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Executives

Renee Lyall

Jerry M. Kennelly - Co-Founder, Executive Chairman, Chief Executive Officer and President

Randy S. Gottfried - Chief Financial Officer, Principal Accounting Officer and Executive Vice President of Business Services

Eric S. Wolford - Executive Vice President and General Manager of Products Group

Analysts

Alexander B. Henderson - Needham & Company, LLC, Research Division

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Rod B. Hall - JP Morgan Chase & Co, Research Division

Jonathan B. Ruykhaver - Stephens Inc., Research Division

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

Erik Suppiger - JMP Securities LLC, Research Division

Natarajan Subrahmanyan - TheJudaGroup, Research Division

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

Rajesh Ghai - ThinkEquity LLC, Research Division

Daniel H. Ives - FBR Capital Markets & Co., Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Hendi Susanto - Gabelli & Company, Inc.

Chris Cho - RBC Capital Markets, LLC, Research Division

Catharine Anne Trebnick - Northland Capital Markets, Research Division

James F. Hillier - UBS Investment Bank, Research Division

Matthew S. Robison - Wunderlich Securities Inc., Research Division

Riverbed Technology (RVBD) Q2 2012 Earnings Call July 24, 2012 4:30 PM ET

Operator

Good afternoon, my name is Ashley, and I will be your conference operator today. At this time, I would like to welcome everyone to the Riverbed Second Quarter 2012 Financial Results Conference Call. [Operator Instructions] I would now like to turn today's conference over to Renee Lyall, Director of Investor Relations. Ma'am, you may begin your conference.

Renee Lyall

Thank you, Ashley. And welcome to our conference call, everyone, for the second quarter of 2012. The speakers today are Jerry Kennelly, President and CEO; Randy Gottfried, Chief Financial Officer; and Eric Wolford, EVP and GM of our Products Group. A press release detailing our second quarter results was distributed today at approximately 1:07 p.m. Pacific Time over Business Wire. The press release is available on our website at riverbed.com. This conference call is being webcast live at riverbed.com/investors, and will be archived on our website for the next 12 months on the Quarterly Earnings and Events pages.

Our discussion today will include forward-looking statements, including statements regarding our products, partners, markets, performance, strategies and financial outlook. Forward-looking statements are only predictions and involve risks and uncertainties that may cause our actual results to differ materially from those expressed or implied by these statements. Factors that may affect our results are summarized in our quarterly release and described in detail on our SEC filings.

Forward-looking statements are made as of today's date only, and Riverbed disclaims any obligation to update any forward-looking statements. Unless otherwise stated, financial information reviewed on today's conference call is presented on a non-GAAP basis. Historical non-GAAP items are described and reconciled to GAAP results in today's press release and in a supplemental reconciliation available on the Investor Relations portion of our website. Any future products, feature or related specification that may be referenced during today's call are for informational purposes only and are not commitments to deliver any technology or enhancement. Riverbed reserves the right to modify or cancel future product plans at any time.

I'd now like to turn the call over to Riverbed's President and CEO, Jerry Kennelly.

Jerry M. Kennelly

Thank you, Renee, and good afternoon to all of you joining us today. We are proud to report strong second quarter results. Revenue grew 9% sequentially and 17% over last year to $199 million as we drove a solid ramp in sales of our new models in both the Steelhead and Cascade product lines.

On our call last quarter, we outlined what we needed to do as company to improve our performance. We are pleased with the progress we have made to date. The refinement in the sales approach was one of the first steps we took. The broad Riverbed sales force is now primarily focused on selling our core products, which include our Steelhead products for WAN optimization and our Cascade products for network performance management or NPM. Separately, our Stingray unit is selling ADC, and targeting the application buyers with whom our virtual strategy resonates best. And our Whitewater team targets the storage buyers responsible for backup. We believe this refinement, along with the simplified compensation plan, has created a more streamlined sales effort.

We're following a similar strategy with our channel partners, better aligning our product education and training for our partners' areas of expertise. We also established new technology and distribution relationships and strengthened existing partnerships.

At EMC World, we showcased a joint proof of concept for Granite with EMC that allows IT managers to consolidate and manage all edge applications, servers and storage centrally at the data center. And with VMware, we reduced the ability to create VMs, moving between Cloud. I will talk more about our new relationship with Juniper shortly.

Finally, in our Q1 call, we committed to extending our products to new customer segments. In May, we introduced some new low-end Steelhead 150, targeted at customers in emerging markets, as well as customers with a very large number of sites. A good example is the retail industry, where there can be thousands of locations per retail chain.

We'll continue to work toward crispier execution as we focus our efforts on what we believe to be a very large and still early-stage markets.

Throughout the quarter, we meet frequently with analysts and investors. Probably the most common question asked over the past 3 months has been about the size and penetration of a WAN optimization market. We believe there's significant growth ahead of us in our core market, and we believe the need to WAN optimization remains strong. Our Q2 results, customer deployments and our Q3 pipeline support this belief.

