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Executives

Jill Eisenstadt - Investor Relations

Dominic P. Orr - Chairman of the Board, President, Chief Executive Officer

Steffan Tomlinson - Chief Financial Officer

Keerti Melkote - Founder and Head of Product Management

Analysts

Mark Sue - RBC Capital Markets

Ryan Hutchinson - Lazard Capital Markets

Jack Monte - Lehman Brothers

Analyst for Greg Mesniaeff - Needham & Company

Sanjiv Wadhwani of Stifel Nicolaus & Company, Inc

Ehud Gelblum - J.P. Morgan

Erik Suppiger - Signal Hill Group LLC

Thomas Lee - Goldman Sachs

Bill Choi - Jefferies & Co.

Blaine Carroll - Ftn Midwest Securities Corp

Joanna Makris - Brean Murray, Carret & Co., LLC

Aruba Networks, Inc. (ARUN) F3Q08 Earnings Call May 22, 2008 5:00 PM ET

Operator

Welcome to the Aruba Networks third quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Jill Eisenstadt of Investor Relations.

Jill Eisenstadt

Good afternoon and thank you for joining us on today’s conference call to discuss Aruba Network’s Fiscal Third Quarter 2008 Results. This call is also being broadcast live over the web and can be accessed in the Investor Relations section of the Aruba Network’s website at www.arubanetworks.com.

With me on today’s call are Dominic Orr, Aruba’s Chief Executive Officer; Steffan Tomlinson, Chief Financial Officer; and Keerti Melkote, Founder and Head of Product Management.

After the market closed today, Aruba Network’s issued a press release announcing the results for its fiscal third quarter ended April 30, 2008. If you would like a copy of the release, you can access it online at the company’s web site or you can call the Blue Shirt Group at 415-217-7722 and we will fax or email you a copy.

We would like to remind you that during the course of this conference call, Aruba Network’s management may make forward-looking statements, including statements regarding expected revenues and non-GAAP EPS for the fourth quarter of fiscal 2008, future performance of its verticals including federal, growth in the business and sales of the company’s products, including its 802.11n solutions, its ability to make follow on sales to new customers, and other statements as to the company’s future economic performance, financial condition, or results of operations.

These forward-looking statements are not historical facts, but rather are based on the company’s current expectations and beliefs. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of factors, some of which re beyond our control.

These forward-looking statements apply as of today and you should not rely on them as representing our views in the future and we undertake no obligation to update these statements after this call.

Please refer to the risks and uncertainties described under the captions Risk Factors, and Managements Discussion and Analysis of Financial Condition and Results of Operations, in our quarterly report on form 10-Q filed with the SEC on March 7, 2008, as well as our earnings release posted a few minutes ago on our web site, for a more detailed description of these risks and uncertainties that may affect our results.

Copies of these documents may be obtained from the SEC or by visiting the Investor Relations section of our web site. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges, including non-cash stock-based expenses and acquisition related expenses for all periods.

We have provided reconciliations of these non-GAAP measures to GAAP financial measures in the Investor Relations section of our web site located at www.arubanetworks.com and in our earning pres release.

Now I’d like to introduce Dominic Orr, President, and Chief Executive Officer of Aruba Network.

Dominic Orr

Good afternoon and thank you for taking the time to attend our fiscal third quarter results conference call.

We are pleased to report a return to sequential revenue growth in the third quarter. A quarter ago we focused on three main issues that impacted our results: softer federal sales, a slow than expected ram in our two- tiered distribution network in America and an elongated sales cycled due to a slow down in the general economy.

While overall economic conditions are still impacting our sales cycles in select markets, I am pleased to report progress in the areas that are within our control and double-digit sequential improvement in four out of five of our core verticals.

For the quarter revenues increased 23% year-over-year to $42.6 million and we reported healthy non-GAAP gross margins of 70.7%. Some of the highlights from the quarter included: a very positive quarter of new customer acquisitions, the best in our company history with strong momentum at the end of the quarter; strong sequential sales growth across all international theatres; the strength of education and healthcare markets; increasing demand for mixed generation 802.11n products ahead of formal ratification of the standards; the close of our acquisition of AirWave Wireless, which further differentiates our position in the market place and bolsters our competitive position; and a 60% sequential increase in sales through our two-tier US based distribution partners.

