Websense, Inc. F2Q08 (Qtr End 06/30/08) Earnings Call Transcript

Websense, Inc. (WBSN)

Q2 2008 Earnings Call

July 28, 2008 5:00 pm ET

Executives

Kate Patterson – IR

Dudley Mendenhall – Sr. VP & CFO

Gene Hodges – CEO

Douglas Wride - President

Analysts

Samuel Wilson - JMP Securities

Todd Raker - Deutsche Bank

Sterling Auty - J.P. Morgan

Daniel Ives - Friedman, Billings, Ramsey

Walter Pritchard – Cowen & Co.

Rob Owens - Pacific Crest Securities

Philip Rueppel - Wachovia Securities

Bud Leedom - Global Hunter Securities

Presentation

Operator

Good afternoon ladies and gentlemen and welcome to the Websense conference call. (Operator Instructions) I would now like to introduce your host Kate Patterson, Websense’s Vice President of Corporate Communications and Investor Relations; please go ahead.

Kate Patterson

Thank you all for joining us this afternoon to discuss our second quarter results. With me on the call today are Gene Hodges, Websense CEO, Dudley Mendenhall, our Chief Financial Officer and Doug Wride, our President.

Before we turn to the results, let me quickly outline our conference calendar for the third quarter. We intend to present at The Pacific Crest Technology Conference in Vaile, Colorado on August 4^th; the Deutsche Bank Technology Conference in San Francisco on September 9^th; the Banc of America Annual Investment Conference in San Francisco on September 15^th. Please check on our website for more details and the webcast links.

We also plan to open the NASDAQ stock market on the morning of September 17^th and will host a Tech Talk concerning our new products over the lunch hour on the same day. More details to follow. We hope to see you there.

Before I turn the call over to Dudley, let me remind you that during this conference call management may make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to known and unknown risks, uncertainties, and other factors that may cause the company’s actual results to be materially different from historical results.

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

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

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

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

Dudley Mendenhall

Thank you Kate, let me start by stating that I believe that we posted a very strong quarter. Our top line performance driven by the strength of the recurring revenue aspects of our subscription model allowed us to generate strong revenue growth that exceeded our expectations and helped us offset the macroeconomic headwinds that caused so many headlines and so much uncertainty during the quarter.

Consequently we are significantly exceeding the 20% accretion expectations for earnings that we outlined for the SurfControl acquisition with $0.37 of non-GAAP EPS for the second quarter, up 68%, and year-to-date we have generated $0.73 of non-GAAP EPS, up 70% over the first half of 2007.

Billings for the second quarter were $87.3 million, up almost $20 million or nearly 30% from Q1. Although Websense and SurfControl both historically showed a strong seasonal increase in Q2 versus Q1, our performance this quarter was above the recent norm.

For comparison purposes SurfControl was up 19% sequentially in 2007 and 26% sequentially in 2006. Websense was up 28% sequentially for both years so a combined increase based on historical averages would have been in the range of about 22% to 27% as compared to the 30% actual increase.

This was excellent performance on the part of our sales teams worldwide as they continued to establish their relationships with partners and customers in their new territories. Average contract duration increased from the Q1 average of 20.6 months to 21.8 months, but was below the year ago average duration of 23.6 months.

One year contracts accounted for 56% of total billings compared to just 48% a year ago. The strength of our billings performance despite the shortening of the average contract duration compared to a year ago suggests good ongoing demand for our products and reflects our efforts at customer retention.

As we gear up for the new product cycle the higher proportion of one year contracts is a very positive development. Having these customers up for renewal sooner accelerates the opportunity to cross-sell and up-sell our web security gateway and DLP solutions as well hosted email and hybrid solutions.

Now turning to revenue non-GAAP revenue was $88.2 million which excludes the Q2 impact of the non-cash write-down of SurfControl’s deferred revenue in the amount of $15.2 million. GAAP revenue after the write-down was approximately $73 million. We will continue to report on the revenue prior to this purchase accounting adjustment to provide visibility to our normalized run rate.

