SonicWALL, Inc. Q1 2008 Earnings Call Transcript

May. 9.08 | About: Sonic WALL (SNWL)

SonicWALL, Inc. (SNWL) Q1 2008 Earnings Call April 29, 2008 5:00 PM ET

Executives

Kelly Blough - Investor Relations

Matt Medeiros - President and Chief Executive Officer

Rob Selvi - Chief Financial Officer

Analyst

Sterling Auty - JP Morgan

Robert Breza - RBC Capital Markets

Joel Fishbein - Lazard

Scott Zeller - Needham & Company

Vik Churamani - Lehman Brothers

Rob Owens - Pacific Crest

Operator

Good day, everyone. Thanks for holding and welcome to the SonicWALL First Quarter Earnings Conference Call. Just a quick note that today’s conference is being recorded, and at this time, I’d like to turn things over to Kelly Blough; please go ahead.

Kelly Blough - Investor Relations

Thank you, Kevin. Welcome to our First Quarter 2008 Earnings Conference Call. With us today are Matt Medeiros, President and CEO of SonicWALL, and Rob Selvi, CFO.

Before we begin, I’d like to remind everyone that during this conference call, we will be making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include, without limitation, revenue guidance for the second quarter of 2008, our expected GAAP and non-GAAP earnings per share for the second quarter of 2008, expected gross margin for the second quarter of 2008, our plan to decrease cost and increase efficiency across our business, benefits associated with in sourcing our support organization, anticipated receipt of FIPS and common criteria certification and the benefits associated with those certification, efforts associated with increased operating efficiencies, benefits associated with our strategic direction, benefits associated with our new NSA product family and actions designed to address the economic situation in North America.

All forward-looking statements made on this call are subject to risks, uncertainties, and assumptions that could cause actual results or events to differ materially from those contained in the forward-looking statements. For a detailed description of the risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward-looking statements as well as the risks related to our business in general, we refer you to the periodic reports that the company has filed from time to time with the SEC, including discussion in the ‘Risk Factors’ section of the company’s Annual Report on Form 10-K for the year ended December 31st, 2007. The company undertakes no obligation to update forward-looking statements at any time or for any reason.

In addition, the following information includes non-GAAP results, which exclude amortization of purchased technology in the cost of goods sold, amortization of intangible assets and operating expenses, restructuring charges and stock-based compensation expense. Please see our website and our Form 8-K filed with the SEC earlier today for reconciliation of non-GAAP and GAAP results.

I’ll now turn the call over to Matt Medeiros.

Matt Medeiros - President and Chief Executive Officer

Thank you, Kelly. Good afternoon and thank you for joining us. Earlier today, we announced first quarter revenue of 55 million, pro forma earnings per share were $0.05 and GAAP earnings per share were break-even.

I will start with comments about the quarter before handing it over to Rob, who will review the financials in detail. We had a positive start to 2008 and we are pleased with our performance against several important metrics. Year-over-year, SonicWALL revenue outpaced the market, growing 23% driven by continued strong performance in license and services. License and services grew 41% year-over-year, 10% sequentially to 32 million, representing 57% of revenue for the quarter.

Gross margin improved in the first quarter to 71.5% and despite the operating expense burden associated with the typical first quarter including cost related to payroll taxes, employer contributions and sales training and events, we were able to achieve upside in our operating margin performance.

There were some challenges in the quarter as well. For the last two quarters, we’ve seen softness in terms of demand in North America; small business starts have decelerated and partners in North America’s small business market are indicating to us that product inventories across all vendors is moving more slowly. We are pleased to report in spite of this environment we’ve been able to increase our market share. Infonetics reported for the fourth quarter, their most current data, that SonicWALL holds the #1 market share position in our entry level UTM product line.

The challenges that SonicWALL experienced in the first quarter were primarily related to the economic softness in North America. North America revenue was up 15% year-over-year, but down 4% sequentially. In North America, we experienced sequential declines in unit shipments, which resulted in lower product revenue and lower subscription services billings in the quarter. Product revenue grew 5% year-over-year and declined by 13% sequentially.

Unit shipments worldwide were 49,000. Despite lower subscription services billings, we were able to show growth in deferred revenue though at a slower rate than in previous quarters. All of this, in addition to some one time items that Rob will describe, led to lower cash flow from operations. At the end of this call, I will describe actions we are taking in North America to address these challenges.

As we told you in February, we are focused on four strategic objectives. First, international growth. Second, subscription services growth. Third, developing and introducing new and innovative products. And fourth, scaling the business to achieve greater efficiencies and profitability.