We are very encouraged by our continued ability to win new accounts and the third quarter was notable for the addition of over 500 new customers spread across all of our verticals. This record number of new additions excludes all the new customers that were also brought over by AirWave.

We believe this new customer growth is the single most important positive indicator for our long-term future in the current economic environment. Finally I’ve seen a decrease in the size of initial purchase orders of some customers. Our ability to continue to sell into new accounts is a strong positive indicator that we can continue to win customers from incumbent suppliers and demonstrates that we can grow, even in a tough economic environment.

The quality of our new customer list is excellent and we believe that many of the additions in the quarter will develop into strong seven figure customers. These customers come from all of our verticals and included a Fortune 500 energy utility in the US, one of the worlds largest professional services company; a leading telecom company in China; one of the worlds largest consumer product companies based in Europe; one of the leading hospitals in Los Angeles; and a major health system in Pennsylvania and the United Kingdom; and multiple university and school districts through out the United States and abroad.

Overflow picked up vertically in the last month of the quarter giving us some momentum as we entered Q4. The education market has been a clear area of strength with a strong focus on ease of use, high performance, and low total cost of issue. New customers range from some of the largest public universities in America to the independent school districts and we’re not confined to the US market, as we are rolling our major education line-up systems in China, in Japan, in the United Kingdom, and through [Algenier].

We continue to see lots of opportunities for growth in this market place with our solution appealing to both university and K-12 school districts. Another key area of growth has been the healthcare market, where we have significant wins both domestically and abroad.

Aruba’s products can bring vital information into the hands of health practitioners wherever they roam and hospitals and healthcare organizations are a great target for our solutions. The unique security, voice, and quality of service requirements of these customers, coupled with their need for centralized management, make them a great match for our technology.

Our strong performance in the education and healthcare markets, counter balance continued softness in the retail market and a modest quarter in the federal market. While our federal sales show sequential improvement, we did not see a return to over 10% of revenue as we had expected. Although federal can be a lumpy vertical we believe we are solidly entrenched with our existing customers and continue to win new contracts in this market. On this note, we recently won a new significant contract with a major organization in the US Department of Defense that we believe could be a core customer for years to come.

One of the key reasons for our new customer success, especially in education, has been our clear leadership in bringing the captive 802.11n solution to the market. We recently announced a shipment for our 10,000-11n access point and importantly fast growing demand for his technology has occurred despite the lack of formal ratification of the standard. We believe that our 802.11n solution offers a fundamental advantage in performance, ease of use and interoperability, all subjects of great importance to our customers.

Our 11n solutions are clearly differentiated from our competitors, offering high performance at system level and an easy migration path from incumbent, stand alone wireless LAN solutions.

Using AirWave software, advertisers can manage the legacy and 802.11n management base from a single management console, lowering total costs of ownership. Our control is over 80 gigabytes of system capacity, to take advantage of the high air space of 802.11 technology offers. Overall, we have not seen any significant change in the competitive front and we believe that we can clearly win the large majority of our head set engagements.

Obviously, our primary competitor is an established company with a broad product portfolio and larger install base. Never the less, we are adding customers in record numbers. We attribute this success to our ongoing innovation and our focus on the market and we will continue to aggressively invest in R&D to maintain our leadership.

During the quarter we further expanded our technological lead introducing a wide range of products and solutions, including the AirWave Wireless Management Suite 6 software and multi vendor management platform featuring integration with popular service desk software suites such as BMC Remedy.

An affordable line of 802.11 ABG access point, that can be upgraded via downloaded software to 802.11n operation. The first wireless intrusion protection software, that allows customers to define individual threat signatures, and thereby respond faster to security threats.

New software that can securely extend enterprise WIFI networks over a broadband cellular network. Innovations like this are what clearly differentiate our products in the market and we will continue to spend in this area to maintain and expand our differentiation.

We also continue to invest in and expand our distribution channels. We made good progress with our domestic two-tier distribution network in the third quarter. As a group, our US based validated distributor sales grew over 60% sequentially.

Complimenting this effort, we also expanded our relationship with Dell We have had success selling through Dell in the past and are growing our relationship to sell our full product line to education, healthcare and federal customers that look to Dell to provide proven, easy to use and well supported solutions that meet their needs.

Additionally, our OEM relationship with Alcatel-Lucent remains strong across all theatres.

