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Executives

Matthew T. Medeiros - President and Chief Executive Officer

Robert D. Selvi - Chief Financial Officer

Kelly Blough - Investor Relations

Analysts

Scott Zeller - Needham and Company

Rob Breza - RBC Capital Markets

Catharine Trebnick - America‘s Growth Capital

Sterling Auty - J.P. Morgan Chase & Co.

Christopher Crowe - Pacific Crest Securities

Joseph Yin - Scopia Capital

SonicWALL, Inc. (SNWL) Q2 2008 Earnings Call July 29, 2008 5:00 PM ET

Operator

Welcome to the SonicWALL second quarter 2008 earnings conference call. (Operator Instructions) At this time, I would like to turn the conference over to Kelly Blough.

Kelly Blough

With us today are Matt Medeiros, President and CEO of SonicWALL, and Rob Selvi, our Chief Financial Officer.

Before we begin, I’d like to remind everyone that during this conference call, we will be making forward-looking statements within the meeting of Section 27A of the Securities Act of 1933 as amended and 21E of The Securities Exchange Act of 1934 as amended. Forward-looking statements include, without limitations, revenue, GAAP and non-GAAP earnings per share and gross margin guidance for the third quarter of 2008; revenue, GAAP and non-GAAP earnings per share guidance for fiscal year 2008, expectations of increasing operational efficiency, benefits associated with receipt of FIPS and common criteria certification, the impact of in-sourcing support on our headcount growth, expectations for future product introduction, and the market acceptance of new, updated and existing products, and our positioning through revenue profitability and market share growth.

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

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

I will now turn the call over to Matt Medeiros.

Matthew T. Medeiros

SonicWALL’s second quarter results reflect our continued emphasis on strong operational execution. In the face of economic uncertainty, our total revenue grew 19% year over year to $55.8 million, with License and Services revenue up 36%. In Product revenue up 1%. Non-GAAP earnings per share were $0.06 and GAAP earnings per share were $0.02.

I’ll start with general comments about the quarter before handing it over to Rob, who’ll give us the details of financials.

Demand in North America remain soft, specifically in the Small Business segment. Reduced demand from the Small Business segment, in our view, is due in part to limited access to capital. Recent reports have indicated that business loans have declined year over year and that access to capital will continue to be a challenge. Our strategy of expanding our market focus to include mid-tier and enterprise customers has helped diversify our revenue base and clearly aided in our second quarter performance.

North American revenue was up 1% sequentially and 15% year over year. And unit shipments in North America grew sequentially. All of our internationally regions outperform the US in the second quarter on a year over year basis. In Europe, the Middle East and Africa (EMEA), we held our annual partner event which was met with great enthusiasm. Middle East represented a particular bright spot in the second quarter, with revenue nearly doubling year over year and growing 24% sequentially. We did however note some sequential softness primarily in the UK with declines in revenue and unit volumes associated with our SMB UTM products. Overall, EMEA revenue declined 1% sequentially and grew 18% year over year.

Latin America continue to perform well. With 80% year over year revenue growth from the second quarter, even after an extraordinary performance in Q1. In Latin America, we had great results from both our project-based pipeline as well as our strong run-rate business with key distributors and resellers. During the quarter, we also signed several new distributors and systems integrators to increase the regional sales coverage.

Asia retrieves strong performance sequentially in year over year, delivering 30% growth over the second quarter of 2007. Growth in the region was driven by strength in India, Southeast Asia and China, as well as a strong partner in customer response to our new NSA product line.

We continue to invest internationally to address opportunities particularly in Latin America and Asia Pacific. Worldwide subscriptions billing grew 23% year over year and were level sequentially. Subscriptions deferred revenue grew 35% year over year and 2% sequentially. We are pleased that we were able to achieve this progress in spite of sequential decline in units shipped in the quarter. The sequential decline in units shipped was attributable primarily to the SMB market, specifically related to the TZ products but with exception of the TZ 190. During the quarter, we saw a strong increase in TZ 190 sales. Customers opted to take advantage of enhanced software features and the 3G hardware expandability.

We continue to deliver on our commitment to develop and introduce new innovative products and solutions. In May, we announced the delivery of the SonicWALL NSA 2400, bringing the next generation of Unified Threat Management to organizations with less than 100 employees. We are pleased with the contribution that the NSA 2400 made to our business in the second quarter and we’re enthusiastic about the future prospects for this product line. The entire NSA product line is performing well worldwide. Sequentially, our NSA revenue grew 73%. For the first time, we shipped more NSA than PRO products, in terms of both units and revenues, in a quarter.