I’d like now to provide you an update on our progress in the first quarter against these four important objectives. First, we made healthy progress in our Q1 against the goal of international growth. In the first quarter, revenue from outside of North America grew 39% year-over-year and 5% sequentially. The EMEA region started 2008 by growing 34% year-over-year. Our enterprise products on the whole performed particularly well throughout EMEA, highlighted by a contract with a very large financial institution in the UK for our E-Class SSL VPN solutions.

The APAC region also showed strong performance year-over-year with 32% growth, underscored by successful E-Class placements including Hong Kong, China Travel Services and the National Museum of Japan. We are pleased to report that SonicWALL’s Aventail EX-2500 was named Product of the Year by China Computer World Magazine.

Leading our geographic growth in the quarter was Central and Latin America region, which grew 205% year-over-year. SonicWALL is emerging as a market leader in Latin America. Frost & Sullivan recently awarded SonicWALL the Latin American Best Practices Award for Market Leadership and Market Penetration.

This brings me to our second key objective, growing the subscription services business. In the first quarter, our subscription services revenue grew 42% year-over-year and it was up slightly on a sequential basis. This had an offsetting effect on the weakness that we experienced in North America product sales. As I mentioned previously, subscription services billings were down due to declines in unit shipments in North America.

During the first quarter, we also took an important step towards the third strategic objective of innovation with the release of three new NSA products, the NSA 3500, 4500 and 5000, all of which are based on our multi-core processor architecture. The launch was very well received by our partners and end customers. We were also pleased to earn a very positive product review earlier this month on our NSA E-Class 7500 by Network World. In this review, Joel Snyder independently validated our claim that SonicWALL offers the fastest enterprise UTM device on the market today.

And finally, on our fourth objective, SonicWALL has a long-term plan to decrease cost and increase efficiencies across our business. I am pleased to report that in spite of our business circumstances in North America we were able in the first quarter to make progress against this goal as evidenced by our ability to overachieve, albeit slightly, on our earnings guidance.

We have indicated previously that our expenses would be front-end loaded this year in part because of duplication of expenses associated with the move of our inside sales team from Sunnyvale to Tempe and the buildup of our internal support personnel versus using a third party.

During the quarter, we made strong progress against this initiative, opening and staffing the new sales and support center in Tempe and consolidating SonicWALL and Aventail staffing into a single facility in Bangalore, India. Both of these moves are expected to yield significant cost efficiencies for the company. Now, let me hand it over to Rob to review our financial results.

Robert Selvi - Chief Financial Officer

Okay, thanks, Matt. Good afternoon, everyone, before we begin I want to point that we announced at our analyst event in February that we would be modifying some of the metrics that we provide in order to give a more complete picture of our operating performance. The new metrics include total revenue by product category, product revenue by price band, subscription billings and subscription deferred revenue. So today, we will be providing data against those metrics.

In the first quarter of 2008, SonicWALL generated 55.3 million in revenue, in line with our guidance range of 54 to 56 million. As a percent of total revenue, UTM Solutions contributed 75%, Secure Content Management Solutions contributed 11%, SSL VPN Solutions contributed 10% and CDP Solutions contributed 4%.

Total revenue units shipped in the quarter were 49,000. Product revenue was 23.7 million, decreasing 13% sequentially and increasing 5% over the same period last year. The sequential decline in product revenue was primarily the result of a reduction in unit sales of our low and mid-range UTM and CDP products, offset by an increase in unit sales of our newly release NSA UTM products. The year-over-year increase in product revenue resulted primarily from sales of SSL VPN products that were not available in the year earlier period.

As a percent of product revenue, 63% was generated from products with average selling prices below $1,500, 25% was generated from products with average selling prices of 1,500 to $5,000 and 12% was generated from products with average selling of above $5,000.

License and services revenue of $31.6 million increased 10% sequentially and 41% over the same period last year. The sequential and year-over-year increase in license and services revenue was the result of increased sales of comprehensive gateway security, technical support and email security subscription services. License revenue represented 10.6% of total license and services revenue during the quarter. That’s compared to 11% in the prior quarter and 12.9% in the same period last year.

Total subscription services billings were $31.9 million, down 1% from the prior quarter and up 30% over the same period last year. Multiyear subscriptions accounted for approximately 24% of subscription service billings in the first quarter.

On a percentage basis, North America represented 65% and international represented 35% of total revenue. Europe, the Middle East and Africa contributed 22%; Asia Pacific and Japan contributed 10%; and the remainder was contributed from other regions of the world.

Non-GAAP gross margin was 71.5% compared to 70.6% in the fourth quarter. The expansion in gross margin was primarily related to product mix as hardware contributed a lower proportion of revenue in the quarter. Discounting levels in the quarter were somewhat improved from levels in the prior quarter as well.

