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Executives

Kate Patterson - Investor Relations

Dudley W. Mendenhall - Chief Financial Officer, Senior Vice President

Douglas C. Wride - President

Gene Hodges - Chief Executive Officer, Director

Analysts

Analyst for Daniel Ives - Friedman, Billings, Ramsey

Samuel Wilson - JMP Securities

Katherine Egbert - Jefferies

Todd Raker - Deutsche Bank

Walter Pritchard - Cowen & Company

Bud Leedom - Global Hunter Securities

Philip Rueppel - Wachovia Securities

Steve Kim - Shamrock Capital Advisors

Sterling Auty - J.P. Morgan

Rob Owens - Pacific Crest Securities

Websense Inc. (WBSN) Q1 2008 Earnings Call May 1, 2008 5:00 PM ET

Operator

Good day, everyone, and welcome to the Websense first quarter 2008 earnings conference call. Today’s conference is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Ms. Kate Patterson. Please go ahead.

Kate Patterson

Thank you. Thank you all for joining us. Good afternoon. We are here to discuss our first quarter results. With me on the call today are Gene Hodges, Websense's CEO, and Dudley Mendenhall, our Chief Financial Officer. Doug Wride, our President, will be joining us from Beijing.

Before we begin a review of the financial results, let me remind you that during this conference call, management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties, and other factors that may cause the company’s actual results to be materially different from historical results, or any preliminary results expressed or implied during the call.

The potential risks and uncertainties which contribute to the uncertain nature of the statements include, among others, risks associated with integrated acquired businesses and launching new product offerings, customer acceptance of the company’s services, products, fee structures in a changing market, the success of the Websense brand development effort, the volatile and competitive nature of the Internet and security industries, changes in domestic and international market conditions, risks relating to the required use of cash for debt services, the risks of ongoing compliance to the covenants in the senior debt -- excuse me, senior credit facility, risks related to changes in accounting interpretations, and other risks and uncertainties described in Websense's public filings with the Securities and Exchange Commission.

The information in this call related to financial results, projections, and other forward-looking statements is based on current expectations and we expressly disclaim and responsibility to update forward-looking statements should circumstances change.

Our discussion also includes financial measures that are numerical measures that can’t be calculated in accordance with generally accepted accounting principles. The company believes the non-GAAP financial measures enhance investors’ ability to evaluate the company’s operating results and compare current operating results with historical operating results. For more information, please consult the press release that was issued this afternoon and which is also posted on the investor relations portion of the company’s website.

I will now turn the call over to Dudley Mendenhall, our Chief Financial Officer.

Dudley W. Mendenhall

Thank you, Kate. Let me start by walking you through some financial highlights for the first quarter and then we will move on to guidance for the remainder of 2008. First, in terms of billings, we had billings of $67.5 million, which were down about 10% compared to the combined billings of SurfControl and Websense in Q1 a year ago due to several factors.

First, a contraction in the average duration to 20.6 months; anticipated disynergies in the Surf customer base and a termination of certain non-strategic OEM partnerships and non-strategic products, as previously forecast. Customer retention overall, however, continues to be ahead of our expectations; a focus on existing customers as we completed the consolidation of the Websense and SurfControl field organizations relative to new business; and I would also like to point out that Q1 is our smallest quarter by a significant percentage and that it comes after our largest quarter, Q4.

Let me give you a little more color on each of these factors. On the contract length side, this factor had by far the largest impact on billings in the quarter as the average duration length shortened to 20.6 months from 23.4 months in Q4 and 23.4 months in Q1 a year ago. One-year contracts were 61% of total billings, the highest level since Q1 2004 when it was 62%.

We believe that the contraction was caused by several factors -- the blending of the SurfControl and Websense renewal customer bases in a lower billings quarter, as Surf has historically had shorter average contracts; the possibility that some customers shortened contract due to macroeconomic factors; and low promotional activity in the quarter could also have an impact on contract duration, but it is difficult for us to determine how much of the duration shortening in Q1 was attributable to lack of promotional activity versus macroeconomic factors.

Q1 saw the least aggressive promotional activity in recent memory of Websense. We simply were focusing on just keeping all of our customers. Despite the duration shortening and lower promotional activity, we did not see any increase in customer attrition, even in the financial services sector. Hence, even if there is a macro tightening, it is manifesting itself in our business as contract shortening, which means we’ll have more customers up for renewal in the first half of next year.

As we have analyzed the billings, we note that the number of three-year contracts without promotional discounts in prior quarters is roughly the same as in Q1. We have restored our promotional activities in Q2, focusing on new business and multiple product sales to motivate customers to buy more, even in slow economic times.

Another factor was disynergies in the customer base. We continue to retain more of the SurfControl customers than expected, but some attrition always occurs in the consolidation process, as we previously forecast. Renewals were flat year over year and retention rates held at historic levels due to our focus on customer retention. Further, it was also a difficult environment for new business development following our strong Q4.