Our revenue from the combined PRO and NSA product category increased by 11% over the first quarter. Also in the second quarter, our NSA product line was awarded Common Criteria and EAL 4+ Certification, which we feel will further improve our competitiveness in government and enterprise opportunities, and help us to accelerate growth in our mid-tier and enterprise UTM solutions.

We have seen tremendous progress in our expansion up market. In the first half of this year, 37% of our product revenue came from price bands over $1,500 compared to only 13% in the first half of 2007. We see this as a prove point in our ability to deliver innovative solutions and post-sales support to mid-tier and enterprise customers.

Further evidence of our continued commitment to our MSP’s mid-tier and enterprise customers can be found in this morning’s announcement of our new product release for our management system, GMS 5.0. GMS 5.0 offers customers the lowest total cost of ownership of any platform capable of managing UTM, SSL VPN Remote Access, Secure Content Management, anti-spam, email security and data protection devices all under a single console.

Our CDP revenue grew 31% sequentially in the second quarter. During the quarter we delivered new firmware updates for the CDP product line and we’re pleased by the initial customer response. Later this year, we’ll release a complete refresh of the CDP product line, a move that should help to drive stronger revenue performance in subsequent quarters.

In the second quarter, we demonstrated strong operating margin improvement. Our operating income grew 67% sequentially, bringing our operating margins for the second quarter to 7.5% from 4.5% in Q1.

Now, let me hand it over to Rob to review our financial results.

Robert D. Selvi

In the second quarter 2008, SonicWALL generated $55.8 million in revenue, in line with our guidance range of $53.5 to $57.5 million. As a percent of total revenue, UTM Solutions contributed 75%, Secure Content Management Solutions contributed 11%, SSL VPN Solutions contributed 9% and CDP contributed 6%. Total revenue of units shipped in the quarter were $46,000. Product revenue was $23.8 million, level with prior quarter results and increasing 1% over the same period last year. A leveled product revenue performance was primarily the result of declines in unit sales in our low end UTM business, offset by strong revenue performance in our mid-tier and enterprise business, evidencing a successful transition to the NSA product line.

This shift in product mix resulted in an increase in average net revenue per unit of $485 from the first quarter to $515 in the second quarter. As a percent of product revenue, 53% was generated from products with average net revenue per unit below $1,500; 24% was generated from products with an average net revenue per unit of $1,500 to $5,000; and 13% was generated from products with average net revenue per unit above $5,000.

License and Services revenue of $32 million increased 1% sequentially and 36% over the same period last year. The sequential increase in License and Services revenue was the result of increased sales, Comprehensive Gateway Security and email security of trips and services. Year over year increase in License and Services revenue was the result of increased sales in Comprehensive Gateway Security, technical support and email security subscription services. License and Services revenue represented 57% of total revenue in the quarter. License revenue represented 9.2% of the total License and Services revenue during the quarter as compared to 10.6% in the prior quarter and 11.8% in the same period last year. Total subscription services billing were $32 million, level with the prior quarter and up 23% over the same period last year. Multi-year subscriptions accounted for approximately 25% of subscriptions service billing from the second quarter. On a percentage basis, North America represented 65% and international represented 35% of total revenue; Europe, the Middle East and Africa contributed 21%; Asia Pacific and Japan contributed 11%; and Latin America contributed 3%.

Non-GAAP gross margin was 71.1% compared to 71.5% in the first quarter. Product gross margin improved to 55% from 54% in the first quarter and this improvement was offset by a decline in License and Services’ gross margin due to fees related to third-party support contracts for the North American and Asia Pacific regions.

Non-GAAP operating expense have declined by $1.6 million, approximately 4% from the prior quarter. The decrease in expenses primarily reflect a sequential decline in expenses associated with sales expense, compensation expenses, including payroll and 401K contributions. In terms of non-GAAP results, total operating expenses represented approximately 64% of revenue for the quarter. Operating expenses for research and development represented 18.9% of revenue; sales and marketing expenses represented 37.2% of revenue; and general and administrative expenses represented 7.6%.

At the end of the second quarter, total regular employee headcount was 741 compared to 720 at the end of the first quarter. This increase reflected a hiring in Shanghai and Bangalore. We expect headcount to grow by approximately 70 people in the third quarter as we finalize the transition to in-source support for North America and the Asia Pacific regions.