The strong revenue performance compares favorably to our expectations of a modest sequential decline from Q1 revenue of $86.5 million and was driven by the strong billings performance coupled with shorter average contract duration compared to a year ago. Non-GAAP operating expenses of $60.5 million increased $1.8 million sequentially from Q1 primarily due to an increase in sales and marketing expense of $1.6 million associated with the increase in billings.

We have brought the annual expense run rate from about $300 million a year ago for Websense and SurfControl to about $240 million today. It is clear that we have achieved an even exceeded our cost synergy objectives for the acquisition and that we are generating substantial efficiencies in the combined organization.

As a result operating margin was 31.3% in the quarter well above the 25% posted in Q2 2007 and above our targeted range of 28% to 30%. Non-GAAP operating income was $27.6 million. Our non-GAAP revenue performance and improved operating margins coupled with a slightly lower share count and lower interest costs allowed us to post strong non-GAAP earnings per share of $0.37 in the second quarter.

Year-to-date we have now generated earnings per diluted share of $0.73, an increase of 70% from the $0.43 earned in the first half of 2007 well above the targeted 20% accretion anticipated from the acquisition.

Now turning to our cash flow and balance sheet, our GAAP cash flow from operations was approximately $5 million, after cash outflows of approximately $3 million associated with the acquisition. This GAAP cash flow of $5 million is nearly double the 2007 amount in Q2 and is principally a result of strong collections.

Our cash flow is driven primarily by collection of the prior quarter’s billings and the second quarter is typically the low point in our operating cash flow due to the seasonal low in Q1 billings which result in lower collections during the quarter.

Year-to-date our GAAP cash flow from operations is $23.9 million including approximately $14 million in one-time expenses. If you add back the $14 million in one-time expenses cash flow is approximately $38 million as compared to our original annual guidance of $65 million to $75 million so we continue to forecast that we will exceed that range.

Our balance sheet remains strong with cash and cash equivalents of $65 million and total GAAP deferred revenue of $302.5 million, up 39% year-over-year. Non-GAAP deferred revenue which includes an add back for the deferred revenue written off as part of purchase accounting was approximately $341 million essentially flat with Q1 since billings and non-GAAP revenue were close.

Accounts receivable increased $14.5 million sequentially to $61.6 million reflecting the $20 million sequential increase in quarterly billings. Our collection performance remained excellent and DSO’s remained within the historical target range, flat sequentially at 63 days and down 11 days from Q2 2007.

Our confidence in our cash flow has allowed us to make additional repayments on our long-term debt totaling $5 million bringing total principal payments to date to $55 million and reducing long-term debt to $155 million from $210 million at the close of the acquisition. During the quarter we also repurchased a total of 274,000 shares for approximately $5 million.

Now turning to our forward guidance our increasing confidence in our performance as well as our strong results in the first half of the year allows us to increase our 2008 GAAP revenue, non-GAAP revenue and non-GAAP EPS outlook. We now expect GAAP revenues to be in the range of $290 million to $295 million, non-GAAP revenues to be in the range of $340 million to $345 million and non-GAAP EPS to be in the range of $1.30 to $1.35.

The strength of our current business combined with our success at retaining customers and an increased level of renewal business in the second half of the year gives us the confidence to leave our 2008 billings guidance in the range of $345 million to $355 million even with the current uncertain economic outlook and shorter contract duration.

We still expect our non-GAAP operating margins of 29% to 30% for the year as we expect a slight uptick in sales and marketing expenses associated with the anticipated level of second half billings particularly in the seasonal strong Q4.

Turning to billings we expect to hit the inflection point in billings growth in Q3 and begin to show some upward momentum and year-over-year growth going forward. We believe that quarterly performance will reflect the seasonality of the standalone business. Websense which accounts for the majority of billings is historically flat to down slightly in Q3 compared to Q2 while SurfControl’s typically witnessed a sequential downturn of as much as 30% in the September quarter.

Therefore Q3 billings could be down sequentially over Q2 in the range of 55 to 7%. For Q4 we expect strong sequential growth over Q3 and remain confident in our full year billings guidance. In terms of non-GAAP revenue I want to remind you of our typical patterns and how these play out in a subscription model, despite the fact that billings fluctuate quarterly based on normal seasonal patterns, revenue is recognized pro rata over the life of the contract which has the affect of muting the seasonal fluctuation in billings.

