subject to risks and uncertainties including that McAfee may not achieve its planned revenue realization rates, succeed in its efforts to grow its business or effectively combat the security threats of the future, build upon its technology leadership or capture market share, or benefit from its acquisitions or strategic relationships as anticipated; McAfee customers may not respond as favorably as anticipated to the Company's product or technical support offerings, the Company may not satisfactorily anticipate or meet its customers' needs or expectations and the industry shift to security suites may not be adopted to the extent anticipated; the Company's product and service offerings may not continue to interoperate effectively with newly-developed operating systems; the Company may experience delays in product development or the release of previously-announced products; the Company may choose not to deliver a previously-announced product; the Company may experience delays or losses in revenue resulting from outages in the integrated systems on which it is highly dependent.

In addition, a number of operational and other factors, including new product introductions, the mix of products and services sold, the size of deals closed in a quarter, the amount of revenue deferred in a quarter, the integration of acquired businesses, changes in senior management, the competition we face in the market, currency fluctuations, and the greater macroeconomic environment to name a few may cause our revenue, 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. We encourage listeners to review the risk factors contained in today's press release, as well as the Company's filings with the Securities and Exchange Commission, including the Company's 2007 10-K filed February 27, 2008 for more detailed information on the risks and uncertainties related to the Company and its business. We do not undertake to update any forward looking statements.

Well with that, it is now my pleasure to turn the call over to our CEO and President, Dave DeWalt. Dave?

Dave DeWalt

Okay. Thank you, Kelsey. Good afternoon and welcome everyone. Thank you so much for joining us. Q1 was the strongest revenue and sales first quarter the company has had in several years. We delivered another quarter of accelerating sales growth and posted our ninth consecutive quarter of double-digit revenue growth. We continue to take market share in both consumer and corporate and are leveraging positive momentum in our business. I am confident that we have the right products, we are in the right market and we have the right team.

Sales in Q1 were very robust. Our revenue plus change in deferred was up approximately 30% year-over-year and each segment of our business delivered double digit growth, clearly demonstrating that our customers, from the consumer to the large enterprise, see the value of McAfee's solutions and security risk management strategy.

Revenue for the first quarter was $370 million, up 17% year-over-year, with balanced performance in our segments and our geographies as indicated by the double digit growth to both our consumer and corporate segments and the double digit growth in North America and in our international markets.

North American revenue was $190 million, an increase of 15% from last year's first quarter and accounted for 51% of the business. International revenue was $180 million, an increase of 20% from last year's first quarter and accounts for 49% of the business. Europe, the Middle East and Africa grew 20%, Asia Pacific grew 36%, Latin America grew 24%, and Japan grew 7%. This revenue growth underscores the momentum that we are seeing across all of our geographies.

As a result of investments we have made in our sales force and improvements in execution, we continue to expand our success in the corporate segment. Corporate revenue was $217 million, up 16% year-over-year. Total Protection for the Endpoint had another great quarter and drove many, many competitive displacements. We continue to see price point increases of about 30% as we upgrade our current customers to ToPS for the Endpoint. We closed 271 deals over $100,000, 37 deals over $500,000 and 8 deals over $1 million.

Consumer also had a record quarter. Revenue was $153 million, up 19% year over year. In addition to record revenue, the consumer team reported record sales. Online sales of McAfee Internet Suite and Total Protection grew more than 50% year over year. We signed or extended 14 consumer agreements and launched 97 new or enhanced consumer online partnerships.

I am very pleased to announce that McAfee has secured new agreements with the following strategic PC OEM partners. First of all, Acer Computer. In a multi-year worldwide partnership, McAfee is shipping 60-day trials of McAfee Internet Security Suite with SiteAdvisor on Acer's computers. These shipments started in the second quarter of 2008. Secondly, Sony Computer. Earlier this month, we started shipping 90-day trials of McAfee Internet Suite on Sony Corporation's PCs for their Japanese channels. And for Dell, we improved our positioning. We will be the default and recommended security partner from May 2008 through July 2008 in all of North America, Asia Pacific and Latin American markets. At the same time we will have default positioning in EMEA and recommended positioning in Japan. The combination of these partnerships coupled with Toshiba Europe GmbH, Cox Communications and a record setting number of first quarter partnerships in Europe positions us well for significant growth in our consumer business.

During the first quarter, 59% of revenue came from corporate customers and 41% came from consumers. McAfee operates a very balanced business model. We remain confident in our ability to achieve guidance which Keith will detail in a minute. But before he does that, I want to provide you a little bit more color on a couple of business dynamics we saw in the first quarter that impacted our Q1 results, but are strengthening our overall long term outlook.

First of all, we experienced reduced in-period revenue realization rates driving more revenue to the balance sheet. There are three factors affecting upfront realization rates. First of all, synergies with our acquisitions such as SafeBoot and ScanAlert, an increase in the number of large transactions in a quarter, and thirdly, an increase in our overall subscription revenue. The decline in upfront realization rates as compared to the first quarter of 2007 cost us approximately $0.02 of earnings per share during the quarter.