In the second quarter, 3 of our top deals illustrate the current demand for WAN optimization within the IT infrastructure. One of our largest international consumer product companies in the world just began a global deployment of Steelheads, with the major drivers including consolidation of data centers and associated disaster recovery, consolidation of exchange and improving the performance of SharePoint, for which they also deploy their optimized product.

Another customer, a multi-billion dollar U.S.-based services organization and a long-term customer of Riverbed, increased their Steelhead deployment as they move to an outsourced IT model. And one of the world's largest oil and gas companies deployed in additional Steelhead products to enable their 150,000-plus employees to seamlessly access our web-based application hosted from a single location.

These 3 customers are example, they're at different stages of deployment, but all are multi-million dollar, multi-year customers for Riverbed. Companies like these standardized from Riverbed every day to support the successful delivery of key IT priorities including consolidation, virtualization of server and desktop environments, SaaS and other cloud or outsourced services, all of which put data in fewer centralized locations, forcing users to access that data from around the globe. These IT initiatives lead to more data traversing the WAN, both between data centers and clouds and from data centers to remote offices and mobile workers.

We continue to deploy Steelheads in the more traditional environments while, at the same time, newer application delivery models create new opportunities for WAN optimization. Steelhead Cloud Accelerator has already earned industry recognition from the value we can provide, being named the Best of TechEd 2012 in the cloud computing category. And yesterday, we announced support for inbound QoS and Steelhead's operating system RiOS. Inbound QoS provides the control needed over all incoming traffic to guarantee stable bandwidth with predicable levels of performance. Our Steelhead products ensure that WAN isn't a roadblock to IT and permits the delivery of application and services over distance.

Our new product, Granite, further expands our total addressable market by enabling complete consolidation of edge services and storage to the data center, addressing used cases that traditional WAN optimization alone cannot address.

Granite provides a powerful ROI to customers currently spending millions on edge infrastructure. We are seeing broad interest in Granite from existing customers planning upgrade to entirely new customers. As we have said before, we are not expecting material revenue from Granite in the near term, but early sales and interest in the product are promising.

The Cascades business grew nicely in Q2 at a 30% annual rate, led by sales of new products and platform. Cascades also delivers a compelling ROI by reducing down time, automating network operations, enhancing network visibility to support consolidation and virtualization and providing bandwidth management. The payback period for Cascade deployment can be as short as 6 months. Cascade delivers strong business value, as competitively differentiated, and we continue to feel very positive about our opportunity in that market.

The Stingray business is tracking a full quarter ahead of goal the we communicated last July as exceeding $20 million in revenue within only 3 quarters. We continue to be a pioneer in the virtual ADC market, having released a major upgrade to Stingray in the second quarter. Stingray 9.0 fully integrates comprehensive web content optimization into our software virtual ADCs. These capabilities unique to Riverbed, as we redefine the role of the ADC to deliver a fully accelerated user experience, scalable cloud utilization and the reliability expected from web and cloud-based applications.

The Juniper announcement today is another catalyst for Stingray. Juniper plans to deliver an integrated data center networking box solution that leverages Riverbed's ADC software code. Riverbed's focus has always been on the software and virtual ADC opportunity. The Juniper transaction allows us an incremental revenue opportunity in a segment of the market that we didn't attempt to address on our own. As part of this agreement, Riverbed and Juniper will also work together to deliver best-in-class WAN optimization through integration of Riverbed's Steelhead Mobile technology into Juniper's Pulse client. The integration of Steelhead Mobile into Pulse provides a pathway to extend our WAN optimization capabilities to smartphones and tablets.

This partnership allows both companies to strengthen existing products and gain entrance to new customers and new markets. Randy will discuss the financial details of the agreement in his section.

In summary, we were pleased by the acceleration of sales in Q2. There is significant market growth ahead of us. At Riverbed, we are always expanding our addressable market through ongoing innovation and a focus on delivering improved performance of applications across public, private and hybrid cloud networks.

We also provide award-winning service, and we received global certification under both the J.D. Power and Associates Certified Technology and Service & Support program, and the Technology Service Industry Associations Excellence in Service Operations for the second consecutive year. This is a major achievement, and Riverbed is one of the select few companies to receive this recognition.

Despite a weaker global economic environment, we posted a solid Q2, and we are looking forward to continued growth in the second half. All of our products make the IP infrastructure operate more efficiently and deliver a solid ROI that resonates with our customers in any economic climate.

At this point, I will turn the call over to Randy to review the financials.

Randy S. Gottfried

Thanks, Jerry. As a reminder, unless stated otherwise, the numbers I'll discuss are non-GAAP.

