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Executives

Stephen Wideman - Assistant Treasurer

Scott Davidson - CFO

Vinny Smith - CEO

Analysts

Aaron Schwartz - JP Morgan

Walter Pritchard - Cowen and Company

Tim Klasell - Thomas Weisel Partners

Kirk Materne - Banc Of America Securities

Richard Sherman - MKM Partners

Derek Bingham - Goldman Sachs

Quest Software Inc. (QSFT) Q1 2008 Earnings Call May 8, 2008 5:00 PM ET

Operator

Good day, everyone, and welcome to the Quest Software First Quarter Earnings Release Conference Call. Today's call is being recorded. With us today are Vinny Smith, Chief Executive Officer; Scott Davidson, Chief Financial Officer; and Stephen Wideman, Assistant Treasurer. At this time, I would like to turn the conference over to Mr. Wideman. Please go ahead, sir.

Stephen Wideman

Thanks, very much. Welcome everyone to Quest Software's first quarter 2008 call. I'm happy to have on the call with us today, Vinny Smith, Chief Executive Officer; Scott Davidson, Chief Financial Officer. Scott and Vinny will give some thoughts on the quarter that ended March 31st, 2008, and then we'll open up the call for Q&A. Our call is being webcast from our investor relations website and you can get a copy of our press release just issued a while ago on this website as well. A replay of this call will also be available on this site for using the instructions noted in our release.

At this time, let me turn briefly to our Safe Harbor Statement. Some of the statements we make today may be considered forward-looking. Including statements regarding our anticipated revenue and operating margins and future periods and other statements about our plans, prospects, and strategies. These statements involve a number of risks and uncertainties that could cause actual results to differ materially.

Please also note that these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements in light of new information or future events. Please refer to our SEC filings, including our annual report on Form 10-K for the year ended December 31st, 2007, as well as our Q1 earnings release for a more detailed description of risk factors that may affect our results.

Copies of these documents can be obtained at the sec.gov website or by visiting in investor relations section of our web site. Also please note that certain of the financial measures we'll use on this call, such as EPS, net income, operating margin, and operating income are expressed on a non-GAAP basis, and have been adjusted to exclude various charges, including amortization of intangibles, share-based compensation expense, and expenses of our stock option investigation. We report our GAAP results as well as provide a GAAP to non-GAAP reconciliation in our earnings press release, a copy of which is available on the investor relations area of our website at quest.com.

With that I am happy to turn the call over to Scott.

Scott Davidson

Great. Thanks, Stephen. Overall, I think we all agree that our Q1 results were very good. At the summary level total revenues were $172.8 million for the quarter, which increased 15% year-over-year. Non-GAAP operating income was $23.3 million, non-GAAP diluted earnings per share was $0.21. Q1 cash flow from operation was $55.3 million, and deferred revenue was approximately $295 million, which is a $63 million or 27% increase over Q1 last year.

Now let me talk about the quarter in a little bit more detail. The total revenues increased to $172.8 million, compared to the prior year's first quarter revenue of $149.8 million. As previously disclosed, we modified our revenue recognition practices during Q1 of 2007, for large reseller transactions. In order to provide comparability in our reported results, between Q1 2008, and Q1 2007, it's important to note that in Q1 2007, the reported results included a $5.5 million in license revenues that were actually booked and recognized in Q1 2007. But otherwise, would have been deferred under the prior practice.

The Q1 2007 reported results also included $13 million in license revenues associated with reseller transactions for prior periods where cash was collected in the first quarter of 2007. If we had implemented this change prior to the first quarter of 2007, we would have reported $136.8 million in total revenues, and $61.3 million during the first quarter of 2007. On that basis, the year-over-year total revenue growth was actually 26% and license revenue growth was actually 29% on that comparable basis.

So for purposes of clarity on this issue, and to provide the common basis of comparison, in order to calculate the growth rate between Q1 2007 and Q1 2008, you need to exclude the $13 million in revenue from Q1 2007 that I mentioned in order to compare the Q1 2007 with Q1 2006 growth rates, you need to exclude the $5.5 million in revenue from the Q1 '07 number.

Services revenue were $93.6 million, representing an $18.1 million increase or 24% growth rate over the comparable quarter. It should be noted that the modified practice related to rev rec on reseller transactions is primarily related to the license revenue component, and such, there is no need to adjust Q1 '07 services revenue to recalibrate the growth rate on a comparable basis as we just went through on the license line

Along product lines, license revenue was driven by our Windows and application management and virtualization product areas this quarter, while maintenance revenues of our database and Window's management product showed nice growth as well.

Looking at the revenue mix for the quarter. License revenues represented 46% of total revenues, while services generated the 54% balance. This compares to a 50-50 mix in the comparable quarter last year.