Regarding synergies with our acquisitions, our data encryption acquisition SafeBoot is hitting on all cylinders. The team had an outstanding first quarter with sales growing 65% year-over-year. They closed the largest deal in their history with a consultative body for the UK National Health Service that purchased over 700,000 nodes and we are seeing that the compelling value in data protection has helped accelerate customer conversions of ToPS for the Endpoint, illustrating that our strategy of adding incremental technologies to our ToPS suite is working.

As with all acquisitions, revenue contributed by SafeBoot during the quarter is fully ratable until the establishment of Vendor Specific Objective Evidence, or what is called VSOE. Additionally, any of our other products bought in combination with SafeBoot, or other recently acquired McAfee products, are also ratable until VSOE is established. Therefore more revenue is deferred to be recognized in future periods.

Regarding an increase in the number of large transactions. Large transactions are good for McAfee. They standardize us in enterprises and make us a long-term strategic partner to our customers. During the first quarter, transactions over $500,000 increased more than 140% year over year, while transactions over $1 million increased by 33% year over year. And the pipeline for large Q2 transactions looks very solid as well.

Generally, a greater amount of product revenue is deferred in a large transaction versus a smaller transaction. This results in lower revenue realization rates compared to the average realization rates for the rest of our corporate business, with most of the value of the transaction ending up on the balance sheet as deferred revenue to be recognized in future periods.

Thirdly, an increase in our subscription revenue, over 40% of revenue in the first quarter was subscription. This was a 25% increase over the same period last year. Subscription revenue which is fully ratable is primarily derived from our consumer small and mid-market segments, both of which offer a software as a service or SaaS model and that has been helping us to leverage good growth trajectories.

Revenue that cannot be recognized in period goes to the balance sheet. We reported another all-time high deferred revenue balance this quarter of $1.08 billion, up 21% year over year. The ratable revenue stream and deferred business model creates visibility into future quarter revenue streams which is a very positive thing for our business.

The second business dynamic affecting our Q1 results was accelerating critical business investments into the quarter. Additional investments in the first quarter negatively impacted reported earnings per share by approximately $0.02. As discussed on our last earnings call, we believe that there is an opportunity for us to take market share at both the end-point and in the network, and this opportunity is going to unfold over the next 12 to 18 months. Now is the time to position ourselves for growth.

We invested in sales. With the arrival of new sales leadership at the company, we have been conducting a thorough review of McAfee's go-to-market strategy. Coming off a successful sales kick-off in January where we had approximately 600 direct and channel partners, we hired early in the quarter to increase capacity in the model and take advantage of growth opportunities we saw.

Meanwhile, attrition was sharply down as well in the quarter and it was not until the end of the quarter that we completed a restructuring to better align our go to market model. In addition, we have done the following things. First, we have been adding talent. For example, we brought in a new leader of Asia Pacific, a new leader of U.S. sales for consumer, and a new leader of sales operations. Secondly, we are increasing the number of quota carrying reps in the field. We added just over 60 new sales reps during the first quarter, excluding acquisitions. And finally, we are aligning our compensation models to drive sales behavior for our strategic products and direction. When aligned, trained and incented properly, our results will show that our sales force coupled with the channel is improving our execution.

Our first quarter investments position us for ongoing success. We also invested in research and development. We continue to believe that the quality of our research and our security solutions differentiate us from the competition. This year, we have announced and brought to market new solutions across multiple product segments. These include the following. Total Protection for Data, our new data protection suite. SafeBoot and our Data Loss Prevention are now integrated with ePO and that was available March 31. This was the fastest time to ePO integration for any other technology acquired by McAfee. We also announced ToPS for the Network, the world's fastest network security suite, including our New Content Security Blade Server and our new 5 gigabyte and 10 gigabyte Network Security Platform. This is another growth driver for the company that can help us drive conversions from competitive point products to our McAfee suites.

We also announced our Web Security product line. After a very successful first quarter acquisition, ScanAlert grew sales approximately 20% quarter over quarter. The combination of ScanAlert and SiteAdvisor, which now exceeds 130 million downloads, creates a safe search and safe shopping strategy, another unique growth driver for McAfee.

And finally, a broad relationship with VMware to advance virtualization security. As part of this relationship, McAfee will leverage the newly announced VMware's VMsafe security technology into future security solution offerings. Investments in research and development are essential in responding to the latest threat environment and will keep McAfee in an industry leadership position.

Our focus for 2008 remains on the strategic imperatives I outlined for you during our last call, dominating the end point security, interlocking our end point solutions and our network products, and securing new frontiers such as the Web and virtualization. We are clearly making progress against these initiatives.