Therefore a change in the growth rate of our billings takes several quarters to show up in the revenue growth line. That is why cash flow should also be considered in measuring our performance. Consequently we continue to expect non-GAAP quarterly revenues to decline modestly on a sequential basis and be within the range of $84 million to $85 million for each of the remaining quarters of 2008 reflecting lower year-over-year billings in the first half, discontinued products and OEM relationships.

Let me conclude by saying I am very pleased with our financial discipline and performance. We have exceeded the anticipated accretion from the SurfControl acquisition on both the top and bottom lines and on cash flow and we have done a great job with renewals and customer retention.

We are now well positioned for growth in 2009.

With that let me turn the call over to Douglas Wride.

Douglas Wride

Thank you Dudley, first let me reiterate that we did post excellent performance this quarter as our sales people continued to adapt to new territories, customers and back office systems. As an aside, in Q2 we successfully completed the integration of our back office systems and implementation of our sales force automation globally.

Our world class IT organization accomplished this in record time and my hat goes off to them. Now let me give you a quick update on the SurfControl acquisition.

As of June 30, we officially completed the formal integration of the acquisition and have turned our focus to driving growth. I’d like to summarize the integration across key areas.

As of this week the last of the transitional employees either became full time Websense employees or left the organization. Out of 600 SurfControl positions held by employees or contractors prior to the acquisition approximately half or 300 were eliminated and the work absorbed by Websense people.

Put another way a year ago the two companies employed about 1,400 people and had an annual expense run rate of about $300 million. Today we are at about 1,200 employees and an annual expense run rate of approximately $240 million.

The integration objective has always cost synergies and not necessarily headcount but those of you doing the math will note that we’ve added about 100 heads in the interim. As expected the majority of the headcount growth has been in our China operations which now accounts for over 10% of our total headcount.

I’m pleased to say that we reached our goal of reducing the annual cost structure of the combined company by at least $60 million. When you factor in assumed expense growth we’ve actually exceeded those goals. By over achieving on the top line we’ve been able to exceed our operating margin targets for the first half of this year as Dudley expressed.

We’ve made excellent progress on integrating the product roadmaps and rationalizing the product offering. As we mentioned last quarter we successfully completed the sale of Cyber Patrol right at the end of the quarter and we are winding down sales of other discontinued products. We experienced good renewal rates from the SurfControl installed base and are seeing a growing trend of customers deciding to migrate to the Websense platforms.

Although with the acquisition we stopped selling the SurfControl Risk Filter appliance outside of China we just released an upgraded version of Risk Filter last month in that market. We are pleased with the progress made on this front this year and we will continue to drive this offering in China.

The most challenging area of the integration has been customer support due to a combination of factors. We are working hard to remedy this situation and I’m confident that we are making very good progress.

As I mentioned last quarter I’m spending more of my time on our distribution and will our selling partners. Let me give you an update on some of our activities this quarter on that front.

We held partner road shows and meetings around the world to educate partners on our roadmap and partner programs. We have begun the certification and training process on the new Websense version 7 products worldwide which will accelerate in August and early September.

The Websense global education team has put together an extensive training plan for both internal and partner training and certification and we will be ready as the new products roll out. We continue to make small adjustments in our two tier distribution structure reflecting both the levels of new and renewal business generated as well as the competitive environment.

These small adjustments have been well received as has the creation of our new virtual partner advisory counsel. Our goal is to be the best securities partner in the space, offer the best products, create the most innovative partner programs, and become the most responsive channel organization.

This is critically important to our business model. Not only are the majority of our products sold by partner recommendation, we depend on our partners to be our first line of support and we remain 100% committed to this channel.

In Q1 and Q2 we launched our new integrated partner program and the response has been good. But I think it’s fair to say we can get better. We’ve come a long way in the last two years and now that the financial side of the SurfControl integration is behind us, we’re ready to focus on moving forward again with our partners, 50,000 customers, and our expanded product offering.

Our distribution channel and ongoing operational responsibilities are where my focus will be going forward. With that I’ll turn the call over to Gene.