Second quarter revenue was $199 million, up 9% sequentially, and up 17% year-over-year. Second quarter product revenue was $129 million or 65% of total sales. Product revenue grew 11% over the prior year.

Service & Support revenue was $70 million in the second quarter, representing 35% of total sales. Service & Support revenue grew 30% over last year.

WAN optimization was 90% of total revenue in the second quarter, NPM was 7% and ADC contributed 3%.

Total WAN optimization revenue increased 9% sequentially and 12% over the prior year to $178 million. Within WAN optimization, sales of our new Steelhead CX and EX models ramp strongly, and in the third month of the quarter, contributed about 50% of remote office supplies revenue. High-end data central appliance sales and virtual solutions increased significantly, achieving record revenue.

Cascade revenue grew 11% sequentially and 30% year-over-year to $14 million led by sales of new appliance configurations.

Total Stingray revenue was $7 million in Q2. Second quarter revenue does not include any revenue received from the Juniper transaction, which we'll begin recognizing in Q3.

Under our agreement announced today, Juniper will pay Riverbed $75 million to license Stingray Traffic Manager, most of which was paid upfront in July. This prepayment will be recognized in the revenue over a 4-year period, beginning in Q3 2012. Initially, at of $3 million quarterly rate, eventually growing to about $5 million per quarter.

Turning to distribution, 95% of our Q2 revenue came from indirect channels and 5% was sold direct. Two distributors contributed more than 10% to total revenue, with Arrow Electronics at 17% and AppNet at just over 10%. We had no 10% end user customers in the second quarter.

As a reminder, we're now reporting geographies as Americas, EMEA and APJ as a percentage of total revenue. We saw sequential and year-over-year growth across all of these major regions. The Americas contributed 59% to revenue; EMEA, 26% and APJ was 15%.

Looking at verticals. Financial services, government, manufacturing and technology were the largest contributors in the quarter, all about 10% of total revenue.

Moving to costs and expenses. Product gross margin was 79.4% in Q2, about flat with Q1. Drive prices have come down from the peaks, but are still well above pre-flood levels, so continue to have some impact. We expect product margins to improve over time.

Service & Support gross margin came in at 75%, up almost a full percentage point compared to the first quarter. The sequential improvement was driven by higher revenue.

Our Q2 total gross margin was 77.8% compared to 77.5% in Q1. Total operating expenses were $105 million, in line with our guidance. We added 65 employees in the second quarter and ended June with headcount of 1,739.

Operating margin for the quarter was 25% at the high end of our guidance, and up of almost 100 basis points compared to the first quarter.

Net income was $37 million or $0.23 per diluted share in Q2, ahead of our guidance of $0.21 to $0.22.

Moving to the balance sheet and cash flows as of June 30. Cash and investments totaled $550 million, and we continue to have no debt. During the second quarter, we doubled the stock buyback authorization to $300 million, and in Q2, we repurchased $100 million of Riverbed shares, a balance of $164 million remains under the repurchase program.

Cash flow from operations was $30 million for Q2, compared to $15 million the prior quarter and $32 million in Q2 2011.

Days sales outstanding were 39 days compared to 35 days in Q1 and 37 days 1 year ago. The increase was largely driven by a mix shift in distribution.

Inventory totaled $18 million exiting the second quarter, compared to $19 million at March 31 and $15 million a year ago.

Total deferred revenue was $173 million, up 2% sequentially and up 30% over the prior year. As we discussed in prior years, there's some seasonality on our support renewals as customers tend to co-terminate support contracts near calendar year end. As a result, the sequential growth rate in Q2 is typically lower.

Exiting Q2, deferred revenue was mostly comprised of prepaid support contracts. In Q3, product deferred revenue will increase significantly, largely driven by prepayments under the Juniper partnerships I described.

Turning to guidance, we're feeling good about our overall business opportunity, the growth of our recently introduced products and the market acceptance of our newer offerings. The global spending environment is cautious, and we factor that into our guidance.

Revenue in the third quarter is expected to be in the range of $214 million to $219 million. Gross margins should be about flat. We're forecasting operating expenses to be between $112 million and $115 million. Q3 operating margin is expected to be about 26%. As you know, the fourth quarter is seasonally higher in terms of sales and marketing expense. As a result, we expect Q4 margins to be relatively flat with Q3.

Earnings per share for the third quarter is expected to be between $0.25 and $0.26 based on approximately 164 million shares outstanding and a 26% tax rate.

I'll now turn the call back over to Jerry for his closing remarks.

Jerry M. Kennelly

Thank you, Randy. Q2 was a quarter characterized by improved execution at Riverbed, and we expect to see continued improvement in the second half of the year as new platforms and new products continue to ramp. The performance of the network and IT infrastructure is critical to support the agility of global corporations and governments today.

Steelhead and our suite of products enable the smooth flow of data within the enterprise and extending to the Cloud. Looking forward, we are excited about our business, our products, our strategy and our direction.