Our first quarter top-line performance underscores the strength of our security risk management strategy and improved sales execution. Security continues to be a spending priority for our customers and McAfee's cost effective comprehensive solutions offer a compelling investment.

With that, Keith will take over the call to review our quarterly performance. Then I will come back for a brief conclusion, and we then will take your questions. Keith?

Keith Krzeminski

Thank you, Dave. Good afternoon everyone. Our first quarter 2008 revenue was better than anticipated. Revenue was $370 million, up 17% year over year. 82% of our total revenue came from deferred revenue on the balance sheet. Moving down the income statement, GAAP gross profit margins for the first quarter were 75.7%, compared with our result in Q4 2007 of 75.8% and Q1 2007 of 77.8%.

Non-GAAP gross profit margins for the first quarter were 79.5%, compared with last quarter's 79.0% and a year-ago gross profit margin of 80.8%. The slight year over year decrease in gross profit margins was associated with product mix and ongoing revenue share agreements with partners. Total GAAP operating expenses in Q1 2008 were $226 million, up 11% from last year's $203 million for Q1.

Total operating expenses, on a non-GAAP basis in Q1 2008 were $212 million compared with $171 million for Q1 2007. This increase reflects the acquisitions of SafeBoot and Scan Alert and the investments Dave outlined for you earlier on the call. GAAP sales and marketing expenses for Q1 were $118 million. Sales and marketing expenses, on a non-GAAP basis, for Q1 were $114 million, or 31% of revenue.

Q1 GAAP research and development costs were $58 million. Q1 R&D costs on a non-GAAP basis were $55 million or 15% of revenue. GAAP G&A expenses for Q1 were $42 million. On a non-GAAP basis, G&A expenses for Q1 were $43 million or 12% of revenue. This slight sequential increase from Q4 2007 of $3 million was due to legal expenses and incremental telecom charges.

Please note that our annual merit increases, which have been factored into the guidance provided on today's call, will be made during the second quarter of 2008. Our GAAP operating income for Q1 was $53 million. This results in an operating margin for the period on a GAAP basis of 14.4%. Our operating income for Q1, on a non-GAAP basis, was $82 million, leading to a non-GAAP operating margin of 22.2%. Other income for the quarter was $15 million, compared with $16 million in Q4 2007 and $14 million in Q1 2007.

Total employee headcount at the end of the quarter was 4,472. This is up by 225 from 4,247 employees that we reported at the end of Q4 2007, largely reflecting over 120 additions from our acquisition of ScanAlert and additions made to the sales force previously discussed by Dave.

The GAAP tax rate for the quarter was 54%. On a non-GAAP basis, our tax rate was unchanged from a year ago at 27%. In Q1 2008, we reported net income on a GAAP basis of $32 million or $0.19 on a diluted basis. Our first quarter net income on a non-GAAP basis was $71 million or $0.43 per share on a diluted basis.

Our net accounts receivable balance at the end of Q1 2008 was $195 million compared to the balance at the end of Q1 2007 which was $147 million. DSOs were 48 days for Q1 2008 compared with 42 days in the first quarter of last year. The increase in DSOs was primarily due to the acquisition of SafeBoot in the fourth quarter of 2007, increased sales volume and the timing of orders processed during the quarter. We noted a record level of deferred revenue at the end of Q1 2008. It was $1.08 billion, up 21% on a year over year basis and also up $36 million over the fourth quarter of 2007.

Our short-term deferred revenue increased $36 million in the first quarter compared with the fourth quarter 2007. We ended Q1 with $838 million in short-term deferred revenue. Our long-term deferred revenue was flat in Q1 compared to the fourth quarter 2007, and we ended the quarter at $243 million. We did not see unusual contract extensions during the quarter or unusual discounting.

We ended the year with cash and marketable securities of $1.293 billion, down 4% year over year. Please note that these totals reflect an outflow of cash associated with the acquisition of ScanAlert, which closed in January 2008. Also, during the first quarter, we used approximately $113 million to repurchase 3.4 million shares of our common stock. As of today, we have a total of approximately $637 million in authorization available for share repurchases through July 2009. Repurchases may be made from time to time in the open market or pursuant to a 10b5-1 plan adopted by the company.

In the first quarter 2008, we generated a total GAAP operating cash flow of $65 million. The cash flow summary for the first quarter is as follows. Starting with GAAP net income of $32 million, we add $28 million for depreciation and amortization. We then subtract $7 million of non-cash adjustments to reconcile to net income, including stock comp and other, add $35 million for deferred taxes, and subtract $23 million for changes in working capital, deferred revenue and other items. This nets to a GAAP operating cash flow of approximately $65 million in the first quarter of 2008. Year over year operating cash flow was down due to the additional use of cash for working capital requirements resulting from increased payments for partners, incentive compensation, legal and restatement related costs.