GAAP earnings for the second quarter were $1 million, or $0.02 per diluted share. Stock-base compensation expense before taxes primarily associated with the expensing and stock options was approximately $2.8 million. For the quarter, non-GAAP tax expense was $2.1 million against non-GAAP income before taxes of $5.8 million.

Non-GAAP net earnings for the second quarter were $3.6 million, or $0.06 per diluted share. Non-GAAP net earnings for the second quarter excludes $1 million of amortization of purchase intangible asset and $2.8 of stock-based compensation expense.

And now I’ll review the balance sheet and cash flow statement.

During the quarter we generated operating cash flow of $5.5 million. Total cash, cash equivalent and short-term investments was $106.2 million. During the quarter, we spent $46.1 million to repurchase approximately 5.8 million shares of our common stock at an average price per share of $7.91. As of the end of the second quarter, we repurchased a total of approximately 25.8 million shares at an average price per share of $7.73. As of June 30th, 2008, we had $800,000 remaining under the current $200 million authorization for stock repurchase.

Net account receivables were $23.9 million from the second quarter compared to $25.3 million in the prior quarter. DSO was 38 days compared to 41 days in the prior quarter. Net inventory was $7.5 million in the second quarter compared to $8.1 million in the previous quarter and $4.5 million in the same period last year. Net inventory consists of inventory at two of our top US distributors in finished goods at our third-party manufacturers. The year over year increase of net inventory is primarily associated with stocking of NSA products. Total annualized inventory term on a non-GAAP basis were 9 times compared to 8 times in the first quarter of 2007.

Deferred revenue at $105.8 million was level sequentially and increased 40% compared to the same period last year. 83% of total deferred revenue of the total deferred revenue balance is attributable to subscription services. For comparison purposes, subscription services’ deferred revenue represented 81% of total deferred revenue in the first quarter of 2008 and 86% of the total deferred balance in the second quarter of 2007.

I’ll now complete my comments with guidance for the third quarter of 2008 and the year ending December 31, 2008. Anticipating the effects of typical third quarter seasonality combined with ongoing economic uncertainties for the third quarter, we expect revenue in the range of $53 to $56 million. Our expectations for gross margin in the quarter are in the range of 71-72%. We do expect to continue to make progress against our objective of operational efficiency and as such we expect earnings in the third quarter to be in the range of $0.06 to $0.08 per diluted share on a non-GAAP basis, and GAAP earnings of $0.01 to $0.03 per share.

Additionally, in light of economic conditions and year-to-date performance, we’re revising the annual guidance that we’ve provided you in February. For the year, we are revising our revenue range to between $220 and $230 million, with non-GAAP EPS of $0.25 to $0.30 per share and GAAP EPS of $0.06 to $0.10 per share.

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

Matthew T. Medeiros

Thanks, Rob.

At our Analyst Day in February, we announced four strategic objectives for 2008: 1) International growth, 2) Subscription services growth, 3) Developing and introducing new and innovative products, and 4) Scaling the business to achieve greater efficiencies and profitability.

When I look back over the first six months of 2008, I’m proud of what we’ve accomplished against these objectives. We’ve made important strategic investments internationally that will enable us to take advantage of a merging, higher growth markets. We have delivered world-class enterprise security solutions that have already won accolades from customers, channel partners and industry analysts.

In the first half of this year alone, SC Magazine awarded a 5-star review to our Email Security 400 Appliance. Given that 5-star reviews are rare, we were especially proud that our high-end SSL VPN Aventail EX-1600 and our SonicWALL SSL VPN 2000, two weeks ago, captured 5 stars each. Earlier in the year, we received recognition for our new NSA product line in a network world review.

As we have said, we are expanding our reach into the mid-tier and enterprise markets, while remaining fully committed to the SNB customer and channel. Further affirmation of our continued commitment to SNB came in the second quarter from Gartner and their market scope report that recognized SonicWALL in the SNB Firewall category with their highest ranking. In the second half of this year, we will introduce new SNB-focused products that will promote our continued leadership.

I want to take a moment to mention two customer deals which we feel are particularly important. These two deals are worth mentioning because both customers were interested in an alternative solution over the more complex and higher priced incumbents. SonicWALL is the alternative for innovative, state-of-the-art, yet budget-minded, IT departments and companies. In Japan, the largest electronic retail chain purchased several NSA E7500s and E5500 UTM solutions, all with our TotalSecure bundle. This customer’s using our UTM products for a customer web catalog and prior purchase data gateway. For this particular retailer, this very new secure online customer network is vital for their expansion.