Overall, it’s a tough economic climate, but we continue to make progress and gain momentum. The diversity of our core verticals, especially our strength in education and healthcare is a key factor in our performance and we were pleased with some notable wins in the enterprise and in the federal markets. We are gaining new customers, leading the industry in innovation and expanding our distribution channels. I believe our competitive position has never been stronger and the long-term value of our new and existing customers made us very optimistic for our future.

A little later in the call I will be happy to answer any questions that you may have, but now I will turn it over to Steffan to go over the financials in more detail.

Steffan Tomlinson

Before I begin the discussion of our third quarter results, I’d like to note that all comments made in the prepared remarks exclude the impact of non-cash stock-based expenses and acquisition related expenses unless specifically noted.

In Q3 total revenue of $42.6 million increased 5% sequentially and 23% year-over-year. Product revenue of $35.5 million increased 4% sequentially and 19% year-over-year. Existing customers accounted for 61% of sales. Professional services and support revenue of $6.3 million increased 13% sequentially and 65% year-over-year. Ratable product and related services revenue of $800,000.00 declined 9% sequentially and 21% year-over-year as expected.

In Q3 approximately 84% of our revenue came from indirect channels, while 16% were direct sales. As a reminder, our indirect channels represent sales to our value added resellers, distributors, as well as our strategic OEM partner Alcatel-Lucent.

We had no 10% end customer in the quarter and Alcatel-Lucent was a 10% partner. Approximately 66% of our sales were generated in the US with the remaining 34% coming from international. Sales to our AMEA and AsiaPac theatres were up over 15% sequentially. Encouragingly, we experienced bookings growth in all of our four theatres during the quarter.

We continued to produce strong gross margins in the third quarter. Overall, non-GAAP gross margins came in at 70.7%, compared to 69.7% in the prior quarter. This strong performance was above our target range for gross margins of 65% to 68% partly due to product mix and higher margins on new products. Moving forward we expect margins to return to our target range as more sales goes through our two-tier distribution partners in the US.

Non-GAAP research and development expenses increased by approximately $536,000 from the prior quarter and as a percentage of revenues was 19.5% in Q3 ’08. Non-GAAP sales and marketing expenses increased by approximately $2.1 million from the prior quarter and increased as a percentage of revenue from 42.1% in Q2 ’08 to 45.2% in Q3 ’08.

Non-GAAP G&A expenses increased by $442,000, reflecting increased expenses related to the Motorola lawsuit of approximately $500,000.00. As a percentage of revenue G&A increased from 8.6% in Q2 ’08 to 9.2% in Q3 ’08.

While we are not breaking out AirWave as a separate line item, the increase in operating expenses in during the third quarter was primarily related to the completion of that acquisition in late March.

Non-GAAP net-loss for the quarter was approximately $1.1 million or $0.01 per share, compared to a non-GAAP net income of $800,000 in Q2 ’08 or $0.01 per share and non-GAAP net income of $1 million or $0.01 per share in Q3 ’07. For the period, non-GAAP weighted average sales outstanding were $80.6 million on a basic and diluted basis.

The GAAP net loss for the quarter was $6.2 million or $0.08 per share, compared to a GAAP net-loss of $3.5 million or $0.04 per share in Q2 ’08 and a GAAP net-loss of $9.3 million or $0.26 per share in Q3 ’07. Our third quarter of 2008 GAAP results included $4.3 million on non-cash stock-based expenses and $900,000.00 of acquisition related expenses.

Turning to the balance sheet, we finished April with $97.8 million of cash and short-term investments. This represented a decrease of $15.5 million last quarter, due to approximately $16 million in cash used to acquire AirWave and $1.6 million spend on our share buyback. Short-term deferred revenue was $22.5 million at quarter end, compared to $20.3 million at the end of Q2 ’08.

Moving down the balance sheet, we ended Q3 with $28.6 million of accounts receivable, up from $25.7 million in Q2 ’08. Days sales outstanding were 60 days, an increase of 3 days from Q2 and above our long-term DSO target of between 50 and 55 days. This increase was primarily due to a strong sales momentum in April and we expect DSOs to decrease next quarter.

Inventory totaled $16.5 million at the end of Q3, decreasing from $17.3 million at the end of last quarter. Inventory turns decreased from 3.0 to 2.7.