Gene Hodges

Thanks Douglas, Q2 was the third sequential quarter of solid execution across all of Websense functions. Once again our sales team delivered the strong billing performance in spite of an uncertain macro environment. Being further through the Surf acquisition we also have a much clearer picture of what the impact of the current macro situation is. And as you’ll see from the contract duration mix statistic, approximately 8% of our customers decided to take a one year subscription rather then a three contract in this Q2 as compared with Q2 of last year.

As our promotional activities were back to normal this quarter this number is a much better apples to apples comparison if you will, then the number in Q1. Since some of those 8% were former SurfControl customers who may want to wait a bit, be a bit more cautious to see that we prove ourselves, we believe we have a good sense that this 8% swing was the maximum impact the economy had on our business in Q2.

The shortening of contract duration was noticeable but it wasn’t large enough to prevent us from achieving our objectives and it’s important for you to note that we do not see extensive increased loss of customers. The strength of our sales team performance over three quarters is reflected by our increased revenue and EPS guidance for the rest of the year.

We not only achieved strong billings in Q2 but we did it on shorter contract duration then last year, hence every billings dollar generates more short-term revenue and our profits climb. In hindsight our strategy of focusing on retaining the SurfControl customer base through the integration turned out to be a good fit for these tough economic times.

It’s easier to hold onto an existing customer then to acquire a new one even in normal times and it’s probably even easier in uncertain times. We feel confident that we can continue to maintain high retention rates with SurfControl and Websense customers over the next several quarters. Although our attention during Q2 was still mostly on holding the combined company base we did see some positive sparks in the new [inaudible] arena where we’ve been investing.

Data loss prevention sales probably the most market, the DLP sales in Q2 were $2.5 million up 222% year-over-year and 80% quarter-over-quarter. Most importantly Europe is starting to produce DLP orders and did approximately $1 million of the total in Q2. Our DLP pipeline continues to build globally and we now feel comfortable that we will exceed industry growth rates for this application segment during 2008.

Don’t assume we’ll continue to deliver over 200% growth but we’ll be pushing hard to deliver high continued growth up near triple figures. The other major execution success in Q2 was in preparation for the launch of our Q3 product sets. Q2 was the go-to quarter for both engineering and marketing and they got it done. We achieved our managed release targets for both our web security gateway and our data loss prevention endpoint clients in the middle of the quarter.

Feedback that we received from both sets of customers in the managed release was very positive. The functionality of both products looks to be right on the market and quality looks good. So we feel very comfortable about going to general release later this quarter.

Q3 is a time of excitement for Websense. After three quarters of acquisition integration tasks with the focus on retaining and expanding customer base, now we get to go out and play refocusing on new growth. Obviously this is going to be a long challenge as well but we’re starting to make some excellent progress. Now the Websense sales force has a lot of new products and an expanded value proposition to bring to the customer.

Our sales and partner training that kicked off Q3 shifted from how to win in a price war against SurfControl or Blue Coat to how to call higher and broader and to show more strategic value from a killer product line. Our sales and channel team is now integrated, well organized, and has a great new CRM PRM system at their fingertips so they can spend more time selling and less time creating spreadsheets to track for customers.

Q3 marks the completion of the first full round of essential information protection products. We will ship in general availability the world’s best web security product with proprietary real time malware scanning that from all the testing we’ve done is the best web security available on the planet.

Our whole web filtering and Websense security base will also be getting a big time feature update even though they don’t move to the real time scanning capabilities. We basically rebuilt this product from the ground up and it’s more reliable, more scalable and easier to use and extends our lead in giving customers the valuable information they need to manage web security and internet usage.

We’ll have major new improvements in our on demand product line this quarter that will improve our competitiveness in this critical market. Remember our new web security strategy utilizes both in the cloud web security as well as the new real time malware blocking we’re introducing and our classic product set. We’re seeing very positive response from distributed customers who see the power of this combination which can protect workers whether they are on or off the corporate network.

We’ll also have a major new final general availability release of our DLP gateway product along with the long awaited new DLP endpoint client. These will offer integrated data loss prevention policy management that will work whether you’re on the network or off it. This impressive list of new products shows the effectiveness of our engineering organization which is doing a great job in a multi product, multi product stream mode.

Our engineering team is producing innovative organic new products and is strengthening products that we’ve integrated through acquisition using technology synergies to make the full product line greater then the sum of the pieces.