The final factor is sales force integration -- in Q1, we combined and fully integrated our sales forces, which involved the assignment of new territories and sales quotas. We chose Q1 rather than Q4, which was the first quarter after the transaction closed, since Q1 is our smallest quarter and would result in the smallest potential disruption to our annual sales goals.

Now turning to revenue, non-GAAP revenue was $86.5 million prior to the Q1 impact of a non-cash write-down of SurfControl's deferred revenue. The impact of this write-down was approximately $20 million. We’ll continue to report on revenue prior to this purchase accounting adjustment to provide visibility to our normalized run-rate. The strong revenue performance was driven by several factors. First, with strong year-over-year growth in Q407 billings and the full quarter impact of those billings into revenue in Q1; secondly, the shorter contract duration, which resulted in a higher ratio of revenue recognized due to the shorter contract length.

As we mentioned in our press release, we expect non-GAAP revenue to decline each quarter on a sequential basis throughout the remainder of 2008 before it begins to increase again in the first half of 2009. This is primarily due to the termination of certain product lines and OEM agreements. For example, we sold CyberPatrol in a transaction that closed late in Q1.

Moving to operating expenses, with non-GAAP operating income of 32.1%, our Q1 non-GAAP operating model clearly demonstrated that we have successfully achieved the anticipated cost synergies of the acquisition.

Non-GAAP operating expenses of $58.7 million were below the Q4 expense of $62.4 million by $3.7 million. A significant portion of this decline was due to the lower sales and marketing expenses associated with the seasonal decline in billings, but the remainder was due to our successful cost rationalization efforts.

The Q1 decline in sales and marketing is one of the anomalies of a subscription-based model. Because we pay commission on billings in the quarter they are booked and Q1 shows a seasonal decline, sales and marketing expenses tend to be lower in Q1 than in Q4. Further, Q1 revenue benefits from full quarter impact of large Q4 billings from the prior year. The result is that Q1 tends to have the highest operating margin of the year.

I fully expect the Q1 operating margin percentage, which is well above our target range of 28% to 30%, to be the highest of the year. For the year, we still expect to finish in our target range but the quarterly margin will gradually decline over the remaining three quarters as we hold the line on expenses against modest sequential declines revenue.

Our non-GAAP revenue performance and improved operating margins allowed us to post strong non-GAAP earnings per share of $0.35 in the first quarter. Again, this is non-GAAP and excludes the negative impact of acquisition expenses, the deferred revenue write-down of stock-based compensation, and also excludes a non-recurring, non-cash positive impact of a favorable tax ruling by the State of California. Except $3.9 million of transitional items, all of the expenses just referred to in the acquisition related column are non-cash.

Turning to our cash flow and balance sheet, our GAAP cash flow from operations was approximately $19 million after cash out-flows of approximately $11 million associated with acquisition and transitional related items, and our legal settlement. This cash flow performance reflects our strong Q4 billings and excellent collection on our receivables. Our receivables declined from $76.3 million to $47 million, bringing DSOs down to 63 from 66 in the previous quarter.

The strength of our cash generation allowed us to make additional payments on our long-term debt totaling $30 million, and to resume our share repurchases. Recall that we made an early payment of $20 million at the end of December, bringing our total debt payments to $50 million in the last four months and reducing our outstanding debt from $210 million to $160 million.

During the quarter, we also repurchased approximately 264,000 shares worth of stock for a total of approximately $5 million. We ended the quarter with about $72 million in cash, providing us with ample liquidity to run the business and fund our future growth.

The early payment of debt principal allowed us to decrease the costs of our debt going forward by 25 basis points. We expect this pricing decrease, a lower interest rate environment -- combined with a lower interest rate environment and our lower debt balances will result in lower interest expense in Q2.

Turning to our forward guidance, we are reiterating our previous guidance ranges for billings, non-GAAP revenue, operating margin, and earnings per share of billings in the range of $345 million to $355 million; non-GAAP revenue in the range of $325 million to $335 million; non-GAAP operating margin in the range of 28% to 30%; and non-GAAP earnings per diluted share in the range of $1.15 to $1.25.

For billings, we are anticipating that while Q2 billings will show a strong sequential recovery from the seasonal low of Q1, on a year-over-year basis it will be down in percentage terms about the same as we experienced in Q1 from the combined billings of Websense and SurfControl in 2007.

The anticipated year-over-year decline for the quarter is due to all the factors we’ve previously outlined -- planned customer attrition, the discontinuation of products and OEM partnerships, and modest contract duration contraction.

However, as we turn to the second half of the year, we should begin to see a modest growth on a year-over-year basis in the low single digits in Q3 and acceleration in Q4. The improvement in the second half of the year reflects the growth synergies of the expanded customer base and additional products. Additionally, we will be introducing all the new products we outlined at the analyst day on April 9th, which should encourage renewals and upsell in Q4.