We are seeing continued success in our maintenance renewal efforts on a world wide basis and in addition we recognized the benefits from ScriptLogic and PassGo acquisitions to our services revenue. Geographically, North American operations generated 62% of revenues for the quarter with the rest of the world operations generating the remaining 38%. For purposes of comparison, the mix was 66% North America, 34% rest of world in Q1 '07.

Moving to the expenses I would like to remind you that Q1 2008 non-GAAP results exclude the amortization of share-based compensation, in process R&D charges, amortization of certain acquisition-related intangible assets and ongoing expenses associated with the stock option investigation.

Our earnings press release includes reconciliation of the differences between the as-reported GAAP, and the non-GAAP financial numbers. Total expenses on a non-GAAP basis were $149.5 million, which was 28.6 increase over Q1 of 2007. Of this amount, more of half of the increase was related to the impact from acquisitions and higher cost related to foreign exchange. Average headcount increased by 19% compared to the first quarter of 2007.

Now turning to the individual expense line items, sales and marketing expenses for Q1 were $74.6 million or 43% of total revenue, compared to $61.1 million and 41% of total revenue in the same quarter a year ago. Of the increase, two-thirds is associated with labor in the form of increased headcount, the impact from foreign exchange and higher travel expenses. This headcount increase includes both internal hiring of sales and presales heads and those associated with the acquisition from ScriptLogic. Marketing programs and advertising including trade shows accounted for the rest of the increase.

Research and Development expenses were $36.6 million or 21.2% of total revenue. This compared to expenses of $26.4 million or 17.6% in the year-ago quarter. Approximately 80% of the increase was related to labor including the effect from acquisition in addition to higher cost related to foreign exchange.

G&A expenses were $21.1 million or 12.2% of total revenue for the quarter compared to $14.1 million, which is about 9.4% during Q1 of last year. Costs associated with our acquisitions, legal fees and G&A support accounted for 70% of the increase.

Ongoing professional fees and indemnification expenses relating to our stock option restatement previously totaled for this quarter, $1.6 million, which was similar to Q1 2007. Although this $1.6 million is excluded from the non-GAAP results.

Looking at in term GAAP operating margins were 6% in the quarter and GAAP operating income was $9.5 million. The non-GAAP operating income was $23.3 million, generating an operating margin of 13.5%. The non-GAAP operating margin for Q1 2007 was 22.4%.

As discussed earlier in the revenue growth section, we modified our revenue recognition treatment for the resellers during Q1 2007, therefore, in order to compare operating margins between Q1 '07 and Q1 '08 on a comparable basis we also need to back out the sales cost. So if Q1 2007 was stated on a comparable basis, it would have actually been 16.4%, compared to 13.5 in Q1 2008.

Management of our operating margin will be a key initiative for the remainder of the year and as such we plan to balance our expense growth closer with revenue growth. The primary drivers of the margin compression on a year-over-year basis have been related to increased headcount and associated costs, both organic and from acquisitions, most of which operate at a lower margin profile as they are actually growing faster.

Other income net in the quarter was $7.9 million, versus $5.1 million in Q1 '07. Primary driver of the year-over-year change was related to foreign exchange gains totaling $4.7 million from the devaluation of the US dollar. Average cash balances in the quarter were lower as a result of the outflow related to the funding of the PassGo transaction that coupled with a decline in interest rates, reduce interested income on a year-over-year basis.

Our GAAP effective income tax rate for the quarter was approximately 23.6%, compared to 45.1% in Q1 2007. The difference primarily relates to valuation allowances applied to certain foreign jurisdictions, which discretely impacted Q1 of 2007 and the mix of net income before taxes by jurisdiction as well. Our Q1 2008 non-GAAP tax rate was 28.7%, compared to 32.2% in Q1 of '07. The decrease is primarily the result of changes in the projected mix of income and high and low tax jurisdictions.

GAAP net income for the quarter was $13.3 million and GAAP EPS was $0.13. The non-GAAP net income was $22.2 million and non-GAAP diluted earnings per share was $0.21. Fully diluted weighted average shares outstanding was a 106 million shares.

Now I'll turn to the cash flow statement and the balance sheet. As of March 31st, our cash and investment balances were approximately $383 million. Please note that the $49 million of restricted cash at December 31st, 2007, was expended on January 2nd for the PassGo acquisition.

This is the only acquisition that closed in Q1 of 2008. CapEx for the quarter was $3.2 million. Cash flow from operation was $55 million, and $57 million in Q1 '08 and Q1 '07 respectively. And the DSOs was 58 days and 53 days as of Q1 '08, and Q1 '07 respectively. Deferred revenues were approximately $295 million, up $63 million on the year-over-year basis, with approximately 30% of the increase related to the benefit of the acquisitions in ScriptLogic and PassGo Technologies.