Non-GAAP operating expenses were $37.1 million in the first quarter, up approximately 2% from the prior quarter. The increase in operating expenses reflect increases in payroll, payroll taxes, employer contributions and sales events and meetings, partially offset by reductions in variable selling costs and operating expense controls in other areas. In terms of non-GAAP results, total operating expenses represented approximately 67% of revenue for the quarter. Operating expenses for research and development represented 19.4% of revenue. Sales and marketing expenses represented 39.6% of revenue, and general and administrative expenses represented 8.1% of revenue.

At the end of the first quarter, total regular employee head count was 720 compared to 674 at the end of the fourth quarter. The head count increase is primarily the result of hiring in India and Tempe, Arizona as part of our support transition.

GAAP loss for the first quarter was $66,000 or nil per diluted share. Stock-based compensation expense before tax primarily associated with the expensing of stock options was approximately $2.5 million. We recorded a restructuring charge of $1.8 million in the first quarter necessitated by facilities closures in Pune, India and Sunnyvale, California along with severance costs associated with the realignment of the sales organization.

For the quarter, non-GAAP tax expense was $1.9 billion against non-GAAP income before taxes of $5.1 million.

Non-GAAP net earnings for the first quarter were $3.2 million or $0.05 per diluted share, which represented an improvement over our guidance range of $0.03 to $0.04 due to better than expected gross margin performance and relatively stable operating expenses. Non-GAAP net earnings for the first quarter exclude $1 million of amortization of purchased intangible assets, $2.5 million of stock-based compensation expense, and $1.8 million in restructuring charges excluding the effect of taxes.

And now, I’ll review the balance sheet and cash flow statement. During the quarter, we generated operating cash flow of $2.9 million. The decline in cash flow efficiency in comparison to our experience in recent quarters was primarily due to bonus payments related to the Aventail acquisition of $2.4 million, SonicWALL annual bonus payments of $1.8 million, the release of an escrow related to the MailFrontier acquisition of $1.4 million and changes in balance sheet accounts, such as increases in inventory related to newly released products and a reduction in the growth of deferred revenue.

Total cash, cash equivalents and short-term investments was $147.2 million. This represents a significant change from the prior quarter balance of $229 million, so let me explain the components. First, we reclassified $55.3 million of investments in auction rate securities from short-term to long-term investments. Auction rate securities with their historically low volatility, excellent liquidity and attractive returns have been a significant investment vehicle for SonicWALL, not unlike many corporations. Recently the liquidity associated with these investments have significantly degraded. As of March 31st, 27% of our total cash, cash equivalents and investments was in auction rate securities. Interestingly, this was down $23.8 million from the December 31st, 2007 balance as a portion of our total investment in these securities was successfully liquidated in the first quarter.

SonicWALL uses two separate investment managers both very capable and substantial firms but they have taken very different action with respect to their auction rate securities. One investment manager has reduced estimated fair value by 3 to 20% of their ARS portfolio, but that range is dependent on the characteristics of the underlying securities. In our case, the securities that we hold were written down by them by approximately 5% or the equivalent of approximately $2.5 million. The other investment manager continues to hold their ARS investments at par until a clearer picture of the future of these securities emerges.

Confronted with these facts along with the guidelines offered in the accounting pronouncements such as FAS 157, we have decided to hold our ARS securities at par at this time but will continue to classify them as long-term investments until market conditions stabilize. We will also continue to closely monitor this situation and will provide updates as more information becomes available. Please see related disclosures in our SEC filings.

Also during the quarter, we used $32.5 million to repurchase 3.8 million shares of our common stock. As of the end of the first quarter, we have repurchased a total of approximately 19.9 million shares at an average price per share of $7.68. Approximately 47 million remains against a total repurchase authorization of $200 million.

Net accounts receivable were 25.3 million in the first quarter compared to 26.3 million in the prior quarter. DSO was 41 days compared to 42 days in the prior quarter.

Net inventories were 8.1 million in the first quarter compared to 6.1 million in the previous quarter and 4.2 million in the same period last year. Net inventories consist of inventory at two of our top US distributors and finished goods at our third party manufacturers. The increase in net inventories is primarily associated with stocking of newly released NSA products.

Total annualized inventory turns on a non-GAAP basis were 8 times compared to 11 times in the fourth quarter of 2007. Deferred revenue at 105.8 million increased 6% sequentially and 46% in comparison with the same period last year. 81% of total deferred revenue is attributable to subscription services. For comparison purposes, subscription services deferred revenue represented 83% of the total deferred revenue balance in both the first and fourth quarters of 2007. A decrease in the percentage of deferred revenue from subscription services is reflective of the higher levels of inventory at Tech Data and Ingram due to new product releases.