In terms of non-GAAP revenue, I want to remind you of our typical patterns and how those play out in a subscription model. Despite the fact that billings fluctuate quarterly based on normal seasonal patterns, revenue is recognized pro rata over the life of the contract, which has the effect of muting the seasonal fluctuations and billings. Therefore, a change in the growth rate of our billings takes several quarters to show up in the revenue growth line. This is why cash flow is so significant in measuring our performance.

Consequently, we continue to expect non-GAAP quarterly revenue to decline on a sequential basis and be within the range of $82 million to $85 million for each of the remaining quarters of 2008, with the decline being attributable to lower year over year billings in the first half.

As forecasted billings begin to grow year over year in the second half, this will drive non-GAAP revenue growth in 2009 due to the lag in revenue recognition in our subscription model.

In terms of non-GAAP expenses for the remainder of 2008, expenses are expected to remain relatively flat at the current run-rate, with increases in the second half in line with the forecasted growth in billings. However, despite this strict discipline over expenses, the sequential decline in revenue will result in a modest decrease in our operating margin over the remaining quarters, although we still expect to stay within our target ranges for Q2 and Q3.

In Q4, we again see the impact of the seasonality in billings on our subscription revenue model. Since we anticipate strong billings as growth accelerates and we pay commissions on billings in the current quarter, sales and marketing expense will rise in Q4, driving operating margin for the quarter below our target range. We will also be spending to promote and launch our new second half product introductions, and we have also traditionally geared up hiring in Q4 in anticipation of growth in the next year.

The net impact, however, is operating margin for the year comfortably within our 28% to 30% range, despite the fact that it may drop below our range in Q4.

A final note on cash flow -- we are still anticipating strong cash flow growth in 2008 compared to 2007, net of purchase accounting costs, severance, and restructuring costs, and CapEx should continue to run about $2.5 million to $3 million per quarter.

At this time, I will turn the call over to Doug.

Douglas C. Wride

Thanks, Dudley. Good morning from Beijing. To set your expectations, this will be the last quarter that we will provide an update on SurfControl acquisition cost synergies, as a cost-cutting and organizational phase is largely and very successfully completed. We might -- we have either reduced the costs or implemented the decisions that will produce the $60 million cost synergies we plan for 2008.

We are pleased with the results, which have been on plan and on time. In Q1, headcount was reduced by a further 150 people who had been part of the transitional team, bringing the total headcount reductions to 350 people and total headcount of the combined company to about 1,150 people overall.

There are only about 20 transitional employees remaining, largely in finance and IT positions in the U.K. and in the U.S., and their contracts will end by the end of the second quarter.

At the close of the acquisition in October, we added 13 SurfControl offices. Through Q1, we’ve closed eight offices with two more to close this quarter. Today the SurfControl U.S. and U.K. headquarter offices are virtually empty and available for sub-lease. We initiated the integration of the sales teams with new territories, quotas, and customer lists, as Dudley said. In April, we finished the implementation of salesforce.com company wide, which we think will make a difference in our ability to reach out to both the legacy SurfControl and Websense customer bases.

Since part of the strategic rationale for the acquisition was the ability to upsell and cross-sell a broader range of products, this consolidation of customer records into a robust CRM system is crucial. The sales integration will continue through the year. In fact, as of the end of April, our IT team has done a remarkable job at integrating our systems. Our communications systems worked on day one and they have successfully integrated the content of both websites, created a new partner portal for the combined partner base, developed an integrated order management system, integrated our accounting systems, and implemented salesforce.com. We recognize that there is still a lot of work to do but this team has completed a huge amount of work in a very short period of time.

While this is mostly behind the scenes, we all know that successful systems integration is a key factors in successful acquisitions. My hat is off to this entire team.

We’ve mapped out the support process with new combined support programs coming online this quarter. As is always true in an acquisition of this size in particular, there have been a few hiccups and support has not been spared here. But between the sales and support teams, we’ve worked diligently to iron out wrinkles and exceed expectations.

On the OEM front that Dudley mentioned, at the end of Q1 we sold CyberPatrol, SurfControl's consumer filtering product, to a group of former executives from Pest Patrol. The financial details were not disclosed but they were not material to our results. And we are winding down or renegotiating a number of OEM agreement. SurfControl had more than 65 separate OEM agreements, only a handful of which were strategic. While we intend to retain a handful of strategic relationships, the majority will not be renewed. As Dudley mentioned, the revenues from these agreements will roll off during the following three quarters.

With the heavy lifting of cost-cutting and organizational phases of the integration completed, we are now focusing on the growth phase and spending more time with partners. I am personally spending more of my time working with our VARs and distribution partners worldwide supporting the efforts of Jeff Haggert and David Roberts as we continue to expand and refine our programs. I am in China now on my way to our Asia-Pacific partner conference the week after next.