So looking out at the rest of 2008, we continue to see opportunities in the primary markets. To capitalize on the opportunities we plan to drive growth in both our core business and recently acquired entities while gaining leverage on our recent investments. In particular, we plan to manage the expense growth more in line with revenue growth for the remainder of 2008 and as such are targeting higher operating margins.

With that being said now let's turn to the discussion on guidance for the rest of the year. We had a good Q1, but remain cognizant of the macro economic environment. So as such, our annual revenue guidance remains at $705 million to $720 million, so no change in the revenue guidance.

As discussed earlier, though, we're planning to manage the expense growth more in line with the revenue growth, and as such, plan to increase our GAAP operating margin range from 12% to 13%. Implicit in this guidance is a 17.5 to 18.5 non-GAAP operating margin number for the year. Essentially this is 100 basis point increase over our prior guidance.

The non-GAAP guidance excludes approximately $28.6 million of amortization of acquisition-related intangible assets, $9.4 million of share based compensation expense and $1.6 million in ongoing expenses associated with the stock option work. So that concludes my prepared remarks and now I'll turn it over to Vinny.

Vinny Smith

Thanks, Scott. Good job on the call. Okay. So for me I'll just repeat a couple of the financial highlights and then I'll go and try to put some color on the business in different areas. GAAP point of view a 15% year-over-year growth to $172.8 million again, and license revenue grew 7% year-over-year, services grew approximately 24%.

One point that I found interesting was North America operations generated 62% of total revenue in the quarter with the rest of the world operations generating 38%. That's a 4% delta compared to last year's Q1, and I think this reflects the greater growth, well I know it reflects the greater growth we're experiencing outside the United States.

When I look at other companies in our industry and outside of our industry, I think that this is a pretty common phenomenon that people are experiencing better market conditions overseas, better growth situations, and maybe not quite the same recessionary pressures we're seeing in the US.

In the quarter we did 142 transactions over $100,000. And this compares to 96 transactions in Q1 of last year, which is a nice increase. However, we did just one deal over $1 million in the quarter, which is a little light for us, and this deal was done in Europe.

Turning to our market segments, or our businesses and how we view the market. First one is the database market, and that's been where the business started years ago when we first went public almost nine years ago, and we have been experiencing some increased competition from Oracle over the last several years.

Some of our products have dropped considerably in our license revenue due to this competition from Oracle. However, we have been able to get steady results out of our high-volume business, around Toad, and Q1 was another really nice quarter for Toad.

Other things, going on in the database world as we put out a major release in SharePlex, which introduced many features and greater scalability and more manageability, and SharePlex is our high-end Oracle replication solution that we have had in the market for many years.

With that release, we also introduced a new management paradigm for SharePlex, which is based on our Foglight monitoring and management monitoring tool. So we were excited to be able to let our monitoring product and bring it across to have it help administer and help perform or administer, monitor the SharePlex environment.

Turning to sequel server. This is a much smaller market than Oracle for us. Even though it's smaller for us relative to Oracle, we are still the largest provider in the market by a wide margin. We were hoping that this business would move faster for us over the last two years. It's not moved as quickly as we would like, but we continue to invest in this space.

We think that there's room for us to crack open new opportunities and invent new solutions that will be helpful, because the macro condition in the sequel market is still strong. In the quarter we released support for Microsoft Sequel Server 2008, which is a significant release for Microsoft. So we're keeping up and meeting our releases with theirs as they meet the market.

Turning the second market. The way we think about our business is the application management monitoring part, predominantly that is Foglight. In the past we have struggled to achieve the necessary growth, and from that we didn't drive the profitability we would like in this market. In this area, it is a big investment we have made, and it's significant, and it is complex, and we are making significant strides. We had year-over-year good growth in the product, and we feel that there is ripe opportunity as we move in to this market and figure out how to sell to it, and market to it, and not just build product. And so we continue to make the investment.

We had another release of the product right at the end of Q1, beginning of Q2, it's a significant release. It released not just new functionality and features in to the Foglight core, but we put on top of that a package much like we did for our SharePlex management, but in this case it was to monitor the ESX hypervisor, and the guest inside the ESX host. So, we think that product is going to have a lot legs. We actually are upgrading a prior product we had in the market, which had several thousand customers running it. So it's exciting for us to be moving them on to a Foglight kernel.

At the beginning of Q2, around this product area, we had a formal launch of Foglight 5 to [garner IT expo]. This is part of an investment we're making to bring Quest forward and be recognized as the leading application management provider in the minds of the senior IT managers. So it was a big launch, and we feel like we were effective in just achieving the stature. We have got the product, the marketing, and the sales capability to continue to grow that business for many years.

