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Executives

Gil Shwed – Founder, Chairman & Chief Executive Officer

Tal Payne – Chief Financial Officer

Kip Meintzer – Head of Global Investor Relations

Analysts

Shaul Eyal – Oppenheimer & Co.

Rob Owens – Pacific Crest Securities

Shelby Seyrafi – FBN Securities

Walter Pritchard – Citi Investment Research and Analysis

Daniel Ives – FBR Capital Markets

Brad Zelnick – Macquarie (USA) Research

Philip Winslow – Credit Suisse

Michael Turits – Raymond James

Rick Sherlund – Nomura Securities

Brent Thill – UBS

Aaron Schwartz – Jefferies & Company

Greg Dunham – Goldman Sachs

Sterling Auty – JP Morgan

Jonathon Ho – William Blair

Keith Weiss – Morgan Stanley

Tal Liani – Bank of America-Merrill Lynch

Scott Zeller – Needham & Company

Brian Freed – Wunderlich Securities

Gregg Moscowitz – Cowen & Co.

Check Point Software Technologies Ltd. (CHKP) Q3 2012 Earnings Call October 17, 2012 8:30 AM ET

Operator

Greetings, and welcome to the Check Point Software Q3 Conference Call. (Operator instructions.) As a reminder, this conference is being recorded. It’s now my pleasure to introduce your host Kip E. Meintzer, Head of Global Investor Relations for Check Point Software Technologies. Mr. Meintzer, you may now begin.

Kip Meintzer

Thank you. Good morning, everyone. I’d like to thank all of you for joining us today to discuss Check Point’s financial results for Q3 2012. Joining me on the call today are Gil Shwed, Founder, Chairman, and CEO; along with our Chief Financial Officer Tal Payne.

As a reminder this call is being webcast live on our website and is being recorded for replay. To access the live webcast and replay information please visit the company’s website at www.checkpoint.com. For your convenience, the conference call replay will be available through October 24th. If you’d like to reach us after the call please contact investor relations by emailing Kip@checkpoint.com or by phoning at +1 (650) 628-2040.

Before we begin with management’s presentation I’d like to highlight the following items. During the course of this call, Check Point representatives will make certain forward-looking statements. These forward-looking statements my include our expectations regarding demand for our security products; our expectations regarding the introduction of new products, programs, or the success of those products or programs; and our expectations regarding our business and financial outlook for Q4 2012. Other statements which may be made in response to questions which refer to our beliefs, plans, expectations, or intentions are also forward-looking statements for the purposes of the Safe Harbor provided by the Private Securities Litigation Reform Act.

Because these statements pertain to future events they are subject to various risks and uncertainties and actual results could differ materially from Check Point’s current expectations and beliefs. Factors that could cause or contribute to such differences include but are not limited to the risks discussed in Check Point’s latest annual report on Form 20(f). As a reminder, Check Point assumes no obligation to update its forward-looking statements.

In our press release which has been posted on our website we present GAAP and non-GAAP results along with reconciliation tables which highlight this data, as well as the reasons for our presentation of non-GAAP information. Now I would like to turn the call over to Check Point’s Chief Financial Officer Tal Payne for a review of the results.

Tal Payne

Thank you, Kip, and hello everyone. I would like to thank you all for joining us today for a review of the Q3 financial results. Our revenues for the quarter increased by 8% year-over-year and non-GAAP EPS was $0.79 representing 10% growth – both in the upper half of our guidance. Before I proceed further into the numbers let me remind you that our Q3 GAAP financial results include non-cash equity-based compensation charges, amortization of required intangible assets and the related tax effects. Keep in mind that non-GAAP information is presented excluding these items.

Now let’s take a look at the financial highlights for the quarter. In Q3 our revenues reached $332.4 million, representing an increase of 8%, compared to $308.3 million in Q3 2011. This growth was driven by continued strength in our software update maintenance and subscription revenues. These revenues reached $211.3 million with growth of 13% year-over-year. The growth was driven by our Annuity Software Blades that are recognized as subscription.

We continue to see great success in our Annuity Blades led by IPS application control in our recently-introduced Anti-Bot Blade. Product and license revenues were $121 million compared to $120.7 million in the same period last year. The number of Enterprise Gateways sold continued to grow and an impressive double-digit pace. This growth was offset by customers opting to purchase slightly lower-end models as a result of increased performance of our new appliance line.

Our results were also affected by current macroeconomic environments and by our customers’ tightened budgets. As you recall, our worldwide price list is in dollars. The continued weakening of many local currencies against the dollar specifically in Europe effectively reduced the buying power in dollars of the customers. On the other hand, North America continued to show great results with double-digit growth both in products and in services.

Deferred revenues as of September 30, 2012, were $505.9 million, an increase of $51.5 million or 11% over September 30, 2011. Revenue distributions by geography for the quarter were as follows: the Americas contributed 45% of revenues; Europe contributed 37%; and Asia-Pacific, Japan, Middle East and Africa region contributed the remaining 18%. From a deal size and quantity perspective this quarter, transactions greater than $50,000 accounted for 66% of total order value compared to 63% in the same period a year ago. We had 31 customers that had a transaction value greater than $1 million.