Below the operating cash flow line, we used $10 million for capital spending and $49 million for the ScanAlert acquisition in the first quarter. We also generated $54 million during the first quarter as a result of employee stock options which were exercised. We would like to note at this time that we expect our cash flows for the remainder of the year to be impacted by the timing of certain cash tax payments and one-time payments related to partnership agreements. The composition of our deferred revenue balance as of the end of Q1 2008 was 61% for corporate and 39% for consumer.

Now, I would like to present guidance. The following updated guidance replaces and supersedes 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. Please see the footnotes in our press release for further details.

For the second quarter of 2008, we expect revenue between $360 million and $375 million. We expect our GAAP operating income margin to be 11% to 15%. We expect our operating income margin on a non-GAAP basis to be 22.5% to 24.5%. We assume a GAAP tax rate for the second quarter of 24% and a non-GAAP tax rate of 27%. We expect diluted share count to range between 162 million and 164 million shares. Also for the second quarter of 2008, we expect GAAP EPS between $0.26 and $0.31 per share on a diluted basis. On a non-GAAP basis, we expect EPS between $0.42 and $0.47 per share on a diluted basis.

For the full-year 2008, we expect revenue between $1.435 billion and $1.535 billion. We expect our GAAP operating income margin to be 13% to 17%. We expect non-GAAP operating income margin to be 23% to 27%, and we assume a GAAP tax rate of 24% and a non-GAAP tax rate of 27% for the full year of 2008. Also for the full year of 2008, we expect full year 2008 GAAP EPS between $1.15 and $1.25 per share on a diluted basis. On a non-GAAP basis for the full year, we expect EPS between $1.85 and $1.95 per share on a diluted basis.

Please note that the guidance provided does not include any impact from future stock repurchases. We are not forecasting the timing, expected average purchase price, or total stock repurchased. We will provide updates on the program on a quarterly basis and adjust guidance based on actual repurchase program results. I will now turn the call back over to Dave to conclude.

David DeWalt

Okay, Keith, thank you very much. I believe McAfee is really positioned for growth in 2008 and beyond. Our investments in sales are paying off, we reported our third consecutive quarter of accelerating revenue growth and our ninth consecutive quarter of year over year double digit revenue growth. Year over year, we have increased the number of large deals, our acquisitions are performing well, and we have increased sales capacity and are retaining our talent.

The consumer team is also executing well, the consumer team delivered a record quarter. We won several strategic PC OEM partnerships that we expect to drive more growth in our consumer business for the coming years and we closed our acquisition of ScanAlert and announced our Web Security Group.

Our investments in research and development are paying off with industry leading technologies and we formerly launched our new Risk & Compliance business unit, and our McAfee Security Innovation Alliance program is growing. Our security alliance program promotes the development of interoperable security products. We are the only truly open security platform.

We are confident in McAfee's future. This confidence is reflected in our guidance. We raised guidance on revenue and confirmed earnings per share for the full year. And before we conclude, I want to let you know that we are pleased to announce that we have identified a new CFO and we will be making an announcement shortly. The fundamentals of our business are strong and our momentum continues to build. We are moving forward with a focused strategy with the best team in the business. We look forward to executing in 2008.

And with that, I'll now turn it over to Kelsey for questions.

Kelsey Doherty

Okay great. Thanks a lot Dave. As the operator polls for questions, I would like to remind you that McAfee is hosting its annual Investor Day 2008 on Wednesday, May 7, 2008 in New York City at the Grand Hyatt. Information is posted to our Web site. It is an invitation only event. If you have not received an invitation and are interested in attending, please contact Brandie Claborn. Operator, you may now poll for questions. Please, in the interest of time, limit yourself to one question. Thanks very much.

Question-and-Answer Session

Operator

(Operator instructions) Our first question will come from the line of John DiFucci with Bear Stearns.

John DiFucci – Bear Stearns

Thank you. Dave, can you tell us, was there any change in the way that you do business with your channel partners? In other words, how you recognize expense and revenue? Because consumer business was as you point out really strong. But expenses especially sales and marketing were a lot stronger than we anticipated anyway.

David DeWalt

We didn't have any fundamental change in the channel model. I did allude to a restructuring charge that we took largely related to aligning our model a little bit more effectively. As you know, we have been focusing in on a higher touch model. We continue to be 100% channel fulfillment, which hasn't changed, but we are really trying to focus in on getting better alignment with our sales model around the world, and we did some restructuring as a result of that and some hiring. But, the basic channel model hasn't changed much. Regarding the consumer business there, we had some impact, some bulk of the cash flow change was largely related to some investments we made in the consumer partnership world and they've had some impact. But, I think strategically this is great for the future of the company both sales investment, the model changes and frankly the consumer partnership investments.

Operator

Your next question will come from the line of Michael Turits with Raymond James.

Michael Turits – Raymond James

Hi guys, Michael Turits. Can you drill down a little bit more on the cash flow and give us some – put some numbers behind what some of those incremental cash – uses of cash were, both in the quarter and give us some idea what that might look like going forward? Should we expect cash flow for the year roughly in line with net income? You outlined some categories, but how much below would we think of a typical might it be?