As a part of this focus on growth, we’ve taken a number of steps to promote cross-selling opportunities and offer attractive margin opportunities for all of our partners. During the quarter, we revamped our partner programs to incorporate the best of both programs. SurfControl partners benefit from deal registration, a more lucrative margin framework, renewal protection and rebate programs, and our commitment to a 100% channel distribution model.

I am pleased to report that we have had very little attrition in the partner base and to date, the majority of SurfControl partners have migrated over to our new program.

We are also devoting resources to improving our productivity in the SMB market with automated tools. This will be a huge improvement in Q1 -- I’m sorry, this will be a huge improvement. In Q1, our inexperience with the SurfControl order processing system and running two separate order processing systems resulted in our sales reps spending an inordinate amount of time just getting orders through the systems.

Everyone in sales and accounting involved with these processes in Q1 got the business done through brute force and long hours. This will improve incrementally throughout the year as we roll out integrated systems and automated tools.

Finally, we remain focused on our migration and upgrade programs for SurfControl customers. Not only could this provide billings uplift but it creates the foundation for future upgrades of Websense products, such as the new V7 releases due for general availability this fall.

While this new emphasis will mean more time on the road for me, I am excited to once again get out in the field on a regular basis. I am looking forward to updating you on our programs on these quarterly calls.

With that, since it is very early here in China and I just arrived after about 22 hours door to door, I will turn the call over to Gene. Thanks.

Gene Hodges

Thanks, Doug. As those of you who attended our analyst day and the RSA show saw, this is a very exciting time for Websense. The pieces of our new strategy are finally all coming together.

Two years ago, we saw that the nature of the corporate security threat was changing and if you don’t anticipate these changes in this business, you usually wake up with few options and little time left to execute them.

Websense has made the acquisitions and the organic investments needed to respond to the changing threat. Although these investments were challenging and have resulted in lots of moving parts over the last two years, we have managed our way through those challenges. Coming out the other side of this transition period, I believe Websense is well-positioned to be a major player in the next generation of security. That next generation of security is all about protecting data. We call our strategy to address these new data-centric threats essential information protection.

Data loss prevention and the insider threat against data is one important aspect of this strategy but in a change even more important to Websense's future revenue stream, the outsider threat has also shifted and now predominantly comes from the web. This outsider threat doesn’t just come from back alleys of the Internet anymore. In today’s web 2.0 world, a corporation’s data is exposed to attack from browsing legitimate top 100 class websites. Protecting against these new threats requires the ability to identify malware and proprietary corporate information in real time, as well as a huge database that maps the webscape and allows accurate identification of blended e-mail and web threats.

We believe that Websense is the leader in all of these technologies.

To many buyers, our URL filtering product line was a nice-to-have. Our solution helped enforce compliance with HR oriented regulations and protected the workers from those who didn’t seem to have the sense to stay off porn sites. Often, just good enough low price solutions were sufficient to satisfy this nice-to-have need. But data security is becoming a must-have. As a result, protection from the insider threat, the web 2.0 based outsider threat, and the new generation of blended e-mail/web-based attacks are all high in surveys of future corporate buying intent.

We also believe buyers are looking more closely at best-of-breed technologies to address the web 2.0 threat. Good enough solutions that might have been under consideration in the days of nice-to-have filtering will increasingly not be good enough.

Websense's expanded product lines protects against all these threats and we have differentiating technology in each area. We see no other competitor with this combination of technology assets.

Our customers are starting to understand the changes in threat profile driven by web 2.0 technologies, and this is sparking interest in web security just as we’ve emerged as the leader in this segment and are at the start of a major new product cycle to serve this need.

Our new large competitors are also seeing this change and you see them doing acquisitions to broaden their product offerings to offer more data security products, including critical protection from web 2.0 threats and data loss prevention. But only Websense has all these products now.

Our challenge now turns to learning how to sell these new products effectively around the world. Building these multi-product sales skills will come slowly but we are confident that we will deliver to meet this year’s guidance and go into next year as a growing company with increasing margins. In Q1, we maintained our expanded customer base while aggressively cutting costs. Although we have a few more quarters to go before a well-oiled machine, we are integrated and successfully starting to focus on our expanded strategy.

In Q1, we sold $1.4 million of data loss prevention, 40% up from Q1 of last year. We sold about $5 million of on-demand e-mail and web services, roughly flat with SurfControl's performance last year. We believe this was a strong performance, given we drained the pipeline in this segment for the last three quarters. We also sold about $1.5 million of migration upgrades to move our SurfControl customers to the Websense product line in Q1.

Q2 is the first quarter in the last six quarters where our management team’s attention is not heavily burdened with either the planning or the execution of an acquisition. Without these distractions, we can focus more intensely on the challenge of selling our new data-centric security product line.