At this time, I would like to make some brief remarks about – sorry – complete my comments with guidance for the second quarter of 2008. We are concerned about the impact of the current economic environment, particularly in North America on our business. Because of the uncertainty that presents, we find it necessary to increase the range of our revenue guidance for the second quarter. We expect revenue in the range of 53.5 to $57.5 million. Our expectations for gross margin in the quarter are in a range of 70.5 to 71.5%. We are also being particularly cautious from a spending perspective and are engaged in an ongoing and thorough review of all of our business expenses to create increased operating efficiencies wherever possible. Given all of that, we expect earnings in the second quarter to be in a range of $0.04 to $0.07 per diluted share on a non-GAAP basis and GAAP earnings of nil to $0.02 per share.

And now I’ll turn the call back over to Matt to conclude.

Matt Medeiros - President and Chief Executive Officer

Thanks, Rob. In the second quarter, we will continue to stay focused on our four key objectives: International growth, subscription service growth, product innovation and driving scale efficiencies. Specifically in Q2, we are looking forward to the release of our existing new product – an exciting new product for us, the NSA 2400. This latest release to the NSA family brings the high performance of our multi-core processor architecture to a new lower price point specifically targeted to small and medium-sized businesses.

SonicWALL also plans to release new versions of our Email Anti-Spam Software featuring a more flexible licensing approach, improved reporting, scalable connectivity, and industry leading spam effectiveness.

Finally, this quarter a new release of our CDP software will be available with new features, such as improved file management, scalability enhancement, off-site server improvements and firmware quality improvement. We also are pleased to announce that we have submitted with a qualifying third party and are waiting approval for FIPS 140 in Common Criteria EAL 4+ Certification across our GEN 5 ETM product lines during this quarter. But this certification will be instrumental in providing us access to the U.S. Government customers. More importantly, Common Criteria Certification has become a critical requirement of many international customers and we expect that certification will put us at a level-playing field with many large competitors in the international markets.

We are confronting the economic situation in North America in two ways. First, we have realigned our demand creation and coverage model in North America, leveraging the new sales center in Tempe. We believe this will position us for greater efficiencies and effectiveness in our sales efforts.

Second, with the introduction of the new NSA 2400, we have now substantially completed the majority of the UTM product offerings based on our multi-core processor architecture. SonicWALL has never had a stronger UTM product portfolio from which to build revenue growth on.

We also have a plan to realize additional cost savings throughout the year and we will continue to thoroughly review our cost structures in an effort to keep our spending levels inline with revenue projections based on economic conditions.

We are confident in our strategic direction. International expansion helps to limit the company’s exposure to regional economic fluctuations. Diversification of our product line enables the company to reach across market segments to a broader customer base. Most importantly, SonicWALL can now offer customers high performance and complete alternatives to premium priced and complex solutions, thus extending our market leadership and providing an opportunity for further profitable growth.

I want to thank our employees and our partners for their continued dedication and hard work.

Now, let me turn this over to the operator Kevin for questions.

Question-and-Answer Section

Operator

Thanks very much. (Operator Instruction). And first up, we will hear from Sterling Auty at JP Morgan.

Sterling Auty

Yeah, thanks. Hi, guys.

Matt Medeiros

Hi, Sterling.

Rob Selvi

Hi, Sterling.

Sterling Auty

So a couple of questions, around the macro and the economic, can you talk to us a little bit about how the quarter unfolded, meaning did things deteriorate at the end or was it kind of a steady toughness throughout the quarter?

Operator

Folks, if I can ask you to stand by for just a moment we have just lost the speaker location, he will be dialing right back in. So Mr. Auty, if you will stand by, we will have everyone back online in just a moment.

Sterling Auty

Okay, thank you.

Operator

And again for any one just joining us, we will be resuming the conference in just a moment, please stand by. Thank you.

Matt Medeiros

Kevin?

Operator

Okay, we got you back on?

Matt Medeiros

Apparently we had a failure here.

Operator

Okay, good enough. Well, you are back on and we still have Sterling online for the question.

Matt Medeiros

Sterling, our apologies.

Rob Selvi

Sorry Sterling.

Sterling Auty

I was going to say it’s the first time that a management team hung up on me during a conference call.

Matt Medeiros

Yeah.

Rob Selvi

Cost cutting efforts, Sterling.

Sterling Auty

Did you guys hear the question or do you want me to repeat it?

Rob Selvi

Yeah, we didn’t hear.

Matt Medeiros

Could you please repeat it?

Sterling Auty

Yeah, so I was asking, can you give us a little bit of color in terms of how the quarter unfolded, did things get worse or tougher as the quarter went on or were they kind of equally tough throughout the quarter?

Matt Medeiros

Sterling?