Now turning to Windows and Identity Management. This has been the area of business that has made the company grow over the last six or seven years and it's been a great addition to our company. And this quarter was no different. We had a very nice quarter in the Windows business.

However, we're starting to see more significant competition in Microsoft and some of our key large product areas. Now this is something we knew was coming, we're paying close attention to it and the burden is on us to push our products forward to enable them to maintain their product differentiation, and also that may be not good enough, because eventually Microsoft may come out with good enough solutions, where the market will slowdown for us. So this forces us into a situation where we must break in to new segments around Microsoft and we're doing that.

We're investing around a [comp leg] or broad ID management, identity management, SharePoint archiving. So even if some areas do slow down, we're contemplating how to continue to grow that business by adding new additional businesses to it. So we're making significant investments in some of these areas, and frankly they are starting to pay off already.

In the quarter we were busy in the Microsoft area. We are the premier sponsor at the Microsoft SharePoint conference. We participated with Microsoft in launching their Microsoft Windows and Server 2008 events. And I was excited to be doing that with Microsoft.

In the quarter we also completed our PassGo acquisition. This is a password management company that we, in the quarter integrated in to our Identity Management family, and so we bought the company. I think it was completed in January and the integration was pretty far along by February.

We also completed a licensing and distribution agreement with Avidian, which helps us complete our solution for simplified identity and access management. In the quarter we launched four new products in the access management space. These include enterprise single-sign on, web authority, privilege manager for Unix. This allows us to do delegated and fine-grained provisioning of Unix super-user privileges similar to what we do for active directory. We now enable Unix environments to be operated or to be managed with the same level fine grained granularity, and so that's an exciting product for us as well as password safekeeping.

As an example what we do for our customers in the Microsoft space, we really do drive down the cost to manage this environment , and increase the availability, and we allow them to do it with less effort and with more professionalism. An example of this is password management, which can eliminate 70% of the helpdesk calls by installing our password manager product.

Another point in the quarter, we're starting to see success with our collaboration with ScriptLogic, in the active directory space. They, as an acquisition brought in product, but also really strong channel, and we're hoping to be able to reach more customers of all sizes by utilizing both the traditional Quest, much more oriented as a direct sales force, and the Script which was 100% channel based. So we're starting to see some early wins from that collaboration and we think that we're going to be able to really reach far more customers than we have in the past.

Other points in the quarter, we continue to see strong SharePoint movement in the market, and we are building out this very comprehensive suite of products for SharePoint management. So the fundamentals are there that that market is going to grow in importance and size, and we're going to be there to capture a lot of that market share.

Same for Exchange, Exchange continues to grow for Microsoft, and we're the largest vendor around migration, management, reporting, and we have got a lot of opportunity, and we continue to do well around Exchange.

Turning now to the newest area of our business, when we break our business and internally manage it, we break it in to a couple of different areas. This fourth category is the virtualization space, and virtualization for us means the virtualization of the server. Examples of the hypervisors that are performing this duty are things like VMware ESX and also the desktop virtualization, and so these two are areas where we have been investing. We've been acquiring companies, we have been building products. We finished the acquisition of Vizioncore in January, and Vizioncore focus is in ESX virtual server management. They are the leaders in the market for backup and disaster recovery and replication.

We also incorporated in to the Vizioncore product line another company we acquired last year named Invirtus, and they have a strong products that allow you to do server consolidation, optimization, you might hear acronyms like [PETAV and VETAV], those are things like physical move, the box from the physical environment to the virtual, where you move from one virtual environment to another virtual environment. So those two product lines have been integrated on being brought to market together.

In the second half of last year we bought a company named Provision Networks. They had some very leading edge technology in the area of desktop virtualization and we feel that this is going to be a significant market. We think that desktops in the future will be managed very different than how they are managed today. People are looking to address the cost to manage PCs. They are looking to address greater IP control, and what exists on those PCs. They are looking to improve the user experience for the PC user, and with the acquisition of Provision Networks and some of the other things that we are working on to blend in to this solution, we're going to maintain our leadership position in this new market, which we think is a very exciting market.

With this exciting market, it's got size to it. People feel it. There's going to be some intense competition from some large vendors. We're going to be for the first time competing with Cytrics, possibly Sun, and certainly VMware on the virtual desktop side.

So overall in the virtualization space, we are off to a very strong start. We have a very, very strong product for ESX server management. We're attempting to broaden this family out and stay well ahead of the platform vendors, like VMware, who ultimately will likely be our toughest competitors, and the same is true as I mentioned on the desktop. We have a lot of opportunity. Many of the solutions haven't been invented yet, and we're good at inventing things. So like our chances of being successful in both the server management market, and the desktop management market.