Ashley, operator, you can open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Alex Henderson with Needham.

Alexander B. Henderson - Needham & Company, LLC, Research Division

So I guess I was hoping you could give us a little bit of sense of how the quarter progressed in terms of the closure of transactions that were delayed out of the first quarter because of decision-making criteria that people said, "Gee, I want to look at these new products," and how you gauge that process going forward. Will it be 2 or 3 quarters for that to fully play through? Or do you think that, that in the -- by the end of the September quarter that, that slug of delay business will have been fully played out?

Jerry M. Kennelly

That's a great question. I think a lot of it played out in the June quarter. Most of Q1 delay really came running in late April into May. It took us until the end of May to get our sales comp plan realigned, get the new quotas out, simplify the compensation plans, distribute that and get the company kind of realigned. So we really only had the last month of the quarter where we had the execution fixed, and we saw our growth accelerated as that was finished. But I think in terms of the new products, the new platforms, they're out, they're accepted, and we should see a normal run rate for that in Q3.

Operator

Your next question comes from the line of Jayson Noland with Robert Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Just to clarify on the previous comment, Jerry, you would expect to see the majority of your business in Q3 be the 55 and 60 series, CX and EX?

Jerry M. Kennelly

Yes, absolutely will. For those models in which we have, again, that's -- the new models we'll provide to remote site boxes.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Okay. I wanted to ask about Fed gov, specifically. We heard talk in the channel of a good Fed gov in Q2. Is that how it played out? And what are your expectations for Q3 with the fiscal year end?

Jerry M. Kennelly

Government was 18% of revenue in Q2, which is in its normal range, but more toward the higher end of its normal range. And Q3 has -- had a good tradition of being a strong government quarter for us as well, and that's built in to our guidance.

Operator

Your next question comes from the line of Rod Hall with JPMorgan.

Rod B. Hall - JP Morgan Chase & Co, Research Division

I just wanted to ask, one, on the Juniper partnership, I wonder if you could talk a little bit about whether there's any channel of distribution implications for that deal. He didn't mention in the announcement. I'm just wondering whether there are any implications there. And then on the Pulse integration, I wonder if you could talk a little bit about revenue recognition there. Would that be on a per-device or per-unit basis, or how would you make money on that deal?

Jerry M. Kennelly

So it's a great win-win contract. There's a lot of alignment between Riverbed and Juniper. We have a lot of the same competitors, and our own competition, WAN ops, sort of faded some time back. So on the Pulse integration, that's probably -- that's a 2013 story. It's going to be some amount of time to finish that integration to get a product in the market. You're talking at least 12 -- between 12 and 18 months. When that integration is done, and we do have our product ready for the market, we haven't completely finished the pricing model, but it'll either be some sort of usage model or per-unit type of transaction on Pulse. In terms of channel distribution, the 2 companies are distributing separately in the near term although some integration or cooperation is possible during the future. That's not in the deal right now though.

Rod B. Hall - JP Morgan Chase & Co, Research Division

Okay. And then Jerry, I just wanted to -- on rest of world, I know -- we know the rest of world revenues were weaker than they were last quarter. I just wonder if you could maybe give us an update on rest of world distribution. You made comments that you'd like to see that turning around. And just wondering what your thoughts are there and kind of what's going on in the rest of the world.

Randy S. Gottfried

We look at our revenues -- this is Randy. The APJ revenues, we shift a little bit of how we talk about it, so it's more consistent how we look internally. Rest of the world revenue was up quarter-on-quarter, up about 20% year-on-year. So it's still a smaller number relative to the rest of the geographies that tend to be a little bit lumpy and -- but Q2 certainly relative to Q1, we feel much better.

Rod B. Hall - JP Morgan Chase & Co, Research Division

Okay. So you guys are pretty confident that's on track now, no issues with execution there?

Jerry M. Kennelly

It is pretty much on track. The biggest piece of it is the -- in APJ is the South America tends to be a little more lumpy. We have a good business there, but we tend to get larger deals that jump up and down.

Operator

Your next question comes from the line of Jonathan Ruykhaver with Stephens Inc.

Jonathan B. Ruykhaver - Stephens Inc., Research Division

Randy, I think you mentioned record high in data center activity. Can you compare and contrast performance of that in front of the data center portion of your WAN op business with the branch office portion, how's it growing? And if you exclude that data center -- the data center business, what was the sequential growth in the core WAN op branch segment of the businesses like in the quarter?

Randy S. Gottfried

We saw growth in both areas. We don't go into granularity revenue per SKU. In general, the data center models were strong especially our 7050 at the high end. Our branch office actually did quite well. We saw good uptake of the newer CX and EX models as people got through the learning curve and the -- grew more comfortable with those models. We saw good growth there as well.