David DeWalt

Okay, thank you Michael. This is Dave. Why don't I hand it over to Keith, why don't you just talk a bit about some of the bigger impacts there and things going forward?

Keith Krzeminski

Sure, Michael. The change year-over-year in cash flow was – the largest percentage of the decrease in cash flow was related to the strategic investments that Dave alluded to in PC OEM agreement, clearly which will drive strategic growth in the future. Also, we would anticipate that we would continue to invest in new agreements and new partnerships in the future quarters. I would say that the bulk – the largest percentage of the decline in cash flow from prior year to the current year is the result of so-called partner payments and payments associated with those agreements. We also – it's probably also worth noting that we did have some pretty high costs that still lingered related to some of the restatement costs. And when we had to do some cash payments related to settling some expired stock options for former employees, and we have costs associated with that in the first quarter which is unique and related to the restatement. The other puts and takes are in there as well.

Kelsey Doherty

Next question?

Operator

Your next question will come from the line of Rob Owens with Pacific Crest.

Rob Owens – Pacific Crest

Hi guys. So, focusing in on the operating margin, you had a target for the quarter I think of 23.5 on the low end. And you talked about some of the factors that drove operating margins below that. I guess two questions and one about the operating margin. First of all, as you have set guidance for Q2, have you appropriately taken under consideration the VSOE issue or the large deal issue such that margins should fall within that range? And second, if we see upside to revenue, how should we think about leveraging the business and what are you doing in terms of spending? Will you spend into that leverage or will we see that in bottom line?

David DeWalt

Hi Rob, this is Dave. So, good question and quite a relevant one frankly. So, to answer the second part and then I'll drive into it, yes, we have obviously factored into the guidance some of the VSOE impacts that we saw. I tried to outline this a little bit on the script. I know it is a hair confusing but we certainly saw a lot of synergies from our acquisitions that clearly was a positive. SafeBoot was up 65%, we had 20% in quarter over quarter increase in ScanAlert. Some of those drove our deals ratable. And it wasn't just the component of the acquisition, it was the combination of the acquisition with other products from McAfee. So that did have some effect.

Clearly, we have modeled that moving forward. We also saw an increase in large deals and we talked about 140% increase in over $500,000 deals. We talked about a 33% increase in over $1 million deals. When you get large deals, you get less in-period realization and in some cases no in-period realization. And just as we have grown into that, we have got less revenue coming off the balance sheet frankly or having it in period and it's had some effect. We outlined that as a few penny impact just on EPS in this quarter and frankly that was the largest impact on the operating margin as well because it just flowed right down.

We made some investments in the sales model and these were very strategic for us as well. Obviously, we are seeing some great opportunity to take market share here. You can see our revenue plus change in deferred was very strong, as strong as it's been in years. Our revenue growth was very strong and we have been making investments in that. A lot of those came in early in the quarter, and frankly, our attrition was quite down too, which was a little unexpected. We were much higher on attrition last year and the year prior and that's come down pretty sharply and that had a little effect on those sales expenses, kind of the combination of hiring and nobody leaving, and we have made some adjustments going into Q2 that way.

But, all in all, these investments are really good for the business, buying and winning some of the consumer preload deals. I outlined a couple of great wins that will really drive our growth. They had some effect and certainly we'll have some effect moving forward too just because we are very competitive to win those contracts. And we are being very, very conscious of the climate and making sure we have got the right expense controls moving forward. We analyzed a lot of that before he gave the guidance and we are confident that we can reconfirm guidance for the year as well as the growth there and raising it a bit in revenue and feel good about what we see.

Operator

Your next question will come from the line of Heather Bellini with UBS. Miss Bellini, your line is open.

Kelsey Doherty

Maybe we can move on to the next one, it sounds like she might be on mute.

Operator

Your next question will come from the line of Todd Raker with Deutsche Bank.

Todd Raker – Deutsche Bank

Hi guys. Just want to follow-up on this operating leverage question. If I compare, 82% of your revenue stream came off the balance sheet this quarter. It was 81% last quarter. All the increase in deferred revenue was essentially short term. I guess two questions for you, why aren't we seeing EPS leverage in the back half of the year, given those metrics? And are we looking at an operating model longer term that is less profitable at a higher growth rate? Is that how we should be thinking about it over time?

David DeWalt

Todd, I wouldn't draw that conclusion for sure. Certainly here in Q1 and you saw this a little bit in Q4 for us as well. Over the last year, I have been trying to retool and change a little bit of the go to market model for the company. We have been really focusing on that. We did a restructuring in this quarter. We hired some sales personnel in Q4 and Q1. These are all to build for the future and obviously drive more operating leverage and more profitability in the future.