From an operating perspective we reported great results. Our non-GAAP operating income was $195.6 million in Q3 2012, an increase of 8% compared to the same period in 2011. We continue to invest in our business and have increased our headcount by 15% year-over-year, mainly in R&D, sales, and technical support. The effect of these increased costs was offset partially this year by the strengthening of the dollar.

Our non-GAAP operating margin this quarter was 59%, the same level as Q3 2011. GAAP net income for Q3 2012 was $152.4 million or $0.73 per diluted share, up from $134.1 million or $0.63 per diluted share in the same period a year ago, representing a GAAP net income increase of 14% year-over-year. Non-GAAP net income for the quarter was $164.1 million or $0.79 per diluted share, up from $152.9 million or $0.72 per diluted share in the same period a year ago.

Non-GAAP earnings per share were in the upper range of our guidance, representing 10% growth year-over-year. Our cash balances reached $3.247 billion at the end of the quarter. Cash from operations was $180.4 million compared to $154.5 million in the same period a year ago. Collection continued to be strong. Our DSO was 72 days, similar to the previous quarters.

During the quarter we purchased approximately 3.2 million shares for a total cost of $156 million, more than double of what was purchased last quarter and consistent with our announcement to increase our share repurchase program. And now I’ll turn the call over to Gil for his thoughts on Q3.

Gil Shwed

Thank you, Tal, and thank you everyone for joining us on the call today. In Q3 we produced decent results with revenues and EPS in the upper half of our projections. Tal has already addressed the financial results for the quarter and I would like to share some further information with you.

From a geographical standpoint we had distinctly different results from different parts of the world. Europe has been stable this quarter with mixed results from different regions and countries, which is not surprising taking into account the (inaudible) in the summer months and the economic environment. On the other hand, the US has continued to see double-digit growth and very good results. This has been reflected in all parameters –increased number of units; improved average selling price – ASP; and increases in all categories: products, subscriptions, and services.

This is very important, especially given the concerns that some of you might have regarding the competitive environment. The market continues to be competitive as it’s always been, yet in the most competitive market – the United States – we continue to do exceptionally well. If you’ll recall, last quarter we discussed the trend in our product [types]. Our new appliances produce about 3x more performance than the previous generation. This has resulted in numerous [increases]. On one hand, [we have shipped more] lower priced models in the past three quarters; and some customers chose to get the same performance at the lower price.

The good news is that this trend improves our market share as a result of the double-digit growth in (inaudible). Growth in appliance unit sales has been true in all geographies – Americas, Europe and Asia. This quarter we started to experience a slight increase in the average selling price compared to Q2 as customers began realizing the benefits of our higher-end datacenter model and the need for more speed in activating additional security defense measures.

The success of our appliances business was also acknowledged by IDC, a leading market research firm, which recommends Check Point Security Appliance leadership and ranks it in the #1 position for the first time in their Appliance Report that was published in Q3. Our [other card] software blade sales also continued to see some strength and grew by more than 50% year-over-year. In Q2 we announced the Anti-Bot Software Blade which detects and blocks the software agents used in the most sophisticated hostile attacks. The Anti-Bot Software Blade is starting to gain traction and in Q3 it was purchased by several hundred customers.

GAiA, our next generation secure operating system which was launched in April continued to be very well-received and has continued to gain traction within the install base. Looking forward, we are planning many exciting security initiatives in mobility, virtualization and cloud environments. Of course we also continue to focus on strengthening our core network security and expand the performance of our product line with the introduction of additional product models.

From a business perspective, while we’ve seen continued strength from the US, Europe has continued to be impacted by economic uncertainties and the strengthening of the dollar. Please keep in mind that due to the risks around the economy and the shift in our products mix we will provide a wider (inaudible). Projections for Q4 are as follows: we expect revenue in the range of $355 million to $387 million and non-GAAP earnings per share in the range of $0.83 to $0.91 per share. GAAP EPS is expected to be approximately $0.07 less.

With that I’d like to thank you once again for joining us on the call today and open the call to your insightful questions. Thank you.

Question-and-Answer Session

Operator

Thank you. We will now be conducting the question-and-answer session. (Operator instructions.) Our first question is from the line of Shaul Eyal with Oppenheimer & Co. Please proceed with your question.

Shaul Eyal – Oppenheimer & Co.

Good afternoon, guys. A positive quarter indeed, given the environment. Gil, Tal, Kip, a couple of quick questions on my end. Gil: the status of the 61000 and 21400, how did they fare this quarter? And your comment about the ASP increase, does that also apply to say the [build up] products?

Gil Shwed

What was the last part?

Shaul Eyal – Oppenheimer & Co.