Moving forward we continue to believe that our market opportunity is large and growing, our pipeline is strong and booking and momentum were encouraging in April. At the same time, it remains a challenging market and we think it is prudently cautious in this environment.

As Dom highlighted, we also plan to increase our investment in R&D and build out our international sales and marketing teams, along with normal G&A spending related to being a public company.

Given all these factors, we expect to see revenue in Q4 ’08 in the range of $45 to $48 million with non-GAAP EPS of break even to -$0.02 per diluted share.

With that, let me turn the call back over to Dominic.

Dominic Orr

Steffan, Keerti, and I would now be happy to answer any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Sue - RBC Capital Markets.

Mark Sue - RBC Capital Markets

I’m trying to part your thoughts on n demand whether the small sequential balance and up to your guidance is related to market growth seasonality or a product cycle related to wireless LAN and do you also have some thoughts on whether or not wireless has been elevated in the overall rank order of things when it comes to enterprise IT budgets.

Steffan Tomlinson

For n demand, part of that was due to, basically when we look at our enterprise customers in the US and internationally, n has become more of a prominent product that companies are evaluating and the sales cycles for 11n are very much equivalent to EDG pilots that have gone in the past and the market growth for n has increased. We’re seeing broader adoption and broader demand for 11n.

Mark Sue - RBC Capital Markets

So, it’s not just wireless n but it’s a lot of other things that you feel like demand is just generally picking up.

Steffan Tomlinson

Correct. We see demand is picking up, especially in education and healthcare, we’re seeing a pick up in federal, and in the overall enterprise we have seen encouraging signs.

Dominic Orr

I’d like to refer back to the fact that we, in terms of new customer acquisitions this is a record quarter; however we also make a simultaneous observation that the average initial purchase price is lower than previous quarters.

Mark Sue - RBC Capital Markets

On the new customers, do you feel that there are architecture wins with significant recurring revenues or would you still classify them as small deployment wins at this stage?

Dominic Orr

I think in enterprise there is definitely architectural win with recurring revenue. As in the case of some of our very close, it is a single screw, a single hospital, then the recurring revenue would not be in the coverage of access point but more in the area of upgrading our functionality like new software packages or remote catalysts.

Mark Sue - RBC Capital Markets

Lastly just on federal, we’ve seen that bounce around for a couple quarters now. Any thoughts on, its onward, and forward with federal?

Dominic Orr

I actually spend a reasonable, significant amount of energy talking to our customers in our field. I continue to feel very good momentum in our positioning in winning projects the pipeline, but it is also very clear that we are facing some lumpiness in spending, that obviously are not related to the general economic environment, but it’s just some lumpiness in the funding or absorption of products in the programs that we are involved in.

Operator

Your next question comes from Ryan Hutchinson - Lazard Capital.

Ryan Hutchinson - Lazard Capital Markets

I know you’re guiding your gross margins back towards the 65% to 68% range, but just a general sense, given the fact that we’ve been operating above that range for a number of quarters now, can you just walk through what’s going on there and when we can expect to see us back into the 65% to 68% range?

Steffan Tomlinson

For the targeted model, the targeted model assumes that our two-tier US based distribution system is performing at a higher rate than it is now. The good news, this quarter we had a 60% sequential increase, but it’s still operating below where we think it should. Also, retail is a smaller mix of overall revenues, which will impact the overall gross margins.

Ryan Hutchinson - Lazard Capital Markets

In terms of the key verticals you’re playing into today and the success you’re having there, as you look out here over the next several quarters when do you expect to see an uptick outside of those verticals into the overall broader enterprise?

Dominic Orr

I think if you look into our general enterprise bookings for the last quarter it was roughly flat over the previous quarter, but it was over 200% growth over the previous year, so we are seeing actually generally a larger number of enterprises getting into wireless LAN, but as I mentioned, again, the initial purchase order was low.

Ryan Hutchinson - Lazard Capital Markets

Then just on AirWave, are you in a position to quantify how much that contributed to revenues in the quarter?

Steffan Tomlinson

We’re not breaking out AirWave as a separate line item. We view that as a brand new product that is part of our product portfolio and we’re not even tracking, internal we’re not doing segment reporting on it; so, we’re not breaking it out.

Ryan Hutchinson - Lazard Capital Markets

Is it tracking in line with your expectations?