Sterling Auty

Yes.

Matt Medeiros

Okay. The quarter progressed very well; in January and February, we were actually ahead of our traditional linearity. It was the first two weeks of March where it virtually just stopped. We saw a recovery in the last two weeks of March to give us obviously the numbers that we gained, but no, I think that the concern for us was in the first two weeks of March.

Sterling Auty

I don’t think that’s uncommon, we heard that from a number of locations as well, as you look at the subscription business and the license and subscription number, then are you basically saying that a lot of the strength there was from what you were able to do in the December quarter as well as follow on sales to the existing base or was it still just a really good tie ratio with the new units in the quarter?

Matt Medeiros

Well, the tie ratio of the new units in the quarter specifically with our new products, the NSAs, were high. I think the – we did very well obviously in the TZ line, but the problem again is just that the TZ line did not grow for us in unit sales out.

Sterling Auty

Okay. And last question, I apologize because I am not in the office, I am dialing in remote, looking at the product revenue in the quarter, 49,000 units in a quarter seems like that was actually a slight uptick from last quarter if I am not mistaken, why the large fall off, was it purely a mix issue or because I think you said that the discounting was actually a little bit better this quarter?

Operator

And folks, it appears as if we may have lost the speaker line again. Everyone standby for just a moment and they should be dialing back in. Again Mr. Auty, thanks for your patience; just stand by.

Sterling Auty

No problem.

Operator

And again, they are dialing back in, so stand by everybody. And once again, please just stand by everyone, they will be dialing back in. Just a moment.

Matt Medeiros

Hello, Kevin?

Operator

Yes, you are back in.

Matt Medeiros

Yeah, I have -

Matt Medeiros

Sterling, you still there?

Sterling Auty

Yeah, no problem.

Matt Medeiros

We had to switch rooms, some...

Rob Selvi

There was something going on with that phone, so we’ve gotten into a new office.

Matt Medeiros

Anyway, you had a question about units, right?

Sterling Auty

Yeah, I was saying that it seems like – I thought the units were actually a little bit better this quarter than last quarter, can you give us just more color on why the product revenue was off sequentially, was it purely just a mix issue because I thought you commented that the discounting was a little bit better this quarter?

Robert Selvi

Yeah, it was – well, let me just tell you what happened in the quarter, we were actually down sequentially from a unit standpoint, a little over 4,000 units, so we actually in the UTM product line, the TZ and PRO families were down, but we had of course – that was offset by new product sales in the NSA category.

And then in the other products category, we had declines in – well, in both CDP, probably the big mover there was CDP and Access Point. And there was a sequential decline in ASPs. So, to your mix question, that was primarily a function of mix.

Sterling Auty

All right, great. Thank you, guys.

Matt Medeiros

Thanks Sterling.

Operator

Next up, we will hear a question from Robert Breza at RBC Capital Markets.

Robert Breza

Hi. Thanks for taking my questions.

Robert Selvi

Hi Rob.

Robert Breza

Hi Matt, hi Rob. I was wondering if you can talk a little bit about, as you look at the environment, obviously your comments were little tougher, should we think about like the full year numbers kind of widening that range or I guess any comments as you look out a little further?

And then Rob if you could follow up, cash flow was a little bit weaker than I thought, obviously there was a little bit of inventory build, any other comments around cash flow would be helpful. Thanks.

Robert Selvi

Sure. As far as annual guidance, we are not electing to update the guidance at this time. So, we provided the guidance in February and it’s going to remain intact for this quarter. We will see how we do in Q2.

Robert Breza

Okay.

Robert Selvi

And as far as cash flow is concerned, we had some unusual items in the quarter that caused us to be a less efficient with operating cash flow. I mentioned some of them in my prepared remarks. They were primarily acquisition related; the unusual items of about $2.4 million in bonus payments to Aventail, former Aventail employees, now SonicWALL employees. And then we had the SonicWALL annual bonus program, a substantial portion of which was paid in the quarter. That’s not unusual, that happens every year in Q1. The other unusual item was a MailFrontier escrow that was released that was a holdback from the consideration of the MailFrontier transaction. So those were the three things that were a little bit unusual.

We also had a significant license agreement that we consummated in the fourth quarter for technology, it was a technology license, and that impacted cash by approximately a million dollars in the quarter. And then finally growth in deferred revenue was down somewhat over what it had been in prior quarters. So all of that conspired to deliver an operating cash flow number that looked significantly different than the prior quarter.

Robert Breza

Okay. And maybe Matt, as you are out talking with the customers and your partners here, I would assume most of the value-added resellers, distributors are seeing it kind of across the board, just any more color around the macro environment or what you are hearing back from distributors would be helpful, thanks.