And frankly, the guidance of 185 to 195 on a non-GAAP EPS basis shows that there is a lot of leverage in the back half of the year and we feel confident that we are getting there. But again, we are a little bit in the – changing as we are flying here and making the model work for us, and the market share gains are very significant for this company as we have grown and taken it both from Symantec and Trend. There has been a number of competitor displacements, a number of big wins in the consumer business, and a lot of this is yet to show for us as we move forward in our model.

And frankly, I have just been looking at this saying, okay, the best opportunity for me is to grow and take market share. These returns will come, they are very powerful model we built and these investments will pay off for this company. So that is a little bit of what we have been seeing behind the scenes here in terms of our operating position.

Security remains a very high demand product in this economic climate. It's a must have for both consumers and for corporations around the world, both in the U.S. market, if you have seen our North American growth, it was very strong again both on sales as well as in the revenue category. We fixed that, we fixed all the segments of our business, so the optimism is there and certainly I know that I got to drive profitability in the back half of the year and we are showing that with our guidance hopefully.

Operator

Your next question will come from the line of Daniel Ives with Friedman Billings Ramsey.

Daniel Ives – Friedman Billings Ramsey

Thanks. I'm interested from a high level. I mean, given what is going on macro, at least from a perception standpoint, did you guys do anything different kind of hold channel guy's hands, direct sales customers, just given where that was going on and you had a really good revenue quarter?

David DeWalt

Hi Daniel, this is Dave. So what do you mean by hold their hands? Sorry, just more like touch?

Daniel Ives – Friedman Billings Ramsey

Yes. I mean, in this market where people are maybe a bit more scared or elongated sales cycle taking longer to get signatures done, you guys had a real good quarter. Did you do anything in particular to make sure that you didn't have some issues and maybe some other vendors have had?

David DeWalt

No. I think Keith and his script talked about this a little bit. We saw no impact of discounting. If anything, we saw our ASPs increasing, which has been a very positive for us. The bulk of our growth driver has been the conversion of our point product kind of AV and spy, kind of antivirus and spyware kind of model to our ToPS conversion, we have been doing very well with that. When we do get those conversions, it makes us more solid in the enterprise accounts, as well as get us to higher ASP. And now, we have actually announced the top through network product line which can do the exact same thing on the network where point products competitors can upgrade to a suite, multiple functionality blades inside a single appliance.

We are really delivering on an economic scale here for our customers. So, if anything, we are actually seeing good, strong drivers in that business. Because, right now the more frugal the customers actually get, it plays the best to McAfee's model and this is a great time for market share gains and a really good opportunity for the company. So, no, the answer is not and the channel's reflected that. We have got more channel partners, more security innovation alliance partners and we are the only open interoperable alliance or vendor out there with alliances, very proud of that and I think we have really got ourselves flanking our competitors right now.

Operator

Our next question will come from the line of Walter Pritchard with Cowen.

Walter Pritchard – Cowen

And if you guys could just update us on the ToPS product, kind of where that is as a percentage of the installed base, and then as you look at DLP, as well as the SafeBoot encryption product, any sort of color on where those could go in terms of percentage of the penetration of the system security base?

David DeWalt

Hi, Walter, so good questions, actually very insightful. We have been talking a little bit over the last few quarters of the penetration we have been making of moving from our kind of traditional AV franchise point product store ToPS conversions. We had very good success again this quarter. Big driver for our business again is winning that kind of strategy. I don't have the exact numbers for this call, but we did make more progress clearly. We have some large transactions standardized. Frankly, we are actually seeing some of the larger deals happening outside the U.S. now as well, which has been a very good indicator for our success. Initially, we are getting a lot of North American big wins. We are starting to get some outside the U.S. and just a mix of that has been positive. And then on the DLP SafeBoot, one of the things we actually did to ourselves was created a ToPS for data suite. The ToPS for data suite was a combination of some existing McAfee product and some new products. I talked a little bit about the deferred revenue and sort of the ratable business model there, but SafeBoot is growing 65% year over year. This is exactly why we bought that business, it was a very accretive growth business, both top and bottom line. It did have some more dilution in the quarter than maybe we anticipated a little bit in Q1 because of the VSOE issue. But, the growth was outstanding and the DLP and SafeBoot is a wonderful combination for us. I'm real convinced the Endpoint data protection game is the right game for us. It leverages our ToPS conversions. It is international. We had a really good success with that business model and I think we got the right vendor there, so we are very little penetrated right now. When you look at the number of nodes that actually have full disk encryption or a port control management, removable storage management, very low percentage, very high opportunity for the company.

Operator

Our next question will come from the line of Sterling Auty with JP Morgan.

Sterling Auty – JP Morgan

Thanks, hi guys. Can you give some color on, at this point, who is or what source is the largest contributor to the consumer business whether it be by dollars or subscribers or even if you want to give color like the top-five who are now contributing just so we can understand the diversification in that part of the business. And the second question is, how long do you think it will take to get VSOE on the SafeBoot business?