Dominic Orr

The AirWave integration is working out actually above my personal expectation, both in the area of our continued momentum to drive the AirWave to be the multi-vendor leader and generally accepted by the community market as such and its ability to contribute at significant value differentiation to Aruba customer base.

Steffan Tomlinson

Qualitatively it had a nominal impact on the quarter.

Operator

Your next question comes from Jack Monte - Lehman Brothers.

Jack Monte - Lehman Brothers

I was just curious, the Dell relationship sounds pretty good, and I was just curious if that’s an exclusive arrangement or for other comparable products that are offered there as well and also if you could comment on potential opportunities with Hewlett Packard or other companies?

Dominic Orr

The arrangement with Dell is not exclusive and regarding other larger partners that we might be working with, I would say that if you look in to our vertical partner strategy, it’s related to our vertical strategy. Dell is a strategic partner because of the position in the healthcare and education and the government market and as we expand our industry focus we will align the appropriate major partner.

Definitely the momentum of the discussion of partnership is definitely there.

Operator

Your next question comes from Analyst for Greg Mesniaeff - Needham & Company.

Analyst for Greg Mesniaeff - Needham & Company

Hi there, this is Connor and I’m calling in for Greg.

My first question, can you please provide us with an update on your visibility and center verticals. In the call you said it returned to greater than 10%, do you expect it to remain in this 10% to 20% range going forward?

Steffan Tomlinson

On the center vertical we actually said that it didn’t return to 10%. We saw sequential improvement and we were able to Inc at least one major Department of Defense organization which we feel over time could be a seven-digit lifetime value.

Analyst for Greg Mesniaeff - Needham & Company

Second, could you give us a quick over view as to which verticals you’ve seen the quickest uptake of 11n? Is it still higher education?

Dominic Orr

I would say education in general. It’s definitely the vertical that is taking the leadership position in the [indiscernible]. We’ve seen demand and request for pilots across the board.

Analyst for Greg Mesniaeff - Needham & Company

How do they rank after education in the verticals?

Keerti Melkote

In terms of limit and demand beyond education we are seeing that in the healthcare vertical, as well as in the industrial enterprise and after that of course, as Dom mentioned, it’s in pretty much of the other vertical. Also in the high tech vertical it’s a lot of weakness.

Operator

Your next question comes from Sanjiv Wadhwani with Stifel Nicolaus.

Sanjiv Wadhwani of Stifel Nicolaus & Company, Inc

Generally on the guidance front, are you assuming for the July quarter continued softness in the US market? Any color on what you’re thinking your wrap up would be helpful.

Dominic Orr

We have seen from the US enterprise market, we expected last quarter, we have seen the demand not getting less, but it’s approval cycle getting longer. I think in the course of the last 90 days we did not see, at least in the [dougherty] we did not see a further lengthening of the cycle, but we did not see any significant improvement either; nevertheless, of our new customers acquired, there are significant numbers that are in the enterprise market with pilot projects.

Sanjiv Wadhwani of Stifel Nicolaus & Company, Inc

On the federal government side are you expecting a little bit better performance in July or are all bets are off at this point in time and maybe October is when you’ll see a rebound because of fiscal year end for them?

Steffan Tomlinson

We did see sequential improvement which we were happy with. It just fell a little bit short of our internal expectations. The fed business, as we’ve come to learn, is a little bit lumpier than we had thought. In Q4 we’re not breaking out in particular fed, but we do think that there is going to be decent demand out of the federal vertical for us.

Sanjiv Wadhwani of Stifel Nicolaus & Company, Inc

Then 7-1 clarification on the repurchase side, can you give us the average price of what you repurchase shares at?

Steffan Tomlinson

I can give it to you offline, but it was approximately, I think, $5.20.

Operator

Your next question comes from Ehud Gelblum - J.P. Morgan.

Ehud Gelblum - J.P. Morgan

Steffan, when you said that AirWave was minimal, or not impactful in the quarter, going forward it used to be at an $8 million a year run rate. Is that basically still where it would be and should we look at that as kind of the $8 million a year going forward is that just, I know it didn’t impact this quarter, but I just want a sense, is that still the run rate that the business was on?

Steffan Tomlinson

The AirWave sales historically have been choppy, but an $8 million annual run rate is, I think that’s a decent expectation on an annual basis.