Your comments about ASP heading up a little bit during the quarter, does that apply also to the 61000 and 21400?

Gil Shwed

Okay. So [with the product mix] yes, customers have been purchasing more of the 21400 and I think also a little bit more of the 61000, and also at least [two other] products: the 12300 series and so on, which all impact the slight increase on the ASP from Q2 to Q1 which is something we planned and worked on. So all of that has been happening in the last quarter.

Shaul Eyal – Oppenheimer & Co.

Got it. And Tal, with respect to foreign exchange impact, is there any kind of way to quantify that roughly this quarter?

Tal Payne

In the expenses we (inaudible) calculate the [impact], and if I compare it to Q3 last year then it’s probably around $0.01 or $0.02, about $5 million or so. In the revenue it’s much harder obviously because customers in many regions around the world, their budgets are in local currencies. A the majority of them versus last year got weaker against the dollar; some of them in 10%, some of them 15%, some of them 20% - it’s quite a significant effect on customers, and how much it affected their revenues I can’t tell. Probably some of it is responsible for the shift in the ASP towards the mid and large units versus the high. Again, like Gil said, the good news is we actually started to see some shift already in the ASP to the higher products and therefore higher ASP but it’s still early days.

Shaul Eyal – Oppenheimer & Co.

Got it. And maybe just one final question for Gil: any initial thoughts about F2013 or is it too early at this stage?

Tal Payne

What was the question?

Shaul Eyal – Oppenheimer & Co.

F2013 in terms of guidance and projections.

Kip Meintzer

It’s too early. Yeah, 2013 won’t come until next year.

Shaul Eyal – Oppenheimer & Co.

Okay, got it. Thank you very much.

Tal Payne

Maybe I will use this opportunity to repeat the guidance. The guidance for Q4 was $355 million to $387 million and in the EPS, non-GAAP EPS is $0.84 to $0.91.

Operator

Our next question is from the line of Rob Owens with Pacific Crest Securities. Please proceed with your question.

Rob Owens – Pacific Crest Securities

Great, thank you very much and good morning. As you guys talk about the ASP pressure, do I understand it correctly from your comments: are you seeing that more internationally than you are here in the US markets? And I guess the follow-on question to that is how do we think about the model when some of these appliance changes anniversary in Q4? Should we see pricing normalize as we get into the first half of next year?

Gil Shwed

First, we don’t see much ASP pressure. What we see is the fact that customers have purchased the lower-range model and get the same performance for a lower price. We’re not talking about bigger discounts or things like that; it’s just customers with a slightly lower budget find out that the new appliance gives them 3x more performance. They can purchase a slightly lower-end model and maybe purchase two of them. I mean one of the things we did see consistently in the last three quarters is double-digit growth in unit sales which is the good news, and that has been true in all geographies. In all geographies we’ve seen slight shifts into lower-end models and in all geographies we’ve seen the double-digit increase in unit sales including in Europe this quarter and in all the other regions.

Rob Owens – Pacific Crest Securities

And as some of those changes annualize should we expect a little more consistency in pricing I guess relative to customer budgets?

Gil Shwed

I think the big shift in appliances we did a year ago and I think we’re not planning any major product shifts, product changes in the next few months, so next year should be a little bit more stable in that. I mean I would like to hope that we’ll see a continued increased number of units which will translate into the revenue and so on. I think the first quarter where it will be really comparable year-over-year will be Q2, Q1 or Q2 next year.

Rob Owens – Pacific Crest Securities

And then Tal, as we think about deferred revenue for Q4, if I remember last year there was a nice spike there as you guys had [early renewal blades] and some other factors. Do you think that was one-time in nature or do you expect the same type of phenomenon to play out here in Q4 2012? Thanks.

Tal Payne

If I remember, first, given the expected Q3 is the lowest and the biggest drop in the deferred revenues in the balance sheet. Q4 is typically the highest so it’s in line with a general phenomenon. Keep in mind it’s not the deferred… The billing that you calculate is the revenues plus the deferred. It’s implied booking but it’s not real booking. I know when you calculate it now you see a negative number. The booking was not negative; the booking was positive, but slightly weaker because of what we see in Europe which we alluded to at the beginning of the call.

Operator

Thank you. Our next question is from the line of Shelby Seyrafi with FBN Securities. Please proceed with your question.

Shelby Seyrafi – FBN Securities

Yes, thank you very much. So yeah, you talked about the number one concern I see in this report, which is the billings decline of about 1% year-to-year I calculate, although you just said bookings grew. But I just wanted to see besides what you’ve already talked about, to what extent are you seeing increased competition from A.) the likes of Palo Alto Networks; and B.) perhaps the revitalization from Cisco and Juniper and the bigger players?