Matt Medeiros

Yeah. I do think that most of our – most of the distributors that we’ve talked to or partners that we’ve talked to, as I mentioned in the prepared remarks have truly seen a slowdown with all vendors in the security space. What I can tell you is that security is absolutely top of mind and a major requirement as far as future purchases. So I actually still feel very strong about the space that we are in, but we want to be cautious here in North America.

Now, if you take us outside of North America, the fact is that we’ve had substantial growth. And I think that our partners, not only the existing partners, but SonicWALL’s ability to attract new partners in international has been strong and I think that that’s going to be an antidote for us of getting through the uncertainties here in North America market.

Robert Breza

Great.

Matt Medeiros

Thanks Rob.

Operator

We have a question now from Joel Fishbein at Lazard.

Matt Medeiros

Hey, Joel.

Robert Selvi

Hi, Joel.

Joel Fishbein

Hey guys. Just real quick, just a follow-up on the cash flow issue that Rob was asking about, could you just give me the items that will come back in that will help cash flow going forward particularly in Q2? I know you are not going to give guidance for the full year.

Robert Selvi

Yeah. As you know, we don’t give specific guidance on operating cash flow, but I will tell you that the acquisition-related payments that I just mentioned, the Aventail bonus of 2.4 million, the MailFrontier escrow release of 1.4 million, the Linkbit issue or license of $1 million – that was the technology license I referred to earlier – none of those will be present in the second quarter.

Joel Fishbein

So you could say – I mean if we take what your normal – what you’ve been doing in cash flow going – in past quarters again depending on what deferred revenue is, we should be able to back into the numbers, it should be pretty reasonable to other quarters excluding these one-time items?

Robert Selvi

Yeah. I think you can look through the one-time items, of course, the wild card is the growth in deferred revenue.

Joel Fishbein

Right. And then Matt, can you just give a little bit more color on the E-Series? I know you talked about it in the script, but just talk about where you think that that’s going and where you are there competitively?

Matt Medeiros

Sure, Joel. Listen, we were very pleased to have Joe Snyder’s product review in Network World, really claimed that SonicWALL has the fastest UTM device. And I think that along with that product review, some early customer acceptance of that product that is turning out to be reference accounts for us, we’ve really got a great opportunity of continuing to pursue this mid-tier and enterprise-class UTM offering. We also know in talking to a lot of enterprise customers they are really considering UTM as their way of satisfying their gateway security. So, there has been many people that have said enterprise wants dedicated and committed products, and what we are finding is that the acceptance of UTM is becoming far more readily available to the enterprise market.

Joel Fishbein

Great, thank you.

Operator

(Operator Instructions). We’ll move on to Scott Zeller at Needham & Company.

Scott Zeller

Thanks. Back to the annual guidance, just wanted to see if I understand this correctly, you are – it’s remaining intact, does that mean that there is no change to the guidance at this point?

Robert Selvi

Yeah, that’s what that means.

Scott Zeller

Okay. And then for the product -- the revenue by product line, could you just repeat, was that total revenue or just – that was product revenue by product, right?

Robert Selvi

Are you talking about the comments I made in my prepared remarks?

Scott Zeller

Yes. So for instance, the categories such as UTM, secure content?

Robert Selvi

Yeah, that was total revenue.

Scott Zeller

Total revenue?

Robert Selvi

Yeah.

Scott Zeller

And could you tell us quarter-to-quarter, I think you did touch on CDP, but could you tell us quarter-to-quarter what those were? Could you tell us the 4Q breakdown?

Robert Selvi

We are – we will provide historical comparisons on the website.

Scott Zeller

Okay.

Robert Selvi

Of the reporting metrics for the last – the previous four quarters, so you can take a look there. I mean I can tell you generally if you like on the call. We had growth in UTM sequentially. The growth sequentially in total was about $1.4 million. We had a decline in SSL VPN in total of approximately $900,000. Secure content management products were relatively flat quarter-over-quarter. And the CDP product line was down approximately $1.1 million.

Scott Zeller

Okay. And the E-Class products which – do those fall into UTM now or SSL VPN?

Robert Selvi

Yes, they are in both categories actually.

Scott Zeller

Both categories?

Robert Selvi

And there are also are enterprise class products in the secure content management category as well.

Scott Zeller

Okay, all right. Thank you.

Robert Selvi

Thanks Scott.

Matt Medeiros

Thanks Scott.

Operator

We have a question now from Vik Churamani at Lehman Brothers.

Matt Medeiros

Afternoon, Vik.

Vikram Churamani

Hi guys. Question on cash flow, Rob, when we add up some of the one-time items, you are still looking at about $8 million or so in operating cash flow. So, what was the offset, because you are still down year-over-year for Q1 once you add back those – if you were to add those back. And then I have a follow-up.