This ability to both build and successfully integrate acquired technologies is going to continue to be an important differentiator against our new big competitors. Having completed a profitable consolidation expansion of our company, now we’re increasing on renewing growth. And as we fight for new growth we do it with our strongest new product cycle ever and with a sales team that is excited about having more to sell.

We aren’t macro economists but the consensus of those of you who are seem to be clearly that things are going to get worse before they get better and we may together be in the doldrums for an extended period. We simply didn’t see that in Q2 even in the last month of the quarter or for that matter, so far in the opening days of Q3. But we do feel the macro headwinds as we quantify but so far, good execution seems able to more then compensate for that.

We have many more products to sell in the second half, an energized sales force, less sales and sales management team required to attend to an endless list of issues that always arise in an acquisition.

Finally we have a nice bulge to renewal contracts up in the second half especially in the fourth quarter. Given all that the macro climate stays about where it is now, we feel we’re well positioned to achieve our billings objectives for the year and to do that in a way that generates higher revenue and renewal opportunities for the first half of next year.

This will lay the foundation for higher sustained growth in 2009.

We are now ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Samuel Wilson - JMP Securities

Samuel Wilson - JMP Securities

Ex post or looking backwards do you think that SurfControl customer retention has been above expectations?

Gene Hodges

Absolutely.

Samuel Wilson - JMP Securities

Commercial activity clearly back to normal this quarter, billings were above what we were expecting, do you think you’ve figured out now the right level of promotional activities to run to keep some of the volatility down?

Gene Hodges

You can always do better. I think I made a mistake in the first quarter given that the macro climate was darkening and we pulled typical promotions that we might use to give a good cost for money break to move customers to longer duration and we simply changed that back to what we’ve done in the past, generally used a little heavier in the US and in Europe and things went about half-way back to our expected durations.

Samuel Wilson - JMP Securities

What was the linearity for the quarter? Just sort of by month, did it get better as the months went on, worse, what are your thoughts there?

Dudley Mendenhall

Linearity actually improved this quarter. We saw a better upfront booking at the beginning of the quarter which also had a positive contribution of revenue.

Samuel Wilson - JMP Securities

You mentioned headcount at around 1,200, is that the exact headcount?

Douglas Wride

Its pretty close, plus or minus 10.

Operator

Your next question comes from the line of Todd Raker - Deutsche Bank

Todd Raker - Deutsche Bank

I was hoping you could give us some sense for economics per seat and I just wanted to understand, the low end solution being sold in China, does that mean you’re not selling SurfControl any other geography and so how do you see pricing changing here coming up into the anniversary of the acquisition?

Gene Hodges

Doug was referring to a specific product line, an appliance product line called Risk Filter. That was not a big seller in SurfControl anywhere but China. It came from an acquisition in China and was an important portion of the business there. So we kept that product going in China although we’re not selling it anywhere else. SurfControl’s web filter product and email filter product have both been brought forward and are being actively supported and maintained.

Douglas Wride

On the topic of contract value I can only give you direction because I don’t have an exact way to forecast what it will look like in the future, but clearly after the acquisition in the fourth quarter you saw contract value come down which was due to the fact that SurfControl had generally smaller contracts and more focus on one year contracts and more SMB business. So we did see that come down I think permanently in the fourth quarter.

You then saw it come down again in the first quarter because we had that abnormally shortening of duration to one year. It has come back to a more normal level we believe this quarter and assuming that contract duration stays more in the 21 month to 22 month range as opposed to the historic 23 month to 24 month, I think you can assume that the run rate that you saw in the second quarter for contract value should be close to the future if you believe that duration.

Todd Raker - Deutsche Bank

If you look at your guidance for the back half of the year, can you give us a sense in terms of what you’re expecting in terms of contract value or economics per seat?

Douglas Wride

Again I think we’re thinking more in terms of contract duration as a major driver. We’re not really seeing price compression in terms of ASPs so it really in terms of what probably will most drive contract value is duration and we’re assuming that duration stays approximately where it was in the second quarter. But we don’t have any rationale to make it go up or down from here. It may go up a bit naturally in the fourth quarter because that is a big quarter for us and the enterprise market and there could be a natural tendency for that contract duration to lengthen in Q4.