I also mentioned earlier the strength that we had in the TZ 190 product and the success of our up sell program in the second quarter. These products are not just for small businesses but work particularly well in large distributed networks. As an example, Bob Evans Restaurants will be deploying TZ 190s TotalSecure with dual SonicPoint Access Points and GMS, where there’s 600 Bob Evans Restaurants throughout the Midwest and Southern regions. The restaurants will now be offering secure wireless guest services while meeting PCI compliance for the credit card transactions. This deployment compliments the 2007 deployment of SonicWALL TZs at Mimi’s Café on the west coast, which are also owned by Bob Evans.

Over the last two quarters, we have grown subscription deferred revenue and we continue to meet our revenue targets while making significant improvements in our operating expense structure. We believe that the company is well positioned to grow revenue and profitability and to continue to make market share gains.

I want to take a moment and thank all of our employees and partners for yet another good quarter, despite the backdrop of economic uncertainty. We continue to work collectively to win new customers and retain our existing customers. Thank you very much for your hard work. I’d like to turn the call back over to Kelly Blough.

Kelly Blough

I’d like to remind everyone that we will be presenting at the RBC Capital Market’s Technology Media and Communications Conference next Thursday, August 7th in San Francisco. We hope to see you there.

We will now open for questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from Scott Zeller with Needham and Company.

Scott Zeller - Needham and Company

Hi, good afternoon. I wanted to ask about your expectations for the License and Services line going forward. Is it possible for this line to actually grow given the deferred is flat?

Matthew T. Medeiros

Well, Scott, certainly we want it to grow and I think it is possible that it will grow. I think it’s all dependent on unit growth. We’re also working on new solutions constantly that will hopefully aid in the growth of the area of License and Services.

Scott Zeller - Needham and Company

Are you willing at this point to say what your expectation is for units, whether or not you’ll be up or down? Are you going to guide that for the September quarter?

Matthew T. Medeiros

You know, we don’t guide the future on unit sales.

Scott Zeller - Needham and Company

Okay, even directionally?

Matthew T. Medeiros

You know, Rob mentioned that Q3’s seasonal and we certainly gave a lower top range on our guidance and I think that reflects our view on how we see the business.

Scott Zeller - Needham and Company

Okay, thank you very much.

Operator

And next question comes from Rob Breza with RBC Capital Markets.

Rob Breza - RBC Capital Markets

Hi, good afternoon. Matt, you mentioned in your prepared remarks that you started to see a little bit of softness in the UK. What are you seeing in Europe and do you expect that to kind of run across the pond and hit continental Europe? How should we think about Europe? And maybe Rob, if you could just comment a little bit on the cost structure, what you think make a cost structure. I know you added a little bit more headcount in China, India, etc. so maybe the headcount is viewed as important for Europe but let me get your comments on international markets.

Matthew T. Medeiros

Yes, Rob. Let me take the first part of that and that is we definitely did see a slow down in demand in the UK specifically but I think it’s just too difficult for us to predict at this point whether it’s a short or long-term phenomena. We don’t believe that this is a product or a SonicWALL-related specific issue but much more of it’s just a business issue. The rest of the European markets actually performed quite well so this was just isolated in the UK and I would hesitate to say that on one quarter’s data that we’d be able to predict what’s happening.

Robert D. Selvi

Well, as far as the cost structure’s concerned, I think what you’re seeing is pretty a level cost in terms of our domestic operations and increased cost from a SonicWALL headcount standpoint, particularly in certain areas like support, where we’ve been--and this is a forward-looking statement by the way, with respect to Q3 and the rest of the year--where you’ll see headcount-related costs increase for SonicWALL but there will be a corresponding decrease that more than offsets that increased cost. And the core of that offset have to do with third-party expenses for that function previously.

Rob Breza - RBC Capital Markets

Okay, and maybe as a follow up: Rob, you talked about, I guess, plus a million dollars remaining in the buyback. Any discussions you guys have had with your Board yet? Any thoughts on terms of reinstating a buyback?

Robert D. Selvi

Yes, we don’t have anything that announced today in terms of adding to the current authorization which remained at the end of the quarter and, as you pointed out, of $800,000 against the full $200 million. So, nothing turned out today. Obviously, that’s something we talk about every quarter with the Board.