Eric S. Wolford

And Jonathan, this is Eric. Those big boxes can be used as the data center portion of the remote site to data center solution. So when the big boxes sell, it's not just for data center-to-data center business, it's also for data center-to-remote site. So remote site business was strong.

Jonathan B. Ruykhaver - Stephens Inc., Research Division

Okay. But just to clarify, the portion of your business, that is data center. The data center, you saw very good strengths as well?

Eric S. Wolford

Yes, we saw a good strength, yes.

Jonathan B. Ruykhaver - Stephens Inc., Research Division

Okay. Just final quick question. Can you comment on the one safety -- I know it's early, but just what kind of activity you're seeing? And then what is the gross margin profile of that product like relative to the other Steelhead products?

Jerry M. Kennelly

That -- the model just launched mid-quarter Q2, and so it's just getting started. We think it fills in a segment of the market that we probably didn't focus on as much before, so we're excited by the opportunity, but it is just getting started. All of our products have a pretty good gross margin profile. Some of the smaller units are a little lower gross margin, but all of them, especially combined, are -- I think are very attractive. We don't go to that level of granularity per model.

Operator

Your next question comes from the line of Ittai Kidron with Oppenheimer.

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

I guess a couple of questions for me. First of all, your government business has been stronger than usual in the June quarter. So how do you get comfort that you just didn't have like a pull in? I'm sure, Jerry, you had your thumb on every head -- salesperson's heads. So how do you know that they just didn't pull a lot of what would have normally been September revenue into the June quarter? How do you get comfort around that exercise? And second, with regards to Juniper, can you talk about -- I mean, I understand the licensing agreement. But what happens at the end of this licensing period? Does the revenue drop off? Is there a milestone? Is there a renewal? Or how does that work? And the second thing with regards to rest of your interaction with them, is that an OEM basis or is that a reseller basis?

Jerry M. Kennelly

How many questions is that, Ittai?

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

Three.

Jerry M. Kennelly

So on the government business, we have very detailed -- we use salesforce.com like a religion. We have a detailed pipeline, agency by agency, rep by rep, account by accounts. If there's any pull in, it was more Q1 going to Q2 than it was Q3 going to Q2 that helped government. So we're pretty comfortable with our guidance on Q3 revenue to the extent that government's involved in it. On the Juniper, the -- it's a sort of a lump sum perpetual license for the use of the ADC product in their box in kind of a hardware basis. There are provisions for future cooperation, and they have the options to ask for additional products at additional pricing in the future. But at the time being, this is basically an OEM sale of our perpetual license for them to use the ADC in their hardware business.

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

How do you resolve like go-to-market conflicts?

Jerry M. Kennelly

We're just in different segments. We don't expect to be a conflict and I guess, we have a lot of alignments, natural industry alignments with Juniper. And we have a good relationship with them that we've been working on. And we expect it to be very cooperative arrangement going back and forth.

Operator

And your next question comes from the line of Erik Suppiger with JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

One quick clarification. You didn't comment on growth for the year. Do you have any further comments on that front? And then secondly, on terms of Juniper, what exactly are you doing on the WAN optimization side with them? Are you working together? But what is that going to entail?

Jerry M. Kennelly

Yes. So our growth was up. We see Q1 as kind of -- we kind of mucked Q1 more on the execution side than anything else. We think we fixed the execution issue there. Look at this per year, we believe the 15% we talked about is achievable, given that the world economy -- the earth doesn't fall into the sun with the world economy here. So we'll see that. What was the question on Juniper?

Erik Suppiger - JMP Securities LLC, Research Division

The WAN optimization.

Jerry M. Kennelly

Oh yes. So out of the box, we'll cooperate with them to have WAN optimization available on mobile platforms, on notebooks and tablets and phones. And then, we -- like I said we have a good relationship with them. We'll keep talking, and then perhaps there's more we can do in the future in that area, but that's -- just stay tuned, nothing to announce right now.

Operator

Your next question comes from the line of Subu Subrahmanyan with TheJudaGroup.

Natarajan Subrahmanyan - TheJudaGroup, Research Division

My question is on the full year trend. I know in the past, you've provided a 15% growth guidance. At this point, you've talked only about next quarter, can you talk about how you view the trend going into year end. Would the year end normal seasonality offset by potential drop off from the federal business?

Randy S. Gottfried

Sure. It's Randy, I'll just supplement with Jerry just to talk about a little bit. So in general, there's 2 very positive proof of points that came out today, one was the actual results for the second quarter, and the next being the guidance that we saw for Q3. And those were encouraging for us. We do feel good about the business. We're not explicitly updating the guidance that we gave for the 15% for the full year. But based on the data points we have that we're moving in the right direction. As far as the business goes, we're sort of taking it quarter by quarter. But we think we're certainly on a trajectory, and we think that 15% number is achievable, assuming the economy holds out, but we'll see, again, we're focused quarter-on-quarter.