Okay. Let me now turn to just some basic facts around the company. We ended the quarter with just under 3,500 employees. Last year, at the end of Q1, we ended with just under 3,000 employees. So we add approximately 500 people in the quarter. Some of those did come through some acquisitions we made, so it wasn't pure organic hiring.

For me, running this company and being part of this company is about just a couple of things. We are attempting to be great for our customers. We want them to want to do more business with us, and they come us to saying we want to buy more and more from you guys, you are difference, you service us differently, you deal with us differently, and we want more from you. So we're trying to deliver great solutions for our customers and keep those trusted relationships in place.

Second thing is -- and just as important as the first, is we want to have a great company that we all work at, and we're making great strides, and one thing I'm very proud of about our company is the level of people we have today, 3,500 people, it has many of the same cultural qualities we had when we had 20 people or 50 people, or 100 people and the same focus to the company or to the customers we serve is still there. And that's awesome that we've been able to hold on to that kind of cultural quality as we have grown our employee base.

Okay, so that's it for the comments for me on the products and the company. Let's open it now up to Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question of the day will go to Aaron Schwartz of JPMorgan. Please go ahead.

Aaron Schwartz - JPMorgan

Good afternoon. I just wanted to talk about the geographic split there and was wondering if that was truly just some out performance internationally or if the changes you made in the North American sales force have kept you back there a little bit, or if there are the macro impacts more hitting your North American business?

Vinny Smith

This is Vinny speaking. It's tough to give you a feel for that. I can tell you that the changes we made, I don't know, they are definitely for the better, and we're going to benefit for years to come from them, but it's hard to measure in the quarter and how much was due to that versus just a bit of a hotter economy outside the United States than inside the United States.

Aaron Schwartz - JPMorgan

Okay. And then just looking at margins in your commentary around that and raising that guidance for the year. What was sort of the decision-making process around maybe pulling back a little bit of the reinvestment in to the company?

Vinny Smith

This is Vinny again speaking. We are concerned about just the climate out there, and we're really happy the Q1 came in the way it did. We just thought it would be the right thing to do to be a little careful going into what looks like a spicy situation. Remember we do a fair amount of business in particular verticals that are pretty hard hit in the last nine months like banks in particular. So we don't have any hard data that that our business is going to be affected, but we're just showing some concern and being careful.

Scott Davidson

And Aaron, the other I guess answer to your question around international versus domestic, clearly we had a couple of million dollars of benefit on the revenue line related to the foreign exchange benefit, right, from the weakness of the US dollar. I think you have seen that in most of your companies, and we're fairly consistent there.

Aaron Schwartz - JPMorgan

Sure, and related to that, I believe you have a little more impact from currency in the margin as well. Can you just sort of give us a total impact on the operating margin from currency?

Scott Davidson

Yes, so we had about $3.5 million benefit, and about $5 million detriment. It shaved probably close to 0.5% on the margin or so. And the biggest piece that FX impacts us is on the other income and expense line. I talked about in my remarks, we had a $4.7 million benefit in the other income expense line, so below the op income line related to the change in FX, which are on our balances of our subsidiaries outside of the US when those get re-measured.

Aaron Schwartz - JPMorgan

Okay, and lastly for me, if we look at possibly maybe a point more, a margin that you initially guided to and may be pulling back the pace of acquisitions relative to last year. I think a lot of people are anxious just to get your views on your balance sheet and potential uses of cash here?

Scott Davidson

Historically on the use of cash, as you know has been acquisitions. As our CapEx is usually somewhat below $10 million, $7 million, $10 million a quarter max. This quarter it was significantly below that. So historically, the uses of cash are we know either acquisition, dividend, or buyback stock. So I would imagine if not your question, which you are getting at, somebody else will ask the question about stock buyback, and, we have historically used the cash for acquisitions. We do have a Board meeting coming up this month, where, one of the things that we will address with the Board is a discussion around stock buyback, so that is clearly still a potential use that we could do at this point

Aaron Schwartz - JPMorgan

Okay. Congratulations on the quarter and thanks for taking my question.

Scott Davidson

Sure.

Operator

And we'll go next to Walter Pritchard at Cowen and Company.

Walter Pritchard - Cowen and Company

Hi. Thanks, I'm wondering if you, Vinny could just talk a bit about in the Windows market. It sounds like migration over the last few years is an area that you have seen some pressure already. I'm just wondering where else in the Windows business are you seeing more pressure that caused you to make those comments.