We are seeing some early signs of progress. As we’ve shared before, we had sparks of success with our new product lines in previous quarters but the sales successes for each product line were confined to specific geographic regions who had figured out the selling formula. The two most important examples are data loss prevention, where the western region of the U.S. and our sales team in Israel contributed 80% of our DLP billings and on-demand e-mail and web security, where 80% of the billings came out of the U.K. and Australian operations, with almost no contribution from the U.S.

Slowly but surely, our sales teams are teaching each other new tricks. The pipelines are growing rapidly in the regions where we weren’t being successful before. We are not sure how much of this business we’ll get in Q2 but even in learning mode, we believe we will generate significant new business in these product lines over the course of the year.

Generating new business in small and medium business segments remains a challenge, but we’ll have many new tools to apply in the second quarter. Our SMB teams faced a tremendous challenge in Q1 as the transaction volume spiked over Websense Q1 2007 run-rate with only modest increases in sales manpower. Simply put, we stayed focused on the renewals.

This quarter we’ve gotten web and e-mail products bundled with promotional programs to compete more effectively against Barracuda, Trend Micro, and our other new competitors in the SMB segment. We are also going to be more price aggressive in this segment with these bundles.

In the second half of the year, our sales teams will have a tailwind from our V7 product launch in our Heartland web security product line as well as our DLP and e-mail security product lines. This quarter, the first copies of our V7 Websense security gateway and data loss prevention gateway and DLP end-point client all go into customer hands in limited release. These products will be available for general release in Q3.

We estimate we’ll charge over 20% more at street price for the Websense security gateway solution and believe we can generate significant upgrade interest with this product. We’ll be selling this upgrade to our entire install base, not just those up for renewal, as this technology is strong enough, we believe, to warrant consideration of increased investment.

These new products, coupled with a bulge in renewals from expiring 2005 three-year contracts and a greatly expanded international sales team gives many new opportunities for us in the second half in spite of a weak economy. Net, Websense is at the start of the most important new product cycle in our history. The last time we had such a positive lift from new products was the release of Websense enterprise 5.0 in early 2003. This time, w have many additional products to sell in addition to web security.

As I walked the floor of RSA, it was clear that the industry is following Websense. There were at least 10 companies that had caught on to the new criticality of web security given web 2.0 threats. They all had signs up claiming they were the leader in web security. But objective data shows that there is only one leader in web security and that leader is Websense.

After two years of moving parts, it is exciting to have all the pieces together and our focus squarely on execution. It is exciting to see that the market has evolved as we had expected. Given our strong, data-centric security offerings, I believe that Websense is at the right place with the right solutions, positioned to be a global multi-product line leader in the future.

And now, I would like to turn the call over to the operator so we can answer your questions.

Kate Patterson

Thank you. Operator, we’d like to poll for questions, please.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Daniel Ives with Friedman, Billings.

Analyst for Daniel Ives - Friedman, Billings, Ramsey

This is actually Michael for Daniel. Thanks for the color before on the duration but can you just give a little bit more information on what was the major cause and if the macro economy being an issue from talking to customers out in the field, what gives you confidence that the duration is going to pick up again? Thanks.

Gene Hodges

We’re not sure. As we delve into the billings data, the clearest analytical indication is that our lack of promotional activity did have an impact on shortened duration and we get to that conclusion by looking at the number of three-year contracts that were shown or that were sold without the aid of promotional activity in prior quarters. That number was about the same as it was in Q1, so one can draw the conclusion that the incremental amount of three-year contracts in prior quarters was the effect of promotional activity that we did not have in place in Q1.

That being said, obviously the economy is not as healthy as we would all like and when you see a shortening like that, it well could be macroeconomic. Our guidance does assume that we will see some lengthening in Q2 and returning to the 23-plus month type duration that we’ve had in the past. But I would characterize that as something that’s very hard for us to be accurate on.

Analyst for Daniel Ives - Friedman, Billings, Ramsey

Great, thanks a lot.

Operator

We’ll take our next question from Samuel Wilson with JMP Securities.

Samuel Wilson - JMP Securities

Good afternoon. Just two small questions; first, Dudley, just CapEx for the quarter and sort of expectations, maybe rough CapEx level for the next couple of quarters? And Gene, you mentioned Barracuda and it sounds like Trend has been a longtime competitor. Are you seeing some emerging competitors, any change in the competitive environment out there? Or is it just sort of the same old same old? Thank you.

Dudley W. Mendenhall

CapEx was approximately $2.5 million in the quarter and that’s a good run-rate for you to use the remainder of the year.

Samuel Wilson - JMP Securities

Thank you.

Gene Hodges

With regard to the competitive landscape, Barracuda and Trend Micro are fairly new competitors for Websense, but that’s because we have not been selling head-on a combined e-mail and web filtering solution. We do believe that that was a drag on our SMB sales as the SMB market, and now I’m really focusing on the segments, that sub-250 employees, does have a penchant for integrated solutions that is manifest in web and e-mail solutions and in broader small UTMs, such as the --

Samuel Wilson - JMP Securities

Thank you.