Operator

Your next question comes from the line of Jess Lubert with Wells Fargo.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

First, just a clarification. Can you say what the government was as a percentage of sales? I didn't hear that.

Randy S. Gottfried

18%.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

And then the question is there's been some concern in the market that a number of key enterprise applications such as Microsoft Outlook, SIF and SharePoint, which have historically driven strong demand for your products are getting better from a latency perspective. So I guess my question is to what degree have you seen this impacting your data center to branch optimization business? And to what degree do you view this as a risk going forward?

Jerry M. Kennelly

Yes. In fact, they haven't gotten any better. They still are a good driver of our business. The original products were based on SIFs, SMB, the -- now based on SMB 2. It still has the same latency problems and characteristics. I think some people have talked about the form factors, in which people are buying these products, doing them through Office 365. In the SaaS formats, they have the same network performance issues when accessed through a SaaS-type arrangement as they do when accessed over someone's own captive server in their own data center. And so all those products continue to be a driver of our business.

Operator

Your next question comes from the line of Rajesh Ghai with ThinkEquity.

Rajesh Ghai - ThinkEquity LLC, Research Division

My question is on the U.S. Fed business. So last year, the U.S. Fed business was very strong on the social and center printout side for you in the second half. The U.S. Fed, as I understand, closed about 200 data centers last year, and according to plan, they are publicly available. The plans is to close further 300. I'm curious about your assumptions for the second half of the -- for the year spread. What trajectory are you expecting the U.S. Fed business versus the last year? And how do you perceive the risks from a budgetary -- budget-constrained U.S. government curtailing its plans that they outlined thus far?

Jerry M. Kennelly

Yes. So, we give -- government [indiscernible] to which the Fed is the largest piece, but they're global. But in any respect, the consolidation by the U.S. government of its data centers plays exactly into the strengths of our products. And if anything, it's a driver of more business between Riverbed and the Federal government agencies because to get rid of these data centers, you have to overcome the networks' latency and bandwidth issues inherent in all consolidation projects. And that's -- that is our value -- with that part of our product line, and it's great for us. So like I said, we only give guidance one quarter at a time. We've given our guidance for Q3. We have a normal, strong pipeline with Fed for Q3 and government for Q3, and we'll see what Q4 brings us.

Operator

Your next question comes from the line of Daniel Ives with FBR.

Daniel H. Ives - FBR Capital Markets & Co., Research Division

I was just curious about in terms of compensation changes to the channel, obviously, you've undergone some with the new products. Just how bad that's gone. And are you starting to see that maybe benefit you to some extent in the field?

Jerry M. Kennelly

Yes. So the compensation changes. We discussed it more with our own sales force who interacts with the channel. And the -- what we did was really to just simplify our plan before we had sort of targets by individual product categories. We've relaxed those and let people make it just on the natural revenue growth of the most attractive products, and typically, those are our core products. And so that simplification helps our sales force be clear in driving the most revenue they can for the sales cycles they have to spend each day. Our channel partners are under relatively industry-standard distribution contracts. They receive good compensation for the work they do for us. Their compensation is volume-related and service-related, and they generally tend to like selling the Riverbed product because it's differentiated. We don't have billions of channel partners, so they're not competing in any one geography against just the other resellers all trying to make 2 points by moving the box, instead they get strong gross margins on our product. They're differentiated, and they get to sell services alongside with it. So we -- and it is a product that helps them appear to be higher tech with their customers, and they're just box shifting routers and switches. So we tend to have very loyal channel partners who are well-paid, and we've made a simpler, more clarified commission compensation plan with good quarters for our own sales force that interacts with the channel.

Operator

Your next question comes from the line of Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Jerry, your examples -- customer examples in the beginning were helpful. And I was wondering if you could talk a little bit more broadly about the base in terms of installed customers and the opportunity there, the penetration levels to give us a sense? And then on the competition side, you mentioned that they're still falling away. And so I was wondering if that's an active falling away at this point? Or do you feel like you're still taking meaningful share in the WAN op market?

Jerry M. Kennelly

Yes. Let me take a breath -- breather, and let my compatriots talk briefly.

Eric S. Wolford

Yes. This is Eric. On a competitive question, yes, the main competitor continues to and has been and it seems like it will be for a while, Cisco, and our competitiveness has remained strong. I think we still have twice -- over twice the market share, and our win rates continue to be where they've always been. There's been a little drop-off in Blue Coat, but other than that, the competitive environment seems pretty similar. And your first question was?

Jerry M. Kennelly

Penetration.

Eric S. Wolford

The penetration of existing accounts, yes. I mean, we're -- it's still early days as evidenced by the sales that we described. We try to profile out those, where existing customers to where initiating the next phase of a broader rollout, and it was just the next phase of a multi-phased rollout to get to all of the users and all of the locations. So our base of customers represents a gold mine of opportunity for us, and we want to play close attention to them.