Ehud Gelblum - J.P. Morgan

Okay and that’s somewhat built into your guidance for next quarter?

Steffan Tomlinson

Correct.

Ehud Gelblum - J.P. Morgan

Last quarter, Dominic, you talked about some lengthening of sales cycles that you were observing in Europe, I think in the big five or at least in northern Europe. Are you seeing any change in that environment?

Dominic Orr

Yes, actually our business in northern Europe had significantly rebounded.

Ehud Gelblum - J.P. Morgan

The close rates are back to where they had been two quarters ago?

Dominic Orr

Yes, in fact I’m very pleased with them. Generally the whole near theatre have been getting very encouraging results.

Ehud Gelblum - J.P. Morgan

In terms of headcount and hiring, I may have missed it, but did you give a number for what headcount was this quarter and what are your hiring plans? Are you in the process of hiring, or are you keeping the headcount steady; how is that related to what you see in outlook?

Dominic Orr

I’ll let Steffan address the specific number, but we are still actively hiring, particularly in the area of R&D and also the international sales and marketing; that’s kind of a major area.

Steffan Tomlinson

For overall headcount we ended at 552 heads and that was up from 506 from the prior quarter, but that also included approximately 55 people from AirWave who came on board.

Ehud Gelblum - J.P. Morgan

55, so 55, well 506 plus 55 is 561 so you actually lost nine people is that right?

Dominic Orr

Yes we did, that’s actually within the basic order of statistics, that’s kind of a normal…

Ehud Gelblum - J.P. Morgan

Those were AirWave people and they’re in the process of coming over or those were…

Dominic Orr

We haven’t lost any AirWave people.

Ehud Gelblum - J.P. Morgan

So those were Aruba people that just normal attrition?

Steffan Tomlinson

Correct.

Ehud Gelblum - J.P. Morgan

Can you give us what that number was the prior quarter?

Steffan Tomlinson

The prior quarter for Aruba only?

Ehud Gelblum - J.P. Morgan

Yes, if you don’t have it I can get it offline.

Steffan Tomlinson

I believe it was 475.

Ehud Gelblum - J.P. Morgan

There as a press release I found very interesting a couple of weeks ago about working together with River Bed on a combined product?

Dominic Orr

That is, we announced our go to market plans a lot of our, we had a lot of come in customers and they have a lot of branch offices for lower operations costs would like to go to a server less and wireless environment and the fact that River Bed client can accelerate the traffic over wireless equipment gives a very meaningful synergy for those customer sets.

Ehud Gelblum - J.P. Morgan

Interesting. Also, I just remembered, also on AirWave, you said that the 500 new customers included new customers brought over with AirWave.

Dominic Orr

No, it did not.

Ehud Gelblum - J.P. Morgan

It did not include, okay.

Operator

Your next question comes from Erik Suppiger - Signal Hill.

Erik Suppiger of Signal Hill Group LLC

Just on the OpEx side, I think implied in your guidance is OpEx somewhat higher than what I had. Have you been hiring on the sales side more aggressively? Have you seen a notable uptick there or what’s the increase on the OpEx going forward?

Steffan Tomlinson

For research and development we are continuing to invest in the key technologies that make us a clear differentiator in the marketplace. For sales and marketing we are investing in selected territories with more emphasis on international, where we’ve seen very good sequential growth.

Then on the G&A front there are expenses related to our Motorola lawsuit that’s imbedded in the guidance as well.

Erik Suppiger of Signal Hill Group LLC

Then you had a press release announcing your 10,000th n access point. Can you give us a sense for what proportion of access points going out at this point are n versus your legacy?

Steffan Tomlinson

Sure, so in the last quarter it was approximately 20% of our access points that were n access points.

Just one point of clarification on the prior question, we also have a full quarters worth of AirWave OpEx that’s hitting the P&L going forward.

Operator

Your next question comes from Tom Lee - Goldman Sachs.

Tom Lee - Goldman Sachs

I just wanted to dig in a little bit on the balance sheet. I know you indicated the DSOs were up largely due to a strong April. I’m just curious, relative to what you saw in prior quarters, I would have thought if we saw a strong order momentum into April; wouldn’t we have seen some of that reflected in a deferred revenue number? Or, is there any kind of connection between the order backlog and the deferred revenue number?