Rob Breza - RBC Capital Markets

Great. Thank you.

Operator

Moving on to Catharine Trebnick with America‘s Growth Capital.

Catharine Trebnick - America‘s Growth Capital

Hi, good afternoon. I have a question that relates more to your mid-tier sector, the enterprise. Can you give some more color around how that is going in terms of--have you seen sluggishness as you’re seeing in the small/medium business market?

Matthew T. Medeiros

Well, you know Catharine, what we call our NSA products and our PRO family, were actually up 11% quarter over quarter. So the fact is that I think that it’s been quite a bit of an anecdote over the slowness that we’ve seen in the SMB market. Often times we’re actually entertaining a customer who understands security and their security practices. They’re at the point where they’ve deployed possibly two or three rounds of different types of security solutions. And they’re really looking for a solution that is far less complex and more affordable than the ones that they’ve had in the past. And I think SonicWALL’s certainly filling that bill. Our new NSA products are performing substantially above our competition on the standpoint of intrusion prevention and gateway anti-virus. And those are the specific things that people are looking for today. So, we’re pretty pleased with the results thus far.

And as I have mentioned in my prepared remarks, 37% of our revenue now came from products that were above the $1,500 band versus only 18% the year before. But I think we’re moving quite well.

Catharine Trebnick - America‘s Growth Capital

No, I think you’re moving quite well. It just seems like an anomaly, with the way the whole economic conditions are doing. So, that’s why I wanted to make sure I asked the question again.

Matthew T. Medeiros

Yes, we have our own hypothesis and that is that we do believe that small businesses have been more affected in this economic uncertain times than, quite frankly, mid-tier and enterprise.

Catharine Trebnick - America‘s Growth Capital

All right. Thank you.

Operator

And we’ll take the next question from Sterling Auty with J.P. Morgan.

Sterling Auty - J.P. Morgan Chase & Co.

Yes, thanks. Hi guys. Well, I’m wondering if you could give us a little bit more color on the comment on the expenses, the third parties that impacted some of the gross margins, a little bit more specific as to what they are, and is that going to continue at this level?

Robert D. Selvi

Well, as you know, we’ve been in a process of transitioning to an in-source model for customer support for the North American and Asia Pacific regions. That’s been a multi-quarter exercise as we ramped up our own capability in Bangalore, India and Tempe, Arizona. And we continue to maintain third-party support vendors in place to provide that service while we were paralleling our own internal efforts. And in the second and third quarter, we’re sort of completing the exercise. So, there were additional third-party payments that we realized in Q2 and then we will also have some spillover payments in the third quarter. And then that transition will be fully made and in fact, as we sit here today, I can tell you that the transition occurred in about the third week of July. And so far the results look very good.

Sterling Auty - J.P. Morgan Chase & Co.

Okay, and you mentioned the deferred revenue being good despite the lower unit value. Can you just talk to us about what you are seeing? Are you seeing an increase stability to market into the installed bases are particular, whether it be the comprehensive security gateway or something else that you’re seeing for it to uptake, and be able to offset? How much more runway might you have in that opportunity?

Robert D. Selvi

Well, I think we have quite a bit of runway in terms of the potential for growing deferred revenue going forward. That’s not what our experience was in terms of subscription billings in the second quarter. And when you look at the deep tail of that, it was impacted in part by the lower number of units that we have in the quarter and in part by what you might refer to as anomalies, like the fact that we didn’t have a secure upgrade program in place for GEN4 appliances to the new NSA appliances just because of the newness of that product line, most of which was introduced in the last two quarters. So, we didn’t feel it was appropriate at this time to put that program in place. But that was a substantial contributor to billings in prior quarters in the PRO product line and we didn’t have the same experience in Q2. Now, that’s a program that will be in place in Q3 and beyond. And so, we should have the potential to return to more vigorous growth, at least in that segment.

And then to the earlier question about how our units are looking in Q3? Are we going to guide that? We’re not. And so, part of it is dependent upon our unit volume and velocity that we experience in Q3.

Sterling Auty - J.P. Morgan Chase & Co.

Okay, and Matt, in terms of as you’ve been coming up market--as you look at the competitive landscape, where do you think that competitively you’re just lacing? In other words, who are the vendors do you think that you’ll, for a lack of a better description, gaining share again? In other words, where’s the opportunities you’re capturing that was going to other vendors?