Robert Selvi

Well, growth in deferred revenue was down over $5 million quarter-over-quarter, so that’s going to be the bulk of your offset there.

Vikram Churamani

Right. But I’m talking on a year-over-year basis, I mean you did 12.2 million in operating cash flow last year in Q1 and you had about a $4.5 million change on the cash flow for deferred, so I realize deferred this quarter is about 4.7 or so, so it’s roughly flattish, but you must have had some other changes in working capital or somewhere else offsetting that even if you add back some of the one-time items. So I’m just trying to get a better sense for that. And then also maybe qualitatively maybe you can give us some idea in terms of what – is cash flow going to grow this year, what sort of sustainability should we expect out of that number?

Robert Selvi

Well, I think in the asset categories last year we had a delta of probably approximately $4 million, about $3 million of inventory, about $1 million of accounts receivable. So, that’s part of the reason for the change year-over-year in addition to the one-time items.

Vikram Churamani

And then, can you just talk about the – sort of what should we expect in terms of cash flow growth?

Robert Selvi

Well, we don’t really guide cash flow as you know. So I gave some – I guess landmarks in terms of expectations or what not to expect in Q2, but I think we’ll stop short of providing annual guidance.

Vikram Churamani

I mean I realize it. Is it – can you say given the fact that looking at the year I understand there’s a lot of open questions right now, but is cash flow going to grow this year or – I am not looking for a number, but just sort of some qualitative commentary based on what you guys know and based on the tax rates and based on I guess end demand based on what you guys know right now.

Robert Selvi

I think it’s hard to say. I think if I’m not mistaken you asked that question at our analyst event in February as well. And I think I answered it by saying that the cash flow performance would be largely dependent upon the growth of deferred revenue assuming relative stability in the asset and liability categories. What we had in Q1 was not exactly along those lines. So from a relative standpoint, I would say we are not feeling that our cash flow outlook is quite as robust as we were a couple of months ago. Beyond that, I think I’ll just leave it at that.

Vikram Churamani

And if I could just have one quick follow-up, in terms of pricing what’s your assumption going forward especially in light of the US being weaker and what sort of expectation in terms of ramp from some of the newer products, when should we see some of that happening?

Matt Medeiros

Yeah, Vikram, let me take the latter first. The new products actually were the fastest growing products that we had in our entire product revenue. The NSA’s products are being well received. We think that with the new additions to some of the firmware quality improvements that we made on CDP we’ll see regained growth on our CDP product. And then finally on the e-mail security, our e-mail effectiveness or our efficiencies at capturing spam are phenomenal and I do think that we’re going to see continued growth in all of the product areas.

Regarding pricing in Q1, we actually took pricing action early in the quarter on our TZ product line and yet it’s – it was based on our results I think that we did a pretty good job of holding off on discounting any further than the pricing actions that we needed. And we expect to see those pricing actions really take shape in Q1, especially here in North America.

Vikram Churamani

Thanks.

Robert Selvi

Thanks Vikram.

Operator

Moving on now to Rob Owens at Pacific Crest.

Rob Owens

Yeah, good afternoon, guys.

Matt Medeiros

Hey, Rob.

Robert Selvi

Hey, Rob.

Rob Owens

Just curious on the gross margin guidance for Q2 as it comes down at the high-end, 50 basis points I guess if you average 100, is that a function of mix? Is that a function of where you would expect to price for Q2?

Robert Selvi

It is really almost exclusively a function of mix.

Rob Owens

Okay, great. Thanks.

Robert Selvi

Thanks Rob.

Operator

We have a follow-up question now from Sterling Auty.

Matt Medeiros

Hi Sterling.

Sterling Auty

Hey, two follow-up questions. One, sorry if I missed if you put it in the prepared remarks, what was the FX impact in the quarter on revenue and expense?

Robert Selvi

There was no FX impact on the quarter. Every thing is dollar denominated.

Sterling Auty

Okay. And then the second question is in the last quarter there was some discussion I think around some of the spending programs in order to help channel and demand. We saw McAfee with some of its OEM partnerships talking about that as well on some of the spending. I was just kind of curious what might be going on out there in the channel both North America and Europe in terms of whether it’s still classified as just MDF funds or whether there is other programs or spending that’s happening from the vendors to the channel partners to help with the current environment?

Matt Medeiros

Sterling, we’ve stayed very consistent with our approach. We haven’t altered or augmented to any spending programs specifically for channel development. I think our European market is doing quite well. In fact, we are reallocating more monies to Europe from our North American market because we see continued growth there. In fact, we are putting more resources into Europe. In fact, we have a full complement of team now in Europe. We’ve hired a couple of people here in early April.