Vinny Smith

The migration business, we have seen pressure from Microsoft, which is a real profitable area for us. The other area that we're starting to see, we have a very large business around Active Directory and Microsoft, and I'm hoping that we can alter their tone in the marketplace. But Microsoft is getting more aggressive towards us as their new products that are going to launch pretty soon are getting ready to be launched. Being more aggressive with their customers, saying they don't need to buy those from us, which is a bit frustrating, because I don't think that's fair, but Microsoft has a lot of weight in the marketplace.

Walter Pritchard - Cowen and Company

Got you, and just got to clarify on the $5.5 million and the $13 million number. We saw the $5.5 million disclosed in the 10-Q a year ago. And the $13 million was disclosed just in the K, but both of those numbers were related to Q1 of '07.

Scott Davidson

It's a little bit more complex than that. The $5.5 million that related in the Q was, yes, related to Q1 '07. The policy went in to effect on Q1 2007, so that was the effect of the new policy in Q1 of 2007. So, essentially deals that were done in Q1 '07 that were actually recognized in Q1 '07 as before under the old policy they probably would have been deferred to future periods.

So there was a $5.5 million benefit in Q1 '07 related to that. The $13 million is the aggregate of that $5.5 million effect, but also taking in to account the effect from Q2, Q3, and Q4. That's what the $13 million was that was disclosed in the K. So we didn't provide a quarterly number that was comparative to the $5.5 million, which the Q1 number was. We didn't provide that breakdown for Q2, Q3, or Q4 individually. We just said it was $5.5 million in Q1 and $13 million for the year.

Walter Pritchard - Cowen and Company

Okay, that makes sense. And then just around tax rate and other income, so I mean I know taxes are difficult to predict because of the Geo split. But I think you were just talking about somewhere in the 32% range for the year, and it came a little bit light of that. Any update in terms of the forecast for both the tax rate and the other income for the year?

Scott Davidson

The Q1 pro forma tax rate is effectively based upon the forecast for the mix, for the rest of the year. So at this point in time, I think what you do is you take the Q1 tax rate that we have, because that's the best estimate and use that for the full-year basis until we know otherwise. So the 28.7 number is what you should use in your model on a go-forward basis.

Walter Pritchard - Cowen and Company

Could you maybe, just another level of detail. Could you just help us understand how different your tax rates are international versus domestic?

Scott Davidson

I would rather not. They are lower, obviously we've got, as most companies have, just intellectual property offshore, there's tax structures whereby revenue pools or net income pools in different subsidiaries which are lower tax jurisdictions. So to the extent that we pull more net income in those lower tax jurisdictions and we do more business in those markets, our overall rate is lower, but I'd probably not want to go in to any more detail than that.

Walter Pritchard - Cowen and Company

Okay. That's fair enough. Thanks.

Operator

We'll next to Tim Klasell with Thomas Weisel Partners.

Tim Klasell - Thomas Weisel Partners

Good afternoon, everybody and congratulations on the quarter as well. My first question has to do with the shape of the year, and I know you don't want to give quarterly guidance, but if I try to model to your guidance, it would be fairly linear year, and yet with your new rev rec policy I would think things would actually be a little bit more seasonal. Can you sort of help us think of how we should shape the quarters, which was in the top line, and then also on the margin, especially given since last year would be difficult to do compares on.

Scott Davidson

Yes, Tim, it's Scott. That's a difficult question to really answer without providing the quarterly view. But I think what I can help you with is under the new policy as it relates to our business, what you'll see is, historically speaking first, we had a strong Q4, and then we would have the sort of sequential drop into Q1. And I'm talking on a GAAP basis, and so the reality was, as some of this revenue or some of these deals that were booked in Q4 were actually recognized in Q1, the drop from Q4 to Q1 on a historical basis was probably not as steep as other companies.

So what you should think about now is coming from Q4, the drop from Q4 to Q1 is going to be steeper or the Q1 number would be lower, but at the same time your Q4 number is going to be higher, because basically we're not deferring that revenue that's related to resellers that was booked in those quarters. So when you think about it, we're going to represent more, I would say even more so of the traditional software company where Q1 is generally the lightest quarter. Q2 should be up sequentially. Q3 is generally speaking, depending upon where the European market and currencies are typically flattish to maybe even down and then Q4s are usually the biggest quarter.

Tim Klasell - Thomas Weisel Partners

Okay, very good.

Scott Davidson

And so the margin, without going in to the margin for the year, that the margin for Q1 under the new policy was 13.5% the pro forma operating margin, and you can kind of back in to where it's got be in Q4. It's a going to be substantively higher in the biggest quarter, which would be Q4 in order to get to let's say the 18.5% number.