But we’re assuming approximately 21 months to 22 months going forward.

Todd Raker - Deutsche Bank

If I ignore duration for the moment shouldn’t—will pricing start to move up driven by two factors, one is the opportunity to take SurfControl customers and upgrade them once the anniversary of the acquisition is done and two if you are successful cross selling and up selling, shouldn’t economics per seat be moving higher?

Gene Hodges

We’ve not guided in the past to what happens on the per seat contract value but Q3 is the first quarter we’re going to start aggressively pushing Surf migrations. We’d always planned to wait until we got a more differentiated product in the market with the secure gateway and that should help, as well as upgrading the SurfControl base to the current web sets product sets.

Douglas Wride

I think that what Gene’s talking about migration is absolutely true. We saw more migration in Q2 then we did in Q1. We will now be marketing that more aggressively here in Q3 so we’ll see that. Keep in mind that drives 10% to 20% uplift so it’s not dramatic but it’s nice. Then we get the new products that come out in Q3 and I just want to be cautious there that the adoption rate of new products in this space is always a little bit slow. Your existing customers get the upgrades for free when you’ve got the new versions; the new products will roll out more slowly. We’ll gain some steam in the fourth quarter and we’ll start to see results next year in particular.

All of that is leaning in the right way that means that deal size just gets bigger, seat prices get better, etc.

Todd Raker - Deutsche Bank

Can you give us a sense in terms of what percentage of the SurfControl installed base has shifted to Websense so far?

Gene Hodges

In the second quarter about 15% of the base moved over, so we were not pushing real hard. Now we’ll start to push harder and we do not intend to expose that metric over time.

Operator

Your next question comes from the line of Sterling Auty - J.P. Morgan

Sterling Auty - J.P. Morgan

I just wanted to clarify, 15% of the Surf base already migrated and is now running the Websense product platform?

Gene Hodges

That’s just a second quarter number only. It was lower in the other two quarters so 15% or so of the customers—this is by dollar value by the way. I don’t have a customer count. They took our offer and upgraded to Websense products.

Sterling Auty - J.P. Morgan

So 15% of the Surf customers up for renewal in that quarter by dollar value chose to migrate?

Gene Hodges

Correct.

Sterling Auty - J.P. Morgan

If you just take a step up to the high level and look at the strength in billings in the quarter where would you characterize the biggest strength relative to your expectations? Was it capturing the Surf migration? Was it Websense renewals, SurfControl renewals, international? What are the one or two real standouts in the quarter in terms of strength in billing?

Dudley Mendenhall

It was pretty distributed. The Americas was a little bit better then we expected. International had a couple of large deals; the largest deal we’ve ever closed in South America was a good contributor. So it was not a single factor, just a little bit better then we expected everywhere.

Sterling Auty - J.P. Morgan

You touched upon some of the changes in distribution are there more changes to come or do you feel like where you are with the channel will be stable and this is kind of the strategy moving forward?

Douglas Wride

I think where we are today is quite stable. We have a lot of partners, we have good distribution, but we will continue to tweak that, continue to make it a little bit better as we go throughout the world and that’s part of my job; to make it a better win-win for both sides of that.

Sterling Auty - J.P. Morgan

On the cash flow given the strength in billings should we then—you’re saying that we should look for a health uptick in cash from operations for each of the next couple of quarters so the second half should see a seasonal strength?

Dudley Mendenhall

Correct, as we move into collections from the second quarter which were obviously up $20 million

From the first quarter and then move into our strongest quarter, the fourth quarter which obviously we’ll collect in the first quarter of next year, but you will see sequentially a strengthening of cash flow over the next three quarters.

Operator

Your next question comes from the line of Daniel Ives - Friedman, Billings, Ramsey

Daniel Ives - Friedman, Billings, Ramsey

Around duration, do you anticipate the 56% or within that range is going to remain on the one year contracts and maybe just speak to a higher level of customers do you anticipate definitely going into the second half that you might slowly get the customers to go back onto the more of the three year type of contracts?