Gil Shwed

(Inaudible) to be competitive and it is competitive; it’s always been. Now, the generation and the different competitors have been changing along the year. I think Cisco and Juniper have not been the strong competitors for the last year or so, more than a year actually; and I haven’t seen a huge shift there in the last quarter. I think that the good evidence, and I already mentioned that, that the US is the most competitive market in our industry – everybody is focusing on that market. Everybody is focusing on the same accounts and most sales and marketing efforts are focused on that market. We had very, very good success and that has been consistent for the last few quarters, which means that the market remains competitive. We have a lot to offer and we get a lot of feedback from customers that choose Check Point.

Shelby Seyrafi – FBN Securities

I guess perhaps a larger investor concern these days is the momentum of Palo Alto Networks itself. Are you seeing them in more competitive situations and how have your win rates been changing with them?

Gil Shwed

I think we’ve done pretty well. I mean we’ve been displacing Palo Alto in some places already which is not a good indicator for a young company [doing like they’re doing]. And I think it’s not very different from the previous generation of competitors that we’ve seen and I’m really not discounting any competitor. I think they have good [competition] and I think what we’ve shown in the last 18 years is that we keep focusing on the real needs of the customer; we keep focusing on providing the best security, the most comprehensive security and in the long run we’ve sustained that leadership. And I’m sure that we will this time as well.

Shelby Seyrafi – FBN Securities

Okay. And your large deal activity appears to have slowed down. I think you had what – 31 deals over $1 million versus 40 in Q2 and 53% of transactions over $50,000 of your total [over] value, and that’s down as well. Are you seeing this trend toward larger deals slowing down and do you think it’ll turn around perhaps in Q4?

Tal Payne

Maybe I’ll first say related to the data and then give some comments about that. In terms of the transactions larger than $50,000 it’s actually increased to 66% from 63% and in terms of transactions it was 31 customers this time; as far as I recall it was 35 in Q3 last year, not 40. Actually the Americas grew in the number of customers and in dollar value. Also the total, although we had 31 versus 35 the total dollar value increased. The reduction in the number of customers is actually relating mainly to Europe and is in line with our results.

Shelby Seyrafi – FBN Securities

Okay, the last thing for me is on Europe itself. You did have, according to my estimate because you gave a rounded percentage of revenue numbers; I’m calculating 5% growth in Europe year-over-year versus a 9% growth in Q2. As you go into Q4 is it possible that we see a year-to-year decline in Europe? What are you seeing right now so far in calendar Q4 in Europe?

Gil Shwed

Anything is possible but our forecast is positive growth in Europe as well as in all the other regions.

Shelby Seyrafi – FBN Securities

Okay, thank you.

Operator

Thank you. Our next question is from the line of Walter Pritchard with Citi. Please proceed with your question.

Walter Pritchard – Citi Investment Research and Analysis

Hi Tal, just for the follow-up on the deferred revenue question that was asked earlier, and I’m wondering… Understanding that the bookings and the billings don’t match in lockstep but was the disconnect between what you saw in the bookings or what you saw in the revenues related to product or related to the subscription and update side?

Tal Payne

In both, actually. In the deferred revenues remember that there is quite a large amount that is not billed every time, every quarter – there is nothing new. But this quarter specifically it increased in a few high singular millions and therefore affected some of the deferred. It does not imply that the booking was significantly higher; it just wasn’t negative. It was positive growth to the midpoint.

Walter Pritchard – Citi Investment Research and Analysis

Got it. And then Gil, I think you mentioned that you saw some ASP improvement over what you’ve seen in the last several quarters. Could you talk about in what part of the product line you saw that ASP improvement?

Gil Shwed

I think it’s not an improvement in the ASP per product; it’s in the product mix. It’s in the overall for all products, and what we are seeing is a slight increase in customers buying more of the 12000 product, more of the 21000 product, and the 4000 product than in previous quarters. So I think the year-to-year comparable is still changing the ASPs toward the lower-end models because of the higher performance; and quarter-over-quarter we’re starting to see the improvements which we took care of in the last quarter in terms of educating more of the customers and creating more models which will allow customers to buy the right model for them.

Walter Pritchard – Citi Investment Research and Analysis

Got it, great. Thanks a lot.

Operator

Our next question is from the line of Daniel Ives with FBR Capital Markets. Please proceed with your question.

Daniel Ives – FBR Capital Markets

Gil, I mean obviously there’s a lot of moving parts but at the end of the day licenses is flat to it looks like it’s going to decline year-over-year in Q4. So what do you say to investors? Is Check Point going forward as a low single-digit license grower? I mean is this more a phenomenon in the model in terms of what’s happened in the field, in terms of [buoyed] opportunities? Just kind of speak to that. I know you’re not giving guidance for next year but that’s obviously a big question just given the license growth.

Gil Shwed

I think first we did see this year double-digit growth in appliance unit sales which is the most important indicator. I think we did see a shift in the products this year because of the complete change of the product line, the modification of all the products in the entire product line with much better performance. I think in the long run that’s the right thing – to be competitive and to have the best products, and to have the number of units growing.

I think it’s too early to say what will happen next year but I’m hoping for the good, and there’s a lot of challenges in the marketplace but there’s also good things to hope for for next year especially as we’ve seen consistent double-digit growth in the number of units in the last three quarters.