Steffan Tomlinson

We should definitely look at a couple of things on the balance sheet: first is accounts receivable increased from $25.7 to $28.6. You are correct that deferred revenue increased from $20.2 to $22.5 million, which showed that some of the deals that came in at the end of the quarter were put into deferred revenue.

As far as DSOs in general are concerned, we were disappointed that they went up, but it was clearly due to the backend-loaded nature of the quarter. We were actually very efficient on cash collections in the quarter, but when you bill as much as we did in the last month of the quarter, those receivables just aren’t collectable in that month.

Tom Lee - Goldman Sachs

On the payables side, you saw that jump up pretty significantly too. What were some of the drivers behind that on a sequential basis?

Steffan Tomlinson

Basically there were a couple of payments to some of our manufacturing partners that there are A&P that are normal and in other vendors.

Tom Lee - Goldman Sachs

Just talking on the market in general, it sounds like from a competitive standpoint you are clearly doing very well in verticals such as education and healthcare, but I’m just curious, are you seeing others outside of Cisco starting to make some inroads into verticals such as education?

Then related to that are you seeing Cisco becoming perhaps a little bit more aggressive on pricing?

Keerti Melkote

We are only seeing Cisco and I think the competition is, I would say more accentuated, I won’t say more intensified because, as I mentioned last quarter, it is getting more and more fierce a two horse race, so we are actually seeing, having a very focused competition very early on in the game in basically all the deals, whereas as compared to six to nine months ago, it is a noisy environment and it’s only creating the end, it is us against Cisco.

Regarding other competitors, we continue to see in the retail and logistics space the Motorola symbol offering. Other than that I would say that in general we do not see a lot of competition.

Tom Lee - Goldman Sachs

Lastly on that point, is security kind of still the key area where you’re able to differentiate yourselves relative to the competition or is there, what are kind of some of the key reasons you’re able to kind of win a lot of these deals relative to Cisco or other competitors?

Keerti Melkote

I think security was the primary differentiation for us as Lebanon is becoming more important in the marketplace. Our differentiation has expanded into performance as well as management. If you combine AirWave and our new controllers, we offer a full solution that offers security, best in grade in terms of performance, and a very easy migrate [indiscernible]. So, if you take all three into consideration, the entire solution is much more differentiated from Cisco and pretty much anyone else in the marketplace.

Operator

Your next question comes from Bill Choi - Jefferies & Co.

Bill Choi - Jefferies & Co.

I wanted to see if you could provide a little more detail on the verticals. You mentioned four of your top five verticals are in double-digits. In the past I think you’ve kind of grouped them together and said what they are as a percentage of totals. Can you kind of go over that and in particular you kind of talked to the strength in education: is that substantially larger than any of the other leading verticals?

Dominic Orr

I think when we declare a major vertical, it has a trend that it fluctuates between 10% to 20% of our traditionally of our revenue and I would say of the education vertical, I think traditionally we have been very active in the large university, I would say the increase in our activity is in an area of the more medium sized university as well as the K-12. I think those heating up as well.

Bill Choi - Jefferies & Co.

So was education also within that 10% to 20%?

Steffan Tomlinson

Yes.

Bill Choi - Jefferies & Co.

Also, when you look into education, does the domestic versus the international look similar to the corporate average, and also, do you have some sense for how much of it is private versus publically funded institutions?

Dominic Orr

I don’t see a trend of whether private or publicly funded university makes any difference in terms of the need for wireless LAN, or in the K-12 as well. I think their some of the richest school districts are privately funded, but then in the, there is public money available as well.

As regarding whether we see a different trend of domestic versus international? We’ve seen in the healthcare and education vertical it is pretty much a worldwide phenomenon. There might be a small pocket of certain countries not taking off, but that’s generally speaking. OF course all four of our theatres those verticals are very robust and growing.

Bill Choi - Jefferies & Co.

If international is roughly around 34%, there’s vertical too, deep verticals?

Dominic Orr

Yes.

Bill Choi - Jefferies & Co.

Just moving on to gross margin a little bit, Steffan you mentioned a benefit from product mix. Could you give a rough sense of where you are in the mix between controllers, access point, and software modules and is that really the mix shift that you’re talking about or was there something else like 802.11n being a greater percent?