Tim Klasell - Thomas Weisel Partners

Okay, very good. Then just jumping over to any product side, Vinny you hit on that the APM business was doing quite a bit better. I assume that was without any revenues from the virtualization, the VMware product, is that correct?

Vinny Smith

It is correct. We don't lump those revenues together when I say that. They were better, but they were better off of a bad number the year before, so it's a little bit of a misnomer, but the Foglight was, we have got good hopes for, and we think we're in a good slot this year to show progress?

Tim Klasell - Thomas Weisel Partners

Okay. Do you still think you can get the line to profitability this year?

Vinny Smith

No, I don't think we can do it.

Tim Klasell - Thomas Weisel Partners

Okay. Thank you.

Scott Davidson

Tim, it's Scott, just to clarify one point, there when you said the VM or (inaudible) you were talking about the product that realized, that does monitoring within Fog for ESX?

Tim Klasell - Thomas Weisel Partners

That's correct.

Vinny Smith

I misunderstood you. It was late in the quarter, so I don't really think there was much to factor in there at all. There won't be that much revenue. It will bolster our general Foglight, but we won't charge that much for that piece and that piece, that overall contribution will show up in the monitoring business. I thought you were thinking about our backup business, whether it was being lumped in with Foglight.

Tim Klasell - Thomas Weisel Partners

No.

Vinny Smith

Sorry, then.

Tim Klasell - Thomas Weisel Partners

Okay. Thank you.

Operator

And we'll go next to Kirk Materne at Banc Of America Securities.

Kirk Materne - Banc Of America Securities

Thanks very much. Scott, actually just wanted to follow-up on Tim's question just about sort of the linearity of the year as it relates to the operating margins. So if you are projecting some of the linear top-line growth somewhat through the first three quarters. Is cost coming down at all from 1Q to 2Q so that the margins are going to ramp at all, or is it really going to be very much a hockey stick when we are thinking about operating margins?

Scott Davidson

No, you should see a little bit of benefit from costs. I guess the way I would say that you're not going to see costs ramping as fast as your revenue rate would be. So it should grow at lower rate. You may see costs sort of flatten out a little bit in Q2 and Q3, but you're still going to see a hockey stick in -- or you're still going to see the biggest op-margin benefit in Q4.

Kirk Materne - Banc Of America Securities

Okay. That's helpful. And from a virtualization product perspective can you talk a little bit about the go-to market strategy there. Clearly you guys are going to be completing more as platform vendors in that market. I believe Vision Gore had more of a direct sales force. Are there opportunities to try to broaden that out to the channel obviously Cytrics has always been more of a channel company. VMR is obviously trying to build up a broader channel. How do you as a smaller company, compete with those guys if you don't start getting more leverage from the channel when you think about that part of the business?

Scott Davidson

So our ESX product line is sold 100% through the channel today and has got a pretty good size to it already. So we bought that business. We retained its independence partly because it had such a different go-to market plan than we did. So you know, that's a channel-bound business. In the server management space, we are very close with VMware working with them all the time to serve their customers. So we don't have really any conflict today with them. The conflict we will run in to them will be in the future as they evolve their platform and creep into our area.

But we have got some space from where they are today to where they will be in years out, so we think that we can retain a good partnership and keep moving forward what we do for the customers, so ESX retains its kind of like must-have hypervisor status in production environment. So we're hopeful we can hold on to a good relationship with VMware through the years.

On the desktop side; however, we are bound to run in to them and Cytrics and that's going to be a bit of a balancing act, how to deal with this. And we're plan to go more direct in that market right now for the bigger customers, and we're going to push it through a channel for the smaller ones, so in that market on the desktop side we use a two-pronged approach of channel and direct just because it's an early market, and we need be close with the larger customers just to feel where they are going, and what they need from us.

Kirk Materne - Banc Of America Securities

Okay. Great. That was all I had. Thank you.

Operator

Thank you. (Operator Instructions). We'll go to Richard Sherman at MKM Partners Please go ahead.

Richard Sherman - MKM Partners

Good afternoon. My question was about the Microsoft platforms that are coming out now, sort of rolling out from Microsoft. Looks like you are headed in to a much better end market cycle if these platforms are adopted. What are your customers saying about uptake or expected uptake or uptake of vendor server 2008 and the ensuing platforms that are scheduled throughout the year?

Vinny Smith

Yes, I'm not sure. I'm not that close to the Windows 2008 uptake, we're looking at more of the new technologies, not necessarily the upgrade from one OS to another in things like SharePoint and messaging services around Exchange and collaboration. Where we're building out new product families, and we see very good trends that Microsoft is going to do extremely well with SharePoint, with VoIP, with teleconferencing, collaboration, and so we're building out management suites around what we think is a good macro trend. And I'm sorry I can't answer your question on the uptake on Windows 2008 and how it affects us.