And that’s, by the way, much higher growth in units than we’ve seen in the last few years. When I’m highlighting that point it’s not for no reason; in previous years we’ve seen much slower growth in unit sales and much higher growth in ASP. I hope that next year is going to be a better comparison for this year.

Daniel Ives – FBR Capital Markets

Okay, thanks.

Operator

Thank you. Our next question is from the line of Brad Zelnick with Macquarie. Please proceed with your question.

Brad Zelnick – Macquarie (USA) Research

Thank you. Gil, in terms of your product pipeline I’ve heard a lot of anticipation from the channel of exciting things to come next year, and I appreciate you might not want to show your hand to competitors but is there anything you can share with us about what’s coming down the pike?

Gil Shwed

I think we’ll see more things around Cloud and [operating more] security from the Cloud and for the Cloud. We’re already doing security for the Cloud but we’ll be the security provided by the Cloud. I think we’ll see some nice innovation around mobility and some of it relates to the network security side; some of it relates a little bit more towards the Endpoint product line. And I think we’ll continue in the core products with more software blades, with more innovation and with more performance and sort of pushing the envelope of the existing product lines. Some of the big changes we’ll see next year when we plan on the [new layer products, Cycle] and so on. The expansion of performance is a continuing process that we’ll see every couple of months, something innovative or something new in terms of better performance for our clients.

Brad Zelnick – Macquarie (USA) Research

Thanks, Gil, and I can see why they’re excited. And Tal, it’s nice to see the increased rate of share buybacks. Is there any update on Israeli tax law and how you think about repurchases into the future?

Tal Payne

I think we saw a lot last quarter and increased it from 300 million to 1 billion over two years, so it’s quite significant and you can see we’re executing on it. We’ve increased, more than doubled actually from $75 million to $156 million. When it comes to the Israeli law, and again, I always say don’t expect it to be steady over the quarter – some quarters you will see more, some quarters you will see less. We said we’re going to be opportunistic about it, that’s one; and when it relates to the new law they are contemplating some changes in the taxes related to improved tax payments. If anyone wants a bit more it’s too early, it hasn’t passed yet and I just don’t know how to treat it at this point in time.

Brad Zelnick – Macquarie (USA) Research

Thanks for the update.

Operator

Our next question is from the line of Philip Winslow with Credit Suisse. Please proceed with your question.

Philip Winslow – Credit Suisse

Hi, thanks guys. I just wanted to dig in a bit on the deferred revenue line again this quarter. One of the questions I’m getting is have you guys seen any sort of change in your renewal rates on the subscription and the maintenance side this quarter, and also do you see any change in the existing [or I believe] the attached rate of blades? And then also one of the things you’ve talked about in the past is a sort of shifting of deals from sort of the renewal cycles towards Q4 – was that any affect in Q3? The deferred just a bigger drop-off sequentially than we’ve seen ever before in a Q3 so just looking for some more detail there. Thanks.

Tal Payne

Well, the first thing is generally we don’t see a shift or a change in the discount rate, nothing significant. We don’t see a significant change in the attach rate. Again, there is definitely a shift between quarters which is very hard to follow on that. Some of them renew earlier, sometimes some of them renew later which can create a shift easily between quarters. Q4 is the highest one and is expected to stay significantly the highest one, but in terms of a shift between quarters of $10 million to the right or to the left? It can happen very easily.

Remember that when customers buy new products they’re many times doing a [chew up] or realigning all their products for that specific quarter, so sometimes it’s also correlated with the product of that specific quarter. So in general, yes, it can shift between quarters and yes, Q4 should be the highest.

Philip Winslow – Credit Suisse

Got it. And then also just a question on unit growth rate: you guys have been talking about 20% plus for the first couple quarters here. You guys had double digit this quarter so maybe just some color: are you still seeing a high teens growth rate or where in that double-digit are units falling? Then I’ll turn it over to other questions.

Tal Payne

In the units, yes, we did see double digits this quarter as well.

Operator

Our next question is from the line of Michael Turits with Raymond James. Please proceed with your question.

Michael Turits – Raymond James

Hey guys, sorry about this – it’s just a clarification. The bottom end of your EPS range is $0.83 or $0.84?

Tal Payne

$0.84.

Michael Turits – Raymond James

Okay, it is $0.84, good. And then one other issue possibly around ASPs – you know, over a period of time you got some uplift from the mix shift to appliances. I think that we’re largely through that so is that something also that may have been weighing on ASPs and as we get into next year could we be anniversary-ing that to provide an easier count?

Gil Shwed

I think yes, we see [the comps] especially now that we shifted the entire product line, and I think over time we will see also the renewal cycles of the appliances. Remember, now we are sort of moved from selling pure software into selling mostly appliances. We also sell by the way about 20% software licenses for products which I think is a great competitive advantage to us. And in the future we’ll start to see a replacement cycle by customers who take the 2010 or 2011 appliances and replace them with the new model, which should provide a very nice addition to the business model.