Dudley Mendenhall

Again we have seen that level come back more towards the norm, historically about 50% to 52% of contracts were one year but I think that it may not go that low in the future but I would not anticipate it being at 60% either. So I think we’re likely to be somewhere in the 50% to 55% range on one year contracts going forward.

Operator

Your next question comes from the line of Walter Pritchard – Cowen & Co.

Walter Pritchard – Cowen & Co.

I noticed on the seat metric that you disclosed that it was down slightly on a sequential basis, and I didn’t’ hear any discussion in the prepared remarks and I just wanted to get a little bit more detail on what happened there?

Gene Hodges

That was driven by expected attrition of Surf customers and that metric should bottom out pretty soon, Q3 I think and it should start to go back up.

Walter Pritchard – Cowen & Co.

Could you just give us a more broad sense of the renewal side it looks like we can easily make some assumptions around there, just wondering on the new business, where that’s tracking versus your expectation? I know it’s not your focus yet but it is a driver of your results.

Gene Hodges

It was mixed in Q2. DLP was better then we expected. Small business was worse then we expected. I think mainly because small business tends to be the place that the sales force was most challenged in terms of keeping up with an increased number of SurfControl transactions.

Operator

Your next question comes from the line of Rob Owens - Pacific Crest Securities

Rob Owens - Pacific Crest Securities

If I look at the overage in billings that you achieved for the quarter and then look at the overage in revenue relative to what you previously guided to and it was a vague range, I think 82 to 85 with declining results throughout the rest of the year, it seems like your revenue realization in the quarter was higher then I would have expected. Is there something else at play here or is all that coming off the balance sheet?

Dudley Mendenhall

There are really two key things; one is the linearity that we talked about. We’re doing a little better job in booking and billings up front then we have in the last few quarters and so that has an obvious impact as you look at daily revenue recognition. And then secondly the shorter duration is having a contribution. I think shorter duration is having the larger contribution with linearity being second.

Rob Owens - Pacific Crest Securities

But there was no in-period event that drove that number that was all subscription-based revenue?

Dudley Mendenhall

Yes.

Rob Owens - Pacific Crest Securities

And then to reconcile a couple of different comments, I think Gene said a bulge of the renewal contracts are in the second half primarily in Q4 and then Doug talked about just the adoption rate of new products and technologies are typically slow in this industry, so as we look at the new products and specifically the web security gateway, how should we think about that, how aggressive are you willing to go on price because my understanding is when customers move to these new technologies its typically on the renewal cycle so if you were to miss them here then on average you’d have to wait 20 some odd months to get them again.

Gene Hodges

We absolutely see no reason to discount to get the customers to go. We’re very aggressively priced where we are with the upgrade to the web security gateway. From a sales tactics perspective this is not a product, in fact which will be best sold at renewal cycle time. It’s going to take more time because it’s an inline implementation for the customer to get comfortable with that. We’re going to be looking out longer then we have before to see which customers will benefit the most from this capability.

So although I think Doug’s caution if you will that adoption will start out slow is absolutely correct, that adoption rate will probably not be against in quarter renewals, it’ll be more staged out against guys who have been in the limited availability program for example who are already ready to move up.

Rob Owens - Pacific Crest Securities

And then relative to what you thought the price lift would be before for this add-on sale, is there any change especially in light of the macro environment?

Gene Hodges

No I don’t think we’ve seen anything that would really drive that one way or the other.

Operator

Your next question comes from the line of Philip Rueppel - Wachovia Securities

Philip Rueppel - Wachovia Securities

Just a clarification on some of the commentary around the cross sell and up sell to Surf customers, am I right in sort of synthesizing it that you saw increased momentum in the second quarter but the new products are really what’s going to drive that in the second half and we should expect to see further promotions around that?

Gene Hodges

Yes, we’ve had a strategy from the beginning of stabilize and then grow. If you come out of the gate marketing too hard to an acquired customer base before you get a chance to build trust, even get to know who they are, its probably a bit hucksterish and they’re going to pay you back by not moving so quickly. At this point even for a customer moving from SurfControl’s web filter to Websense security suites--not the top end of the product line any more, there’s another step-up they can take in the future. And I think seeing a stair step roadmap capability in the future is reassuring to them and more motivational in terms of making that jump.