Operator

We’ll here next from Katherine Egbert with Jefferies.

Katherine Egbert - Jefferies

Good afternoon. Just a couple of questions for Doug; Doug, did you say specifically when you are going to merge the order management systems with SurfControl and Websense?

Douglas C. Wride

I didn’t, Katherine. The order management systems begin to be merged this quarter. We will continue to roll out automated tools like quote tools and so on. I think we will be improving our abilities throughout this year but the big rollouts happen here in Q2.

Katherine Egbert - Jefferies

Okay, thanks. And then can someone comment so far what you are seeing as we sit here on May 1st, how is April for you? Thanks.

Gene Hodges

We’d rather not discuss Q2 until our July call.

Katherine Egbert - Jefferies

Okay. I can only try. Thanks, good job.

Operator

We’ll hear next from Todd Raker with Deutsche Bank.

Todd Raker - Deutsche Bank

As we move into this new phase here where cross-sell becomes a bigger driver of the revenue stream, how should we be thinking about in terms of guidance in how cross-sell and up-sell is baked into the billings expectation there?

Gene Hodges

Well, obviously we base our guidance on fairly detailed models where we have taken into account disynergies in the Surf base, cross-sell into the Websense base, new business selling of on-demand and DLP services predominantly into the combined base. We are not in our internal guidance forecasting that we will generate much new business in DLP or ODS out of our installed base, and we will generate most of our new filtering business obviously outside the U.S. But all of those are factors that we have taken into account already in our guidance and we have assumed, as I think you have seen borne out in fact as other companies make this transition, that it is a long, slow process to get good at this.

Todd Raker - Deutsche Bank

And if I think longer term in terms of what the potential drivers are around billings, how should I think about as you kind of annualize the SurfControl acquisition, the ability to take price points up in the installed base and the potential impact on the growth profile going forward?

Gene Hodges

You know, it’s pretty hard for us to call the growth rate in web security as we look out. There are indications that the market is getting a second wind, if you will, from these web 2.0 threats, but buyer interest broadly around the world is at early stages. You saw it all over the place at RSA but it is important to remember that RSA is a bunch of vendors and west coast leading edge security practitioners and that’s not the center of the market, that’s the leading edge. But clearly the leading edge is awake and starting to respond to that set of threats.

The DLP market seems to be remaining strong. We are not seeing recessionary impact. The FAAS or on-demand market has more competitors than you would ever want to count but demand is, if anything, shifting from on-premise or software solutions in that direction.

So the demand signals are all relatively positive.

Todd Raker - Deutsche Bank

Okay. Thanks, guys.

Operator

We’ll take our next question from Walter Pritchard with Cowen.

Walter Pritchard - Cowen & Company

Dudley, in the past, maybe before you arrived at the company, in some quarters you had early renewal activity that would impact the business and I’m just wondering as you look back over the last couple of quarters, there has been quite a bit of volatility in the billings number. I’m just wondering, has there been any significant early renewal impact as a result of all the change to the customers, and especially bringing in the SurfControl base over the last couple of quarters?

Gene Hodges

Q4 was fairly aggressive on earlys. Q1 was probably the least aggressive we’ve seen in a long time. As we mentioned, we didn’t have any promotional activity that would move a customer to go to longer contract lengths or bring their order in a month. So we had our horns pulled in pretty far in Q1.

Walter Pritchard - Cowen & Company

Got it, and then Gene, just as it relates to the DLP opportunity and your strategy there, it seems as though you are going up against other guys with solutions in that space that all have an endpoint encryption product, which it seems like it’s been a pretty hot space over the last year. I’m just wondering, how do you either execute around or compensate for not having that piece of the puzzle, at least today as we go to market with your initial broader strategies?

Gene Hodges

We have developed our endpoint client with a series of open APIs and have a few strategic encryption partners who we’ll be working with. We do not intend to make an acquisition in this area but we see good partners for both encryption and for security patch management, as well as highly granular port control that we will be working with closely to have tightly integrated solutions.

So we will have ability to deliver the technology but we do not plan to acquire in any of those areas.

Walter Pritchard - Cowen & Company

And are those end point encryption guys companies that are already owned by bigger companies or are there enough independents out there that aren’t owned by the Mcaffees and Symantecs of the world in terms of --

Gene Hodges

Luckily, there are still a couple of very well-known, very well-established players who haven’t been snapped up.

Walter Pritchard - Cowen & Company

Great, thanks a lot, guys.

Douglas C. Wride

This is Doug. Just on the earlys, I just wanted to point out as far as early renewals, Q4 always has the phenomena of early renewals when you get a budget flush component, and certainly we saw that last quarter, or in Q4. Also, you get somebody who years ago budgeted for a Q4 renewal, even though their subscription didn’t expire until Q1 because they were anticipating the price changes back in early 2000. So we are still seeing the impact of that.