Michael Turits – Raymond James

And then on the renewal rates on blades, any change in those? I think you’ve been saying it was about 30% to 40% on bundled blades and 50% to 70% on standalone blades – any change there? And then as you get to more people being on R70 and R75 is that helping to improve those renewal rates at all?

Gil Shwed

I think the renewal rates each quarter has been very consistent. I think as we mentioned we’ve seen a 50% increase in the ala carte blades which is all these blades that are not bundled with the new products – blades that the customer chooses to either renew or to purchase as a new one. This has been very, very positive traction for the last few years.

Michael Turits – Raymond James

Okay, thanks Gil.

Operator

Our next question is from the line of Rick Sherlund of Nomura. Please proceed with your question.

Rick Sherlund – Nomura Securities

Yeah, thanks. Just to follow up on the previous question: this mix shift to Annuity blades that you started seeing last year in Q4, just a year-over-year change in accounting – shouldn’t we anticipate some improvement in billings as you anniversary the change in the revenue policy from last year?

Tal Payne

Remember that when you come from a previous year and already last year we had quite a significant portion of software blades as part of the services. The renewal rates are not the regular renewal rates that you see in the update and maintenance line here; the renewal is what was mentioned before. For the bundles they’re around 40% and for the unbundled or ala carte the renewal rate is 60%. So you’re losing a significant portion out of it when you start the year and then all the additional ala carte that you get are the ones that compensate for it. So in total the growth rate as you count more for last year is slowing down over time. It’s still significantly quicker than all of rest of the [live bot] products and updated maintenance but the subscription in the first year was around 100% growth rate. Over time the growth rate is lowering to a still high double-digit but lower than the previous year.

Rick Sherlund – Nomura Securities

And if we’re shifting to more Annuity business why aren’t we seeing that in the… It would seem like the deferred would be growing faster than revenues and we’re seeing the opposite. Can you reconcile that for me?

Tal Payne

Sure. So when you are in the first and the second year then it’s much more a material percentage of growth and therefore you see more effect on the deferred revenues. Once you’re already in the third year of the software blade initiative then you have significant revenue recognition and a significant number going into the deferred. The net is becoming less and less material. Still, the growth rate of the software blades in the deferred revenues is faster than the growth of the revenues in the subscription line.

Rick Sherlund – Nomura Securities

I’ll follow up on that. Alright, thank you.

Operator

Our next question is from Brent Thill of UBS. Please proceed with your question.

Brent Thill – UBS

Tal, I think we’re all having a hard time reconciling your deferred down 6% almost; your four-year seasonal is down 2%. So what piece of the deferred did not hit your expectation? Can you just help us understand the composition of the deferred because we’re all trying to really understand this and I don’t think we’re getting a good answer.

Tal Payne

That’s actually two different questions. The question on the subscription of the Annuity blade is a small portion of the deferred. The majority of the deferred is actually the update and the maintenance portion. That number certainly is reducing. You’re right, it’s actually reduced more. It’s actually reduced in the short term if I remember correctly about 5%. If you look at the past five years it’s run between 2% to (-)%5, it depends on which year so the range is 2% to 5%. This year was a high year, it was 5%. Some of it’s relating to the fact that more are waiting for Q4; some came earlier through the year and some of them are relating to the [chew up] and also relating to the fact that Europe bookings were lower than expected.

Gil Shwed

That can be a [super] shift between quarters. Customers that have chosen to renew last year in September with summer vacation, with just aligning their entire enterprise contract to Q4 can choose to renew in October, November, or December. Nothing major happens to them if they renew a month later and so on so it happens. And in the [bit] amounts that we’re seeing that’s not an unexpected phenomena.

Brent Thill – UBS

Okay, and is deferred making up more of your revenue? I would think that you’d have better visibility yet your Q4 guidance range is almost 3x as big as it was last Q4. Can you just help us understand what your assumptions are on close rates and how you’re making up that guidance for Q4? We’re just trying to understand why the range is so big.

Gil Shwed

First I think I’ve been very consistent in saying that predicting the future is always challenging but we know our business. I think we have a good [foreign] customer sales force, I think we have a nice list of [builds] but at the same time we have thousands and thousands of builds and we have small builds. We don’t know accurately what’s going to happen with large builds. There’s always the risk that the deal won’t close on the last day for some reason.

I think what we’ve been seeing this year is that I talked a little bit about Europe, and with the uncertainty around Europe – especially around Europe – I’d like to be a little bit more conservative this year than before. I’d like to hope that my conservatism is un-based and we will see in the next quarter much better results than ultimately that range and what we’re predicting here but I also need to be slightly more conservative given what we’ve seen on the European side of our business. With Europe we haven’t seen anything bad – we’ve seen it be stable, we’ve seen business is growing but not growing enough or as much as we want it to grow. And we need to be very aware of that and realistic about it.