David DeWalt

So, maybe I'll take the first part and Keith can – you can comment on the second one. Regarding the consumer business, we haven't really disclosed what partners are contributing what percentage, although it is not a magic. There is a number of vectors here for our consumer growth which have been very strong . The number one is our Mcafee.com. This is our online business where we are very good at our software as a service model. That continues to be a very strong grower for us. And frankly, it is a feeder from all the other channels, the PC OEM gets the convert into the .com model, our retail model converts into that model, and other kind of components all feed into kind of a classic consumer model. We have won some new partnerships, one of the most proud facts I had on the script frankly was the 97 new and enhanced partnerships we had in the consumer model. Our team in the consumer has taken it and it is fun to watch. We have got a lot of new partnerships that are being announced and have been announced and just strong momentum target partner team that run our consumer business have done a phenomenal job, helping us really invigorate our consumer model here and you can see at 19% revenue growth, lot of new partnerships, lot of things to come and I can't be more optimistic about that one. SafeBoot [ph] VSOE, Keith?

Keith Krzeminski

Sure. Sterling, this is Keith. From a VSOE perspective, we anticipate that it will take somewhere around the year mark to establish VSOE, although there is no bright line test here. We just need to get enough data behind us to show that we have a specific fair value related to the way we sell. Now, one thing that is worth noting is that, we had to convert SafeBoot into our pricing, the McAfee way of pricing. So while we start that up, and we have converted the pricing model, that takes a little bit of time, so once we get more evidence of how we are selling to customers, we'll be able to evaluate VSOE. But, we generally anticipate it will be somewhere around the year mark.

David DeWalt

Next question.

Operator

Our next question will come for the line of Philip Rueppel with Wachovia Securities.

Philip Rueppel – Wachovia Securities

Yes, thanks very much. Talking a little bit more on the consumer side. You mentioned a number of renewals that you had signed with partners. Is there typically a big wave of renewals around the first of the year? How should we expect that going forward? Is it just going to happen every quarter? And along those lines, what has been your experience with renewals both from a pricing perspective and ability to up sell additional McAfee technology or products? Thanks.

David DeWalt

Thanks, Phillip. Todd, you want to come a little closer. I have Todd Gebhart

Here, our Head of Consumer Business and he had a great quarter, so maybe I can let him answer that. Consumer renewals, seasonality, talk to that.

Todd Gebhart

Yes, I'll try and give you an answer on that. So, there is not a season of renewals with partnerships that are established. There are opportunities that when you are going to the marketplace, you look at new partnership opportunities and drive to those, where you can make good business sense with your partner. In terms of the overall business, the seasonality we see generally occurs in the second quarter of the year. But, there isn't a specific seasonality that you see in driving new partnerships through the business. It is through the course of the year and as opportunities drive into the marketplace. I think one of the things that the team has been doing a very, very good job of, when you look at the partnership models, it takes a look at the different areas that wove focus in, in our strengths in not only the PC OEMs, but in telecom and the ISP business, as well as financial institutions, and then you look at the McAfee strategy and our roadmap in looking at the multi-platform delivery that we have and the strategy that we are taking up protecting consumers against not only on the PC, but in the Web, in the mobile area, and that drives longer-term relationships with these partners to help them see that you not only have good security offerings today, but you have a vision in the future that you are protecting their customers against going forward.

Kelsey Doherty

Thanks, Todd. Next question please.

Operator

Our next question will come from the line of Sarah Friar with Goldman Sachs.

David DeWalt

Hey, Sarah.

Sarah Friar – Goldman Sachs

Question on – first on the sales environment. As you move through the quarter, certainly others have talked about some slowing at the end of March. Your results certainly don't look like you saw that. So could you just talk a little bit about linearity? And then secondly on your comment on competitive replacement this quarter, is that kind of taking away from kind of your big other number one, number two competitors or is that starting to see the smaller guys get pushed away here?

David DeWalt

Thanks, Sarah. This is Dave. So, just in terms of sales strength, I didn't see any change in economic conditions in Q1 and I'm really convinced security is a pretty must-have category. I didn't see a single scenario in the quarter where customers said, "Wow, let's change our look at security spend." It was very positive. I certainly read the headlines like everybody else does on the economic conditions and we are probably not immune entirely, but I actually saw positive things happening across-the-board for McAfee all the way through the quarter and we have quite a few orders already closed going into Q2. So this is very solid for us and what we are seeing just in terms of competitive displacements, yes, we saw a lot of number one and number two knockouts, but our strategy has been best of breed sort of in a suite and being able to replace point products has really been what is working for us. And I'm excited in the next chapter of McAfee's future here to really go after the network game the same way and this is a real opportunity for us to attack some of the established security vendors on the network. We have literally the fastest platform, the most cost effective platform with the most features in it, in a single appliance delivered virtually as well as through Blades and this is a nice opportunity for us to do a similar strategy on the network, so we'll see if that can play out like we did on then Endpoint. But best of breed, best of suite, this is the model that's working well for us and I think this will play for quite some time for us.