Sterling Auty - J.P. Morgan Chase & Co.

Sterling, I think the number one vendor in the industry is Cisco. Currently, we’ve had an opportunity to look at older PIX solutions with the competitive upgrade program. With PIX solution in the market place, we’ve done quite well. People find a certain CheckPoint solution to be very complex and we’ve had an opportunity to really prove that we can, in fact, do things like application firewall very well without the complexity of the CheckPoint solution. I think it’s truly a customer direction setting. Those that have incumbent technologies often times are looking for less complexity at a very reasonable price. Like I said before, most of these customers have already had two or three different installations of security. They know what they want. They want it at affordable prices, they want it easy to manage, and they certainly want it to be state-of-the-art technology, which is what we believe our SSL VPN and our NSA products are currently delivering today.

Sterling Auty - J.P. Morgan Chase & Co.

All right. Great. Thank you.

Operator

Next question comes from Christopher Crowe with Pacific Crest.

Christopher Crowe - Pacific Crest Securities

Hi, how are you guys doing? Just had a quick question. I’m looking at interest income for the quarter, just in terms of modeling going forward. I know it’s just kind of a down-take from the first quarter. This about the same level that we should model going forward?

Matthew T. Medeiros

Well, let me tell you what happened in the quarter in comparison to the first quarter and then you can draw your own conclusions. Basically, what happened is we repurchased a lot of stocks in the quarter. That reduced the amount of invested cash. So part of the reason for the decline quarter over quarter, which was about $1 million in interest income quarter over quarter. About half of that was because of the change in average invested balance. And the rest of it was really related to a change in yield. And so, those things contributed equally. We don’t expect an uptake in the yield environment and in terms of our outlook on cash flow in the third quarter, we don’t specifically guide that but it’s really based on the growth of deferred revenue. The rest of the variables that we see fundamentally pretty much cancel each other out. So, net, our performance and operating cash flow is going to be largely determined by, I should say, is deferred revenue growth. And will not be a significant outer to the average invested balance.

So, looking at performance of what’s fairly similar to Q3 would not be a bad modeling assumption.

Christopher Crowe - Pacific Crest Securities

Okay, perfect. Thank you.

Operator

The next question comes from Sterling Auty with J.P. Morgan.

Sterling Auty - J.P. Morgan Chase & Co.

Yes, I wasn’t going to let you guys off that easy. So, you mentioned some of the tech support in the description. You had that kind of pie on the TZ line. Any update there in terms of --have you looked at additional product lines to include that? What kind of contribution you got from that part of the tech support in the quarter?

Matthew T. Medeiros

I’m sorry. I’m not sure I really quit understood that question, Sterling.

Sterling Auty - J.P. Morgan Chase & Co.

Well, if you back a couple of quarters, you have the TZ line that bundles with the solutions, the maintenance and support. 4X7, I think. So just wondering. We’ve talked about before. Maybe you guys would take a look at considering looking at other product lines to include that. Have you done that? If not, just what was the benefit in the quarter just from the existing?

Matthew T. Medeiros

That’s good, Sterling. We certainly have experienced, again, good pickup in the quarter of our bundle solution. In fact, I’ll tell you that the NSA products typically sell almost one for one attach rate for support. So, the type of product, the type of customer, they’re much more tend to buying the support on just a routine basis. And that’s certainly what’s been helping us in the NSA family. We are looking at other ways of bundling solutions. So by way of example, the engineering team’s looking at how we can get certain anti-virus across an SSL VPN platform. We’re looking for ways that we can in fact do SSL VPN better on the UTM platform. I think that those are all ways that we can increase the deferred revenue, increase the subscription services type of activity. So, we’re not looking at just introducing new hardware platforms. We’re also looking to introduce new subscription services platforms that will aid in our growth rates.

Robert D. Selvi

And maybe to answer your question about our bundling strategy versus selling TZ products is either bundled or “naked.” That didn’t seem to have an impact in progression of our bundled CGSS billings in the quarter. So, we did have a decline sequentially in Comprehensive Gateway Security billings in the quarter but it was related to what I had mentioned earlier about the PRO upgrade program, not the TZ program.

Sterling Auty - J.P. Morgan Chase & Co.

And last question from me is that the whole comment, Matt, NSA bigger in units and revenue than PRO just brings up the idea of the product transition and inventory management. What should we be thinking about in terms of the mix and the trends over the next--and you pick the timeframe--two, three or four quarters?