Brent Thill – UBS

Thanks, Gil.

Operator

Our next question is from the line of Aaron Schwartz with Jefferies & Company. Please proceed with your question.

Aaron Schwartz – Jefferies & Company

Good afternoon. I hate to sort of keep coming back to this but the deferred is really getting the attention here, and I guess if you’ve gone through this product line transition – we’ve seen a deceleration of product growth on the income statement but we have expected somewhat of an offset due to a larger accumulation of the software blade Annuity revenue. And it seems like that broke down a little bit here in the quarter but you’re saying this was a lot more due to just maintenance and Europe? Is that correct?

Gil Shwed

I think the entire European business has been stable, a little bit softer than what we’ve seen in the US. In the US we’ve continued to see double-digit growth and we’ve continued to see the same kind of momentum and the same kind of growth rate that we’d seen the year before and for a long time now. In Europe we’ve seen slightly softer (inaudible) this past quarter.

Tal Payne

And maybe I would try to help you a bit more just to collect all the data that we said on the call that relates to this specifically. We said Europe was stable, meaning it wasn’t growing fast so that’s obviously affected deferred revenue. We did say we have lower than $10 million of bookings that did not go into the deferred, so that’s also an effect – it’s relating to updates and maintenance and services that were not part of the deferred and this also effects the deferred. And we also related the seasonality. The Annuity blades are a small portion of the total deferred revenues and that’s why I said it’s not shifting that number in that significant a manner.

Aaron Schwartz – Jefferies & Company

Okay, and you’ve talked about the product mix shift to the lower-end appliances that’s played out this year. Does that impact at all the Annuity blade contribution? Are you just seeing a lower attach rate on some of those blades – is that having a factor?

Tal Payne

No, actually the attach rate is similar in that regard.

Aaron Schwartz – Jefferies & Company

Okay. And last question for me if I could: I know you talked about last quarter some very subtle pricing changes to try to steer the mix shift back up and I think you made some very maybe subtle operational changes as well. Is that just starting to slowly play out in terms of bringing the mix shift back up and would you expect that to play out more fully in Q4 next year? Can you just talk about some of those changes and in addition are you making any other changes there?

Gil Shwed

Yeah, we’ve seen an increase in the ASP from Q3 or in the mix – the ASP is a result of the mix. We’ve seen a small change from Q2 to Q3 and that’s a result of realigning some of the products that we’ve done. We introduced another model in the [small to low] and then the mid-sized model in helping customers get slightly up in the reload side. And we did some realignment of products in the mid- to high-end and in the high- to datacenter products, and here again we’ve seen a very slight increase in those products from Q2 to Q3. The comparison to last year is very different because it was a different product line; the comparison between Q2 and Q3 is actually very favorable, a very nice change and increase in the Enterprise and the high-end and datacenter appliances.

Aaron Schwartz – Jefferies & Company

Thank you.

Gil Shwed

Overall, by the way, I’m very proud of the very big increases that we have in the mid-range products. I think it’s great to see that we are gaining share and getting more units for more projects for more customers. I think overall for the long run it’s always good to base yourself on the wide spread of customers and get less focused on the huge high-end deals which are great in the short term but in the long term they’re not always fully repeatable every year.

Operator

Our next question is from the line of Greg Dunham with Goldman Sachs. Please proceed with your question.

Greg Dunham – Goldman Sachs

Hi, yes, thanks for taking my question. Just one follow-up on that question regarding as customers kind of go down to the lower end boxes or the lower price point boxes with the same performance: did you say that the attach rates on blades is the same in those boxes? And then specifically are you seeing the attach rates of IPS and Application Control on the boxes that are more lower-end as the same? Thank you.

Tal Payne

Let me just make sure we understand the question. The percentage of the software blades, the bundles on those appliances are similar meaning the median has the highest one like we had previously and the higher-end have a lower number of software blades attached to it. Did I understand your question correctly?

Greg Dunham – Goldman Sachs

Yeah, that was the question but then I wanted to ask, you’re talking about the number of blade attach is the same at the high end as the low end, but I want to actually know specifically are the Application Control and IPS attach rates the same on the high end as the low end?

Gil Shwed

I think they’re very similar. Again, with some of the lowest-end models we don’t bundle the Application Control. It’s actually the lowest-end model, we allow customers to purchase it without IPS. On the high end it’s bundled with all the appliances, this application – [it gets] the IPS for the firs year.

Greg Dunham – Goldman Sachs

Okay, thank you.

Operator

Thank you. Our next question is from the line of Sterling Auty with JP Morgan. Please proceed with your question.

Sterling Auty – JP Morgan

Yeah, thanks. Hi guys. On the software blades can you give us a sense of the mix between how much of the blade revenue is coming from the bundles and renewals versus kind of the standalone blade purchases?