Relative to changes that we’ve made here in North America, I think the single biggest difference is that we now have a fully staffed Tempe, Arizona organization that is making contact with the reselling community on a daily basis. So, we went through that transition in Q1. I am absolutely certain that did have an impact on our ability to sell out in North America. Rob, I don’t know if you had anything else you wanted to add to that.

Robert Selvi

Well, I – because you mentioned soft dollar programs in MDF, I guess I’d just want to point out that from a competitive standpoint we have a relatively aggressive MDF program. So whereas you mentioned McAfee, but maybe there are some other vendors out there that are stepping up their efforts on such programs like MDF. I think our program is already relatively aggressive, so we haven’t seen the need to do that so far.

Sterling Auty

And one other question would be that it seems like with Europe doing so much relatively better than North America that a lot of vendors are focusing more of the resources, more of the efforts, kind of curious what you are thinking about in terms of what the competitive dynamic might look like as we move through the next couple of quarters in that region, in particular as everybody -- seems like it’s going to be a pretty crowded market in terms of competitiveness.

Matt Medeiros

Yeah. I don’t think that we are by any means limiting the competition – or the competition is not going after Europe in the same way that we are. But I think what’s working for us is that we have a very profitable program for resellers. We have an absolutely an excellent program relative to recurring revenue that the reseller community and the end customers understand very well. Our managed security service program is a key element to the program. And then finally I think it’s the dynamics of our new products. I mean with the ability for us to outperform every competitor’s UTM solution, e-mail effectivity solution and shortly with this new CDP solutions of software I think we’ve just got a stellar product offering that’s going to be able to help us get through a lot of the – if you will growth issues that we have here in North America.

Sterling Auty

All right, thanks guys.

Matt Medeiros

Thanks Sterling.

Operator

And we’ll go back to Scott Zeller at Needham.

Scott Zeller

Thanks. I wanted to ask about – I know there was some commentary earlier about SMB and Rob you had mentioned that the environment for the second quarter in a row now remains difficult. But could you talk specifically to the change in the December quarter to March quarter around sentiment with SMB because we have heard from other companies that there was a distinct change in the March quarter for SMB spending? Did you – I mean are we saying it’s weak and still weak but unchanged, could you give us some more color on that?

Matt Medeiros

Scott, I think the real issue isn’t necessarily just about SMB spend. Our pipeline shows good development in the SMB market. There has been some postponements from Q1 into Q2 and that might continue depending upon the economic conditions here in North America. But perhaps the most important data that we follow is we look at payroll data for SMB. ADP does a very good job of defining that and we saw a deceleration in business starts, payroll and business starts. So, it’s not as if they didn’t add new payroll, they did, but it was at a far lesser rate than what it had been historically.

Scott Zeller

Is there anyway that you can give us some color on midsize versus truly small low-end and if there was a quarter-to-quarter change?

Matt Medeiros

I don’t have that detail.

Scott Zeller

Okay.

Matt Medeiros

We are trying to get – as you know it’s very difficult to get this from the Small Business Association here in the United States. There is a report called the Kauffman Report that we’ve been using that helps us track it. But it typically is at minimum six months behind where the market is at today.

Scott Zeller

Thank you.

Operator

(Operator Instructions). We’ll go back to Vik Churamani.

Vikram Churamani

Hi. Just quickly, any color on how much Aventail was this quarter?

Robert Selvi

We finished reporting Aventail separately in Q4 and it’s reported now in the combined SSL VPN category.

Vikram Churamani

Okay, well – okay, fair enough. In terms of the – you guys I guess getting through the PRO Series and then replacing that with NSA, when would we finish with that transition?

Matt Medeiros

Well, all of the NSA products have now been introduced. Again the E-Class NSA 7500 all the way down to the NSA 2400, but we are maintaining the PRO product line, especially the 2040 and the 4100. They actually hit a good price point for us in the marketplace. So we are not discontinuing the PRO family at all, we are just going to occupy a different price point with those products.

Vikram Churamani

So there is no transition as such?

Matt Medeiros

The Gen5 UTM devices are all of our NSA products today and that transition is complete. We have introduced the majority of our new multi-core NSA products in the marketplace. The transition from the Gen4 to Gen5 through the NSA product is complete.

Operator

At this time, there are no questions holding in the roster. I’ll turn things back over to our presenters for any additional or closing remarks.

Matt Medeiros

I’d like to thank everyone for attending the call and we look forward to talking with you through the quarter.

Operator

Ladies and gentlemen, that will conclude the conference call. Once more, thank you for joining us. Have a good day.

Matt Medeiros

Thank you, Kevin.

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