Matthew T. Medeiros

Well, let me have Rob help give us some ideas on what we’re doing with inventory collectively. I think, Rob, maybe you can enlighten us with that first and I’ll talk about what we’re doing worldwide.

Robert D. Selvi

Well, I guess the blank economist were managing it carefully. I think we did have a decline in net inventory on our balance sheet quarter over quarter. Obviously, we had some significant additions to inventory in Q1 as we ramped up the NSA products and that will become more normalized over time. With respect to the channel, what we saw really across the world in the second quarter, was a step up in efficiency in channel inventory. And that’s true, as I mentioned, for both TD and Ingram in the United States as well as the rest of our distributors buying large on average throughout the rest of the world.

Matthew T. Medeiros

So Sterling, I think the second part of the question is how’s this relating to the transition between the PRO and the NSA. And as you know, every one of our products that we ship, we actually look for a registration. Right? So we know when we’ve sold it into distribution; we know when they’ve sold it out of distribution; and then we also know when the end customer registers the device. So from that perspective, we’re actually doing, I think, a very good job of understanding what inventory still is remaining in the channels relative to the PRO product and we’re aggressively managing that with our distributors, with our partners, as well as, the end customers to make sure that there isn’t a problem with excess inventory. We certainly haven’t seen it yet. And as you know, we’ve already stopped shipping on the 5060, the 4060, the 3060 and the 4100. So, we’ve had several quarters now of the NSA products actually being fully transitioned into the PRO family or the PRO family being transitioned out. The 2400 versus the 2040 is happening this quarter.

Sterling Auty - J.P. Morgan Chase & Co.

All right. Great. Thank you, guys.

Operator

Our next question comes from Joseph Yin with Scopia.

Joseph Yin - Scopia Capital

Can you talk a little bit more about the PRO upgrade that you were just chatting with Sterling about?

Matthew T. Medeiros

And so what we’ve done, Joseph, is for those customers that purchased PRO products several years ago, we’ve managed an upgrade program that basically gives them the ability to transfer their licenses or their subscriptions over to their new NSA product. There is a charge for that. There’s a charge is an uplift in the product cost but because they are recurring customer for us, there is an advantage to that customer.

Joseph Yin - Scopia Capital

And so are you saying that because you didn’t have this in place, you just didn’t go after segment of your customer base who otherwise would have been upgrading at this point in time and this is something you’re going to go back and get in quarter’s hence?

Matthew T. Medeiros

Oh no, I don’t think you should at all interpret our comments as saying that we didn’t go after it. We always go after it. There was no problem with our data or any of that integrity. It’s just a function of when we felt it was important to go after that market and educating resellers first on the new product, with new customers and new opportunities happen simultaneously as well as upgrading certain customers.

Joseph Yin - Scopia Capital

I’m sorry. I guess I’m missing something here. So subscription billing, as you were saying, were weaker because of two factors: One, less units and the other because of what you characterize as an anomaly that you didn’t have a secure upgrade program for transferring the NSA product.

Robert D. Selvi

Yes, maybe I can help here. So, what I said was that the program that we’ve been talking about, which is an upgrade program for the installed base customers, that we had in place for our generations one, two and three products to the PRO product line. But a similar program was not put in place for the upgrade of existing PRO customers to the NSA products, and that had an impact in billings in the quarter relative to that program. And moreover about for most of the PRO product line, that program will be available but in Q3 and beyond. So, what I was saying is we have the potential to realize some growth in that category in Q3 and thereafter.

Joseph Yin - Scopia Capital

Fair enough. And then just one quick question on the inventory. The inventory that you’re sitting on, can you give a break out of what percentage of that is NSA at this point in time?

Robert D. Selvi

You know, I don’t think I can give you a specific break out of that on the call today but I would say that most of the growth that we realized over the last two quarters, if you set Q4 as a baseline, has been in NSA products.

Joseph Yin - Scopia Capital

Okay, thanks a lot.

Matthew T. Medeiros

But I think, again, the NSA products carry a higher ASP. They also carry a higher cost.

Joseph Yin - Scopia Capital

Okay, thanks guys.

Kelly Blough

Thank you, everyone. This concludes our second quarter earnings conference call. We look forward to seeing you throughout the quarter.

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Source: SonicWALL, Inc. Q2 2008 Earnings Conference Call

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