Richard Sherman - MKM Partners

Maybe just one other. In terms of the Microsoft business is it about half of your Microsoft business is migration related? Would that be a reasonable assumption?

Vinny Smith

No, it's much smaller than. I don't know 15%, something like that, but it's very profitable line for us. It also gets us in the door really early so it strategically has a nice value piece to it. That area Microsoft is competing more with us.

Richard Sherman - MKM Partners

Okay. Thank you, Vinny

Scott Davidson

I think, Rich, when you think about sort of new platforms that come out, I don't think it's so much the introduction of the new platform that comes out that really drives the revenue for us and so much as the end of life support on the existing platform that that really replaces. And so the best comparable I can give you to think about that is in Q4 of 2005, when Microsoft finally end of life support Windows NT 4. That led for a huge raft of migrations that benefited us.

And the question is always you can still get support on your existing platform, it just costs you a lot more money. The Windows 2008 cycle will be driven by customers that have maybe specific applications that need to require the underlying functionality of Windows 2008 that will then upgrade, that will need management tools around them. So we'll see some of that benefit, but the real kicker for us, at least historically, has been when do they stop supporting the previous version of it, because that's when everybody knows that they have to move.

Richard Sherman - MKM Partners

I see. Okay. Thank you.

Scott Davidson

Sure.

Operator

And we'll go next to Derek Bingham at Goldman Sachs.

Derek Bingham - Goldman Sachs

Hi, thanks. Scott, in lifting your margin outlook a little bit, is there any color you can give on some specific cost leverage you'll be pulling, or is it more that you expect higher revenues than before?

Scott Davidson

No. We're not really changing our guidance around revenues as we talked about given the global or at least the U.S. macro economic view. So we have kept the guidance and kept our internal model on revenues fairly the same. What we're thinking about doing is, is extracting some leverage from the investments we have made in the past, or maybe even optimizing some of the ways that we're running aspects of our business, where we can get some leverage out of them, and that maybe in the cost of moving heads around, it maybe in the cost of consolidating things.

It may in other areas, but it's really -- it could be a couple of different things. It's not specifically tied to just one thing. We had, for example, increases in heads that were projected for 2008 that we think we maybe able to push out. So we can back those out of the model, which gives us some leverage, and then there are some other things we can do to sort of optimize places where we're at.

Derek Bingham - Goldman Sachs

Okay. Got it. On the fewer large deals in the quarter would you attribute that to North America, or is there any way to pin the cause of that?

Scott Davidson

No, I don't think that's fair. Sometimes these things seem a little -- it's not -- a little less predictable than the other business, and we just didn't have big deals either. We only had one in Europe, and zero in the U.S., so I -- I don't look at it as a terrible thing. It's just the way it came down.

Vinny Smith

And it's just by basis of comparison and there was two in Q1 '07. So 50% less. But two deals versus one deal so not a big delta there, if you will.

Derek Bingham - Goldman Sachs

But 50% less, Scott.

Scott Davidson

Yes. All right got it.

Vinny Smith

Politician.

Scott Davidson

You got me there.

Derek Bingham - Goldman Sachs

Yes. I had one more please. You said -- if I heard it correctly, 33% of your deferred revenue increase from acquisitions; is that right?

Scott Davidson

Yes, I said about a third.

Derek Bingham - Goldman Sachs

Is there any sense you can give us for how much of the revenue growth came from acquisitions?

Scott Davidson

We're not breaking that out anymore.

Derek Bingham - Goldman Sachs

All right. Fair enough. Thanks very much.

Scott Davidson

Sure.

Operator

Gentlemen, we have no other questions. So at this time I'd like to turn the call back to Mr. Smith for any closing comments.

Vinny Smith

Okay. Well, thanks for listening in, and we're, you know, obviously happy with the quarter. We're trying to strike a balance between being careful about the macro demand picture, but also we've got areas where we can improve and execute better, so we think we can continue to hit the numbers that we've laid out for you guys.

And for me, again, it's just try to create a great company and be a part of one, which means be a part of -- creating a place where it's great to work, and I want to thank all of the employees who work so hard and listening to this call, and also, for our customers. We want to be great for them so they keep coming back. And we've told them over and over again, we only make money with a sustained relationship, and so if we service them well on the long haul they'll keep giving us their business. And, that's actually where we reach our profitability. So that relationship has worked well. And hope to keep pursuing that goal. So thanks, and that's it.

Operator

Thank you. That does conclude the call. We do appreciate your participation. At this time, you may disconnect. Thank you.

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Source: Quest Software Inc. Q1 2008 Earnings Call Transcript
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