Steffan Tomlinson

Our product mix targets are about 1/3 product, 1/3 software and 1/3 services. Effectively when we look at the benefits of why the gross margins were as high as they were this quarter, you have new product introduction in all those categories, including the APs and the controllers that have a better gross margin profile than some of their predecessor products, which is good.

When we look at kind of over time where the gross margin is heading, given the fact that the two-tier distribution system is increasing, we’re going to have some downward pressure on the gross margin line.

Bill Choi - Jefferies & Co.

Okay, just to clarify the percentage of that mix that you just talked about, the 1/3, 1/3, 1/3 is that about the same for this quarter as it normally is?

Steffan Tomlinson

Yes, so just to clarify, it’s 1/3 controllers, 1/3 APs, and 1/3 software and services and those are our targets, we strive to get to those, there is some obsoletion around each of those, but in general those are our targets and we’re striving towards those.

Bill Choi - Jefferies & Co.

You talked about 60%, sequential growth in two-tiered distribution. Has that reached 5% or any rough sense of how much it has contributed as a percent of total revenue?

Steffan Tomlinson

As a collective basket the three US two tier vats in total contributed about 25% of the revenues, which was a very nice sequential increase. It depends upon, I think each quarter as we move forward, what each of those are going to contribute on an individual basis, but none of them are at a 105 partner at this point.

Operator

Your next question comes from Blaine Carroll -Ftn Midwest Securities Corp.

Blaine Carroll - Ftn Midwest Securities Corp

Steffan, during your prepared comments when you were talking about DSOs, you said it was 60 days, your target is 50 to 55 and I thought I heard you say that DSOs will increase next quarter or did you say decrease?

Steffan Tomlinson

I said decrease.

Blaine Carroll - Ftn Midwest Securities Corp

You did say decrease, okay. I was just wondering about and it begs a second question, your visibility into the current quarter and into your guidance, how booked you are and whether you expect the quarter to be backend loaded once again.

Steffan Tomlinson

We’re a book and ship business. We did have strong sales momentum heading into the last month of last quarter. There has been, I would say, reasonable demand in the first month so far and we still feel like we’re not out of the woods yet in terms of being backend loaded in nature. We’ve seen that historically and last quarter was a case in point where we were very backend loaded. We’re trying to mitigate that, but we still feel like this is going to be a backend-loaded quarter.

Keerti Melkote

July being the last month of the fiscal year, it’s just the fiscal nature of things that we expect that to be a big one.

Blaine Carroll - Ftn Midwest Securities Corp

That makes sense and then you talked about your target model. I wonder if you could refresh us on what your target model would be now with the acquisition and also the investment that you’re doing in the R&D.

Steffan Tomlinson

We’re not updating our target model at this point. At the end of our Q4 call, we’ll take the opportunity to update the long-term target model and we’ll evaluate at that time and we’ll share it with investors.

Blaine Carroll - Ftn Midwest Securities Corp

Then a housekeeping question that would be on the share count: what should we use for a share count in July?

Steffan Tomlinson

The basic shares outstanding were $80.6 million. I would say that a number close to that, plus or minus two million shares would be reasonable.

Blaine Carroll - Ftn Midwest Securities Corp

Was AirWave an all cash deal; was there some stock involved in that?

Steffan Tomlinson

There was some stock involved in that. Of the purchase price that we paid we paid about, call it $16 million in cash approximately and we paid roughly $8 million worth of stock.

Blaine Carroll - Ftn Midwest Securities Corp

That’s not going to move the needle that much on share count?

Steffan Tomlinson

Correct.

Operator

Your last question comes from Joanna Makris - Brean Murray, Carret & Co., LLC

Joanna Makris - Brean Murray, Carret & Co., LLC

I’m wondering if you can provide maybe a snap shot into the federal business for the month of May. Specifically have you seen any of the orders that were previously pushed out last quarter start to get reignited, any activity along those lines, or is it still too early to talk about?

Keerti Melkote

It’s actually too early; you’re talking about May, this month.

Dominic Orr

Yes, I think it is too early for us to comment.

Steffan Tomlinson

Yes, and we did see sequential improvement quarter-on-quarter from Q2 to Q3, but as far as commenting on specific deals in the quarter for this current quarter, we’re just not in a position to do that.

Dominic Orr

Ladies and gentlemen, thank you again for calling in for our Q3 earnings conference call. Have a good day.

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