Walter Pritchard - Cowen & Company

But Doug, is it safe to characterize it -- you saw a big more of that or is it -- was it sort of business as usual in terms of Q4 of ’07?

Gene Hodges

Q4 was pretty aggressive and Q1 was very light, historically.

Douglas C. Wride

Correct.

Walter Pritchard - Cowen & Company

Okay, great. Thanks a lot.

Operator

We’ll take our next question from Bud Leedom with Global Hunter Securities.

Bud Leedom - Global Hunter Securities

Just a couple of questions here; first off, I was just wondering if you might be able to provide a little bit of detail on the promotional activities you are planning for Q2 and what impact, if any, that might have on ASPs and obviously corresponding margins?

Gene Hodges

Sure. We’ll be most aggressive in SMB with our bundled e-mail and web solutions. We do have some fairly aggressive promotional pricing for on-demand e-mail in the United States, where we have virtually no market position and want to win some customers. We’ll be offering promotions in some sections of the SMB filtering market to compete against the small guys -- those are the major areas. We don’t expect these will have any cannibalization impact. Q1 was marked for us in the fact that we were just scrambling so hard to handle the renewal orders that we did not go out and try to really get that new business -- didn’t have time to.

Bud Leedom - Global Hunter Securities

Okay, and pardon me if I missed it -- did you, and I know it would be a small number but did you provide any revenue on DLP for the quarter in Q1?

Gene Hodges

I actually don’t know what the revenue is. It is pro rata like the rest of our product line but I haven’t looked at a DLP revenue number. But the billings, which I think is what you guys have been tracking, were $1.4 million, up about 40% and the market demand does look strong for the rest of the year.

Bud Leedom - Global Hunter Securities

Okay. And Dudley, finally, do you have a D&A figure for the quarter?

Dudley W. Mendenhall

Yeah, our depreciation and amortization is running about $2.8 million to $3 million.

Bud Leedom - Global Hunter Securities

Okay, and you expect that to continue for the full year?

Dudley W. Mendenhall

Yes.

Bud Leedom - Global Hunter Securities

Great. Thanks very much.

Operator

We’ll take our next question from Philip Rueppel with Wachovia Securities.

Philip Rueppel - Wachovia Securities

Thanks. You’ve given us some idea of how over the course of 2008 revenue and billings will change give the acquisition and the rolling through of that. When you look at total seats under contract, how is that -- how do you expect that to play out? And can you give us a little idea sort of what were the factors or what was the importance of factors that caused it to be flat, or relatively flat sequentially? Was it more the disynergies of SurfControl? Was it more the focus on the installed base renewals -- how should we think about that going forward?

Dudley W. Mendenhall

Well, you asked several questions there, so I will attempt to address them but let me know which ones I may have missed.

The math under our contract subscription model is such that if you have a few quarters that are flat or down year over year, your revenue will gradually come down in the next three or four quarters after that, and so we are sequentially looking at revenue coming down, staying in the 85 to 82 range for the second and third quarters, and then beginning to bottom in the fourth quarter. And so really just a function of the roll-off that will occur in the first and second quarter with lower year-over-year billings.

I am not sure, was there more in that question?

Philip Rueppel - Wachovia Securities

Yeah, more of the question was how should we think about the driver of that, the seats under contract going forward? Do you expect a rebound there or are a number of those seats rolling off because of the SurfControl disynergies, you know, some of their customers falling off and when do you see that number starting to grow again, shortly or is that something that takes a while going forward?

Gene Hodges

We should see that number start to flatten out in Q3 and grow in the second half with obviously Q4 hopefully being a big step up.

Philip Rueppel - Wachovia Securities

Okay, great. That’s helpful. Thanks very much.

Operator

We’ll take our next question from Steve Kim with Shamrock.

Steve Kim - Shamrock Capital Advisors

You guys mentioned that the mix of one-year contracts jumped to 61%. I just quickly wanted to ask what it was like for two-year contracts?

Dudley W. Mendenhall

Two-year contracts is a very small percentage and it didn’t move much.

Steve Kim - Shamrock Capital Advisors

So it’s in line with historical numbers?

Dudley W. Mendenhall

Correct -- about 5% to 7% is where two-year has been historically.

Steve Kim - Shamrock Capital Advisors

Okay, thanks.

Operator

We’ll take our next question from Sterling Auty with J.P. Morgan.

Sterling Auty - J.P. Morgan

I apologize, I’m bouncing between calls so if you covered this, I do apologize but first on the cash flow, the $11 million for the legal and litigation, could you give us color on what the split was -- how much was the litigation settlement? What was that for and how much was the legal fees?

Dudley W. Mendenhall

The litigation was a labor issue that has been well-detailed in our 10-K footnotes. You can get a lot of detail there. That was about $3 million. The remainder was associated with severance facilities, duplicate systems insurance, et cetera that are items that will go away one the integration is complete.