Jerry M. Kennelly

Although the biggest was a brand new customer.

Operator

Your next question comes from the line of Alex Kurtz with Sterne Agee.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

First, a point of clarification, Randy. What was the -- can you break out the percent of revenue across the 3 products again?

Randy S. Gottfried

Sure. So the percentage of revenue across the 3 products, we've got WAN optimization, which was 90%; network performance management at 7%, and our ADC product line at 3%.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Okay. And Jerry, just kind of pressure you again on the comment, the Juniper press release. You mentioned WAN optimization in the press release with Juniper today. So is the assumption that there will be a potential go-to-market relationship there for the core Steelhead product?

Jerry M. Kennelly

That's something to stay tuned for. I mean, it's -- what's announced is our cooperation in the mobile area with the Pulse product. In the core markets, that hasn't been a focus for Juniper, and we are discussing with them. But they have a big install base of customers that they want to take care of and are very sensitive about. So there's nothing to announce there yet.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

And just lastly, the elephant in the room, just one of your key partners, VMware acquires an emerging SDM player. So how does Riverbed fit into the SDM landscape? I know it's a broad question, but if you take a shot at it, that would be great.

Randy S. Gottfried

It's a great question. We love it. We think that it's the future of the data center, the software-defined data center, programmable infrastructure that is perfect for Riverbed, all 3 of our products have very discrete plays in that future world. Now, we are talking futures, right? So that world is not here today, but as it is conceived, Stingray has a fantastic role, Cascade has a fantastic role to provide visibility and analysis, and Steelhead also has a role. It will be more as software products, less as hardware products, but software-defined data centers are definitely appealing for us.

Operator

Your next question comes from the line of Ryan Hutchinson with Lazard Capital Markets.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Just a couple of follow-ups, I guess here. How much of the government revenue in Q2 were related to push-outs in Q1? And any sense on expectations with respect to sequential growth on nongovernment going into Q3 and Q4?

Randy S. Gottfried

I'll try to tackle that one. It's Randy. I'd say, it's always tricky. Yes, there were some transactions that closed in Q2 that we would hoped to have closed in Q1, but likewise, you always have a little bit of that at the end of the quarter. In general, I think the overall trajectory is good in government. We look at our enterprise business. That too, we think is faring well. As we look to the second half of the year, we actually have some tough comps in government, Q3. And so implicit in our guidance is actually healthy growth in the enterprise business as well. So both those important categories are big deal to us.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Okay. Just a follow-up, you would expect then that the enterprise piece should probably grow on a sequential basis stronger than the rate that we've seen in both Q1 and Q2?

Randy S. Gottfried

We don't give that level of granularity guidance, but I'm -- yes, we're looking for growth. We do not quantify that externally.

Operator

Your next question comes from the line of Brian Modoff with Deutsche Bank.

Your next question comes from the line of Hendi Susanto with Gabelli & Company.

Hendi Susanto - Gabelli & Company, Inc.

First of all, may I know how much order visibility you have going into Q3 relative to historical?

Jerry M. Kennelly

We have -- per ticket, we have fairly decent visibility. So we have a very detailed pipeline. We make a lot sales into our installed base. We have 1/3 of our revenue coming from repeating service contracts, and we have a pipeline that's as big as it's ever been in the history of the company. So it's never perfect. We do the best we can, but relative to log tech companies, we have relatively good visibility.

Randy S. Gottfried

The other thing I'll just add to that comment, we also tend to have a lot of new customers who go through an evaluation process. So we have people who have been working with us sometimes for multiple months that helps add to the visibility, especially when you just look out 90 days.

Hendi Susanto - Gabelli & Company, Inc.

Okay. And then my follow-up, how should we think of what contributes to the lower gross margin we are seeing, and what kind of gross margin expansion opportunity beyond this year?

Randy S. Gottfried

When I think about the margins, ultimately, we still aspire to get back to about a 30% rate at some point, that remains our target operating margin profile. We do think that there's another -- at least another percent to get out of gross margins. I think there is -- there is been some sort of a sustained increase in our costs with the drive prices. Given the dynamics in that industry, we're hopeful at some point to see moderated prices there, but we've not seen them yet. We also have an increasing proportion of our business that's software. Our virtual products have done well. Stingray, in general, has done well. Virtual Steelhead -- all these things, we're very optimistic on. So I think there's exactly some room to improve our gross margins, and ultimately, we'd like to get back to that 30% operating margin target.

Operator

Your next question comes from the line of Mark Sue with RBC Capital Markets.

Chris Cho - RBC Capital Markets, LLC, Research Division

This is Chris for Mark Sue. A quarter ago, the thought was that product revenues would reaccelerate in the second half. How do you feel about the composition of this product reacceleration now that we're another quarter end? Is it better CX, EX or Granite or Stingray that kind of drives that growth?