Philip Rueppel - Wachovia Securities

How about any commentary around success or lack thereof of the—I think you were doing some promotions to take some of the SurfControl products or at least the email web bundle at the low end into the US, is that also sort of part of the somewhat disappointing SMB results?

Gene Hodges

Yes.

Philip Rueppel - Wachovia Securities

Turning to DLP finally, are you seeing any inflection points there, any change in the competition or reasons why you’re starting to see a little bit of a pickup there, are large customers finishing evaluations, could you give us a little color on that marketplace which seems to be heating up nicely for you?

Gene Hodges

First the DLP sales cycle is nine to 12 months or even longer so what you’re seeing here is the efforts of our mainstream sales organizations in both the US and Europe when they started to get busy last Q4. Those are the deals that are closing. So we’ve got some pipeline building then. We picked up strength in pipeline building and that’s one of the reasons why we think DLP is on a good steady upward course.

Operator

Your next question comes from the line of Bud Leedom - Global Hunter Securities

Bud Leedom - Global Hunter Securities

In terms of your managed release of new products in the second quarter was that enough to move the needle on renewals on a sequential basis being that we saw an uptick there?

Gene Hodges

No, the managed release products are probably had about 30 between them and the number was not huge.

Bud Leedom - Global Hunter Securities

Taking that one step further as we look into the second half of the year, I guess my anticipation is the fact that we saw 21.8 months in the second quarter that we might see that begin to tick up maybe beyond 22, as we see maybe a pent up demand for some of these new products, maybe hit in the fourth quarter, is that not something you’re expecting?

Gene Hodges

Let me be real clear on duration, we don’t know. The market is going to push it. We’re not going to deform it, trying to go long or trying to go short in terms of offering more incentive because we think we have the right level of incentive on the table as it is. The economy I think will probably have a bigger impact on that then anything else and we’ll see what happens.

Bud Leedom - Global Hunter Securities

Historically in down economic times I know that’s actually been a net benefit to you because of this contract contraction in the duration sense, I’m just wondering given that we’ve seen it come down obviously in Q1 and Q2 is there any way to quantify the impact on revenue on a short-term basis based on the shorter durations?

Dudley Mendenhall

I’m not sure if I completely understand your question but generally you are reflecting the value of the contract over a reduced number of quarters and therefore by definition the revenue rollout will be much stronger in subsequent quarters.

Bud Leedom - Global Hunter Securities

I guess maybe in terms of the discounting that takes place typically on the longer, the three year contract, obviously as people move to one year there is no discount of that sort so I was just wondering—given the fact that somebody’s taken a one year contract sort of ex discount if there is some way to quantify incremental downticks in duration.

Dudley Mendenhall

No I do not have a simple answer to that because it depends on the seat count, the volume discount associated with that, the product that’s being purchased etc. So I don’t have an easy answer to that question.

Operator

Your final question is a follow-up from the line of Sterling Auty - J.P. Morgan

Sterling Auty - J.P. Morgan

Can you comment on the competitive landscape, it seems like there’s some company specific issues going on with a couple of your competitors, has that helped you at all or how is the competitive landscape changing?

Gene Hodges

The landscape is not changing as rapidly as we thought it might. Trend is a little more visible. As you had mentioned Sterling Secure seems to be struggling a bit and Blue Coat, we still run into them in the large accounts but on a fairly narrow base we are seeing some of the big guys in glancing competition like Symantec and McAfee but its still fairly rare.

Sterling Auty - J.P. Morgan

Can you give us an idea what the [black spider] contribution was?

Gene Hodges

I don’t think we did, it was roughly flat for the quarter and the US has not yet come online so that’s work we have to do.

Sterling Auty - J.P. Morgan

And we said flat, flat sequentially or year-over-year?

Gene Hodges

About both I think.

Sterling Auty - J.P. Morgan

And would you expect it to come online, the US, this quarter or when would you expect it?

Gene Hodges

It will come online in the second half, I’m not sure if it’s the third quarter.

Operator

It does appear we have no further questions at this time, Ms Patterson I would like to turn the call back over to you for any further comments or closing remarks.

Kate Patterson

Thanks for joining us. We’ll be available for further questions and answers this afternoon and tomorrow. Thanks, goodbye.

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