Sterling Auty - J.P. Morgan

Okay, and then my next question is if I remember at the analyst day, it sounds like you are still not completely done with the final headcount on the integration, and what I’m wondering is how much benefit is left at the operating expense line from any remaining cuts in inefficiencies there?

Dudley W. Mendenhall

Well, I’ll talk about the math and then Gene and Doug can talk about color -- again, through the pro forma approach, we have attempted to show you what is the run-rate going forward here, so that has been the whole attempt there. And as I said earlier, and I recognize you may have missed part of this, we expect our core fixed expense to stay relatively flat this year with modest growth in the second half of the year, mostly associated with sales and marketing as billings pick up.

Gene Hodges

As Doug mentioned, we only have about 20 transitional employees still on the payroll and almost all of them, if not all, will be gone at the end of Q2 so there isn’t an awful lot of headcount synergy that we haven’t already claimed and we are above our targets in that area. That happens because you lose a couple of people you’d like to keep. In the second half of the year, you’ll see the headcount start to climb. A good portion of that being in Beijing, where Doug is right now, as we ramp up the support and engineering organizations there.

Douglas C. Wride

And I would just throw in my two cents, Sterling, that at the beginning of my comments, as I mentioned, we’re not going to continue to address going forward the acquisition cost synergies just because we are there. If you take those 20 people that are remaining, they already have dates. We can analyze that. We know where that ends. We basically vacated the facilities that we intended to do and all the related human personnel costs are already accomplished, so we’ve either got it or we can see it and we’ve booked it, so there’s not a lot that’s at risk, if you will, in those cost synergies doing forward.

Gene Hodges

Sterling, about the only upside from here is if we can sublease those ex Surf headquarters building in Scotts Valley and in suburban Manchester in the U.K., so if you have any buddies who are looking for office space, have them call us.

Sterling Auty - J.P. Morgan

You know, the Scotts Valley thing, between you and [inaudible], you might as well just turn the things into condos and maybe get better luck.

Gene Hodges

I think you are probably right.

Douglas C. Wride

We’d be happy to sell those to you, Sterling.

Sterling Auty - J.P. Morgan

Last question, you talked about some of the marketing programs for the second quarter -- what do you think the impact might be on the duration? Do you think we are going to continue to see because of the macro economy the very high one-year contracts in the mix? Or do you think we will start to revert to the mean, at least a little bit?

Gene Hodges

Our assumptions are that we will get partway back to typical durations. In other words, we are assuming that part of the kind of neck-snapping shortening in Q1 was macro and some of it was lack of promotional activity. We’ll eliminate that latter segment and hopefully contracts will go back towards the 23-plus area over the course of the year. We’d be real surprised if they went higher.

Douglas C. Wride

And I would just add to that, you know, this reminds me a lot of 2001, 2002 where early in the year you have budget concerns internally within a company about what is going to happen to my budget in a tough macroeconomic environment and should I be going three years when I may need to save some of that money as I get deeper in the year.

Sterling Auty - J.P. Morgan

All right. Thank you.

Operator

(Operator Instructions) We’ll hear next from Rob Owens with Pacific Crest Securities.

Rob Owens - Pacific Crest Securities

Thank you. Good afternoon, everyone. Could you address the sequential decline in average annualized contract price quarter over quarter, especially given there was less promotional activity in the quarter?

Dudley W. Mendenhall

I think it was really driven by a couple of things. One is the mix of the Surf customer base, which is much more SMB focused than Websense has been in the past. That was probably the largest driver. And then secondly was the shortening of the duration, of the contract duration.

Rob Owens - Pacific Crest Securities

Will the duration matter? Because I thought it was annualized.

Gene Hodges

On the annualized component, it doesn’t but Rob, to be explicit, we did not see decay in ASPs at any size level except in that sub-250 range.

Rob Owens - Pacific Crest Securities

Okay, so the takeaway then is that the Surf base made up a larger percentage of the billings say in Q1 than they did in Q4?

Gene Hodges

I believe that’s correct, yes.

Dudley W. Mendenhall

And particularly in the SMB segment.

Rob Owens - Pacific Crest Securities

Okay, great and then can you give me the linearity of the quarter? How much was back-end weighted?

Gene Hodges

We’re having some pretty spectacular last weeks, so it’s -- you know, if anything, loading is moving a bit more to the end of the quarter. Some of that was probably self-inflicted because we merged the sales organizations. We didn’t see unusual jockeying among corporate procurement departments but they are pretty good at putting a gun to your head.

Rob Owens - Pacific Crest Securities

Great. Thank you.

Operator

(Operator Instructions) And it appears we have no further questions from the phone audience at this time.

Kate Patterson

All right. Thank you very much. We’ll be available for follow-on calls.

Operator

And that does conclude today’s conference call. We’d like to thank you all for your participation. Have a great day.

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Source: Websense Q1 2008 Earnings Call Transcript
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