Jerry M. Kennelly

I think what we saw was -- we gave our guidance, as you know, for the third quarter. Growth is higher than it was, obviously, coming out of the first quarter of the year. We'll see, as the year progresses, I think we're very pleased by the pipeline. We like what we see as far as the transition from the older models to the newer models, which, we think, have sort of reached an inflection point as we exited the second quarter. We still have a nice product funnel coming in over the next few quarters as well. So we feel pretty good. We'll see as we're taking it quarter-on-quarter as far as the business goes, but everything we know is sort of baked into the guidance that we gave.

Operator

Your next question comes from the line of Catharine Trebnick with Northland Securities.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

Could you provide some more color around your traction with the Steelhead Cloud Accelerator, and where you are with that?

Eric S. Wolford

Yes, Catharine, this is Eric. Yes, we have a lot of -- as you know, the Steelhead Cloud Accelerator is our partnership relationship with Akamai where we put Riverbed Steelhead into Akamai's network and some Akamai on to Riverbed Steelhead. We have a very large pipeline that's growing. We have made some sales and have customers who have deployed. We're finding a lot of those customers have international locations where they're crossing the pond and perform the real problem. It is a subscription business, so as a result, all of the sales that are made are ratably recognized in a certain amount of dollars per user per month. So this is not a product license sale, it is a subscription sale. But in terms of -- if we're -- our take on it, we're very pleased with it. And we're very pleased with how it positions us in conversations with CIOs that we kind of future proof wherever they take their application, their own data center, third party data center to the cloud, wherever they take it, they're acceleration that they've invested in, they can leverage and take advantage of. So it's a really great part of the story.

Catharine Anne Trebnick - Northland Capital Markets, Research Division

So meaningful revenue perhaps 2013?

Eric S. Wolford

Yes. More 2013 story, but even then, it's still -- it is a subscription service, so it's not a perpetual license, which means that it spreads.

Operator

Your next question comes from the line of Amitabh Passi with UBS.

James F. Hillier - UBS Investment Bank, Research Division

This is actually Jim Hillier for Amitabh. I got a follow-up on the margin question, as you see some transition from appliance to software solutions, how should we think about the impact to your overall margin structure?

Jerry M. Kennelly

I think, in general, as people move to software, we'll see as we go along. I think in general, the appliance business, we think has a lot of legs left to it. We think that the software business still -- I think the good news about both business is they still have high operating margin potential. and we'll see. I think we're well prepared regardless of how the market turns, whether it'd be move more quickly to a virtualized approach, whether it moves more quickly to -- or it stays, more of a hybrid, which we think is the most likely sort of midterm scenario. And so we'll see. At the end of the day, we want to be prepared for any outcome. But overall, I think there's more margin to get out of this business in total, where our first priority is to reignite the growth in the business, and we think we have made those first steps, middle part of this year. And we'll have to play -- as we move forward, we'll watch it closely and try to move in the right direction.

Operator

And we have time for one more question. Your final question comes from the line of Matt Robison with Wunderlich.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

Can you comment about the book-to-bill ratio and the shift -- the mix between bandwidth savings and operational change? Can you talk a little bit about Granite?

Jerry M. Kennelly

We don't call it book-to-bill, but maybe Eric could talk about the bandwidth savings and...

Randy S. Gottfried

Granite.

Eric S. Wolford

Granite. Yes. So I mean, obviously, Granite will come with lots of bandwidth savings because most of the traffic is kept local on the land, and obviously, we use our de-duplication technology as incorporated into the Granite solution. So while storage is storage centrally, whatever is the working data set is kept locally and used over the land. So the bandwidth savings aspects of Granite are pretty extraordinary.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

Well, what I'm thinking about more is the longer sales cycle business, where you've got companies that are really changing the way they operate rather than the sort of plug-and-play approach to the bandwidth savings, I think, were some of your initial success as a company. How is the mix shift that targets the longer sales sort of pitch where you're enabling companies to really change the way operate?

Eric S. Wolford

Yes, yes. I understand that, yes. So it's a big focus for Riverbed because we think it's more appealing to customers and to us when people focus on consolidation and put this platform out there across all of their remote sites. This quarter, we did see an uptick in big deals, deals over $500,000. And so we've been focusing on moving up and selling that type of platform -- consolidation platform story, and we think that it's starting to work. Granite is a part of that story, but it's by no means, the sole part of that story. But it is an important part of the consolidation story, which is really front and center on our attack on the market.

Renee Lyall

Thank you, everyone, for joining us this afternoon. If you have any questions following the call today, please direct them to me. During the third quarter, Riverbed executives will present at the Oppenheimer and Pacific Crest conferences in August. Have a good evening.

Operator

Thank you. Ladies and gentlemen, this does conclude today's Riverbed Second Quarter 2012 Financial Results Conference Call. You may now disconnect.

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