Operator

Your next question will come from the line of Phil Winslow with Credit Suisse.

Phil Winslow – Credit Suisse

Hi, guys. Just a couple of quick questions. One just on the accounting side, the change in fair value of stock-based liability awards, I saw that for the first time in your non-GAAP numbers, just what exactly is that? And then hey Dave, as you go forward here, when you think about over the next sort of the long-term about balancing operating leverage with sales growth, where is sort of a long-term target that you look for as to sales marketing and substantial bookings and revenue and when do you think we will start to get towards that?

David DeWalt

Sure, that sounds fun. Let me answer the first one, then I'll give the other one to Keith for the stock change and the fair equity value there because it was a change we are in effect. So just in terms of operating leverage and sales growth, I kind of looked at our opportunity here and tried to turn the buy [ph] a little bit more toward the sales growth. As you follow McAfee prior to my arrival, I felt like our sales growth wasn't nearly where it could be. Making those investments in the last year was pretty important us to. My goal is to be number one security vendor. There is no other way about it. I'm trying to win this market. I have got to figure out a way to do that. Taking the market share right now in this climate is really important and in a market condition like it is, with our competitor the way they are, this is just a great time to take a long-term view on the market and really drive that market share. But having said that, I'm very, very conscious of the operating leverage and trust me, going forward, we are really going to try to return to the profitability, really try to make sure that we have hit all of the operating goals, both at the operating margin and at the non-GAAP and GAAP EPS layers for the back half of the year. I think I have made all the investments I need to make in our sales and marketing model, particularly with the restructuring I just did and this gives us a chance now to really build on the future with the partnerships and the sales investment and time to return some leverage.

Keith, you want to talk about the changes there?

Keith Krzeminski

Sure . The question was regarding the fair value change in our stock-based liability awards. Basically what happened, and this is not included in our non-GAAP results. We recorded a gain in our P&L for GAAP purposes as the stock price declined from the end of the year through the quarter, and the liability in essence comes off the balance sheet. So, it's not in our non-GAAP results, but it is in our GAAP results. And it's an accounting requirement under EITF 0019.

Kelsey Doherty

Next question please.

Operator

Our next question will come from the line of Katherine Egbert with Jefferies.

Katherine Egbert – Jefferies

Can you talk about your composition of your deferred revenue? Give us some color on maybe licenses versus services and maintenance, consumer versus corporate, and then an average contract length maybe?

David DeWalt

We haven't broke down all the composition of that. Keith, you have handy the corporate and consumer piece? I think we have that in the script there. Sorry, let me grab that.

Keith Krzeminski

61%, 39% corporate/consumer.

David DeWalt

Corporate 61, 39 for consumer. That is the much granularity we give on that one.

Kelsey Doherty

We have time for one more question please.

Operator

Our final question will come from the line of Brent Thill with Citi.

Brent Thill – Citi

Thanks. Hey, Dave. Regarding the distribution footprint, can you just walk through this year where you've seen the biggest overall improvement that you can make in the efficiency in your footprint as you are going to market?

David DeWalt

Yes, Brent. There is a couple of factors here. Certainly, we have seen the distribution of our products come through a number of mechanisms, some of which weren't actually even at McAfee in the last year. But I thing about this as a heavy channel model. Wee see a tremendous amount of leverage by enabling our channel partners that is critical for us and our success and our operating model; we have done a good job at that. I have tried to make changes moving forward that will hopefully pay off even more there. Just incentives [ph] the channel as well as how we train the channel, certify the channel and leverage the channel in our operations. We also have moved and changed a bit of the model to teleselling and really going after blended shore and telesales as a model of operations, particularly mid-market and into the enterprise segment, a lot of leverage opportunity for us over time there and it is high touch model but it is over the phone and high touch as well as in the field and that is a nice place for us to drive a footprint in efficiencies in the model there. And then also compensation, getting the compensation aligned. I talked a lot last year about the way we compensated here at McAfee, including paying reps on renewals that might have been renewed every year anyway and trying to get those sales reps both over the phone and the channel in the field to focus in on the high-volume high-margin areas of the business, strategic products, focus in on deals that are really strategic to our company, not just a AV renewal and we have made that change and the bigger deals are happening as a result of that. We are seeing more standardization, we are seeing more market share gain and I think some of that's really coming to bear for us as we move into our '08 model. So, nice place to do it.

Okay. Thank you very much for all the questions. I appreciate the time today. I know we went a little long, so I just want to say I'm very optimistic about the future here with McAfee and certainly we've got a great situation in front of us. And I think that will conclude the call for today. So thank you very much.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may all disconnect.

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Source: McAfee, Inc. Q1 2008 Earnings Call Transcript
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