Gil Shwed

The bigger portion is from the ala carte one, not from the bundled one; and sort of the growth rates in the bundled one is directly related to the growth rate in new product sales. The growth rate in the unbundled one is whatever the customer chooses for renewal or to purchase a new one, and as we said in the ala carte one we had more than 50% growth year-over-year.

Sterling Auty – JP Morgan

And can you give us a sense, when you look across your install base what percentage of the install base actually now has blades running? I know there’s a portion that isn’t on a version that can run it, but still, just looking at it as a percentage of your total install base how penetrated are blades at this point?

Gil Shwed

I don’t have the updated data. I think it’s starting to be significant, getting to the… I don’t know, around 50%, probably around slightly below 50% of the install base.

Sterling Auty – JP Morgan

Okay, maybe you don’t have this one as well but last question: I think it’s been some time. Can you actually give us an update – what does the install base look like in terms of units?

Tal Payne

Hundreds of thousands but we don’t provide that data.

Sterling Auty – JP Morgan

Okay. Alright, thank you.

Operator

Thank you. Our next question is from the line of Jonathon Ho of William Blair. Please proceed with your question.

Jonathon Ho – William Blair

Hey guys. Can you walk through for us some of the levers that you see that could potentially drive upside in the quarter? Just given maybe some conservatism and maybe some more concerns around Europe, I just want to understand what are maybe some of the positive drivers that you see that can impact in this upcoming quarter?

Tal Payne

I think bear in mind that in terms of the service line, the majority of it is already part of the deferred revenues and then the current Q4 booking of the services – only a small portion of it will actually come into the P&L. When it comes to the products, the products in Q4 is the highest. It typically has a very significant growth and has the risk and the wider range. Products are very hard to predict and we are backend loaded, so typically Q4 is significantly higher than Q3 and therefore we expect a significant increase. And the rest is depending on the market, the budget of the customers and so on, so that’s why we need a bigger range. So if the economy is better, if budgets of customers are healthier then it should be a very big quarter as usual; and if we see more pressure in terms of the economy then it can continue to affect Europe and other regions, and therefore it will lead us more towards the lower end.

Jonathon Ho – William Blair

Got it. And just in terms of the Annuity blades, can you give us the actual run rate in terms of revenue that’s coming from the blades or do you intend to break that out at some point?

Tal Payne

I can tell you it’s below 50 million. It’s a few tens.

Gil Shwed

I think the annual [rate] is way more than $200 million.

Jonathon Ho – William Blair

Great, thank you.

Operator

Thank you. Our next question is from the line of Keith Weiss with Morgan Stanley. Please proceed with your question.

Keith Weiss – Morgan Stanley

Excellent, guys, thank you for taking my question. Tal, I just wanted to clarify – did you say headcount growth in the quarter was up 15% year-on-year?

Tal Payne

Year-on-year it was 15% and it was significant growth. I provided this data because many of you asked me what happened with headcount so this quarter we decided to discuss it. We increased it mostly in R&D, sales and marketing and tech and technical support; and the reason you don’t see it that clearly in the P&L in dollars is because of the effect of the dollar – because as the dollar is getting stronger the effect is salaries in local currencies, when you translate it into dollars it’s less dollars. And therefore you don’t see that increase in that significant way in the P&L but we did increase our headcount significantly, yes.

Keith Weiss – Morgan Stanley

Got it. So if we look at those headcount increases then look at it against the midpoint of your guidance that looks for I think 4% or 5% revenue growth at the midpoint, the US dollar getting stronger, should we be starting to anticipate or starting to input into our models maybe some pressure on operating margins in Q4 and potentially into F2013 as that headcount growth works its way through the model?

Tal Payne

I think you can see our guidance, and in our guidance pretty much you can see a similar margin.

Keith Weiss – Morgan Stanley

So are there offsets to that 15% headcount growth that’s going to enable you to keep overall expense growth in line with that mid single-digit growth rate you’re seeing on the top line?

Tal Payne

The offset happens with the currencies already. If the currency will get stronger then it will have that effect on the whole operating margin as we have every year.

Keith Weiss – Morgan Stanley

Outside currency, are there other sort of cost reduction programs you have in place that kind of shift fundamentally the expenses or is it just sort of currency is that difference?

Gil Shwed

I think there are growing cost reduction programs, but what we do and one of the reasons in this quarter in particular – we had the huge growth in headcount but we do a lot of entry-level programs and we (inaudible) in the beginning of their career and therefore also with relatively no compensation level. We let them grow in Check Point and overall that keeps the expense relatively flat with the headcount because usually you know, when you have people you have annual raises. So that kind of keeps the per person amount fixed because we try to get people at the bottom of the [picture] when they start.

Keith Weiss – Morgan Stanley

Right, but I mean you guys have done that for awhile and 15% unit growth in the number of heads, that’s in that new portion of the income statement that you just have a lot of employees onboard even if they are at the same kind of per unit price.

Gil Shwed

Again, the overall range remains the same. Remember, when you have employees they usually get a raise every year so the per person rate goes up every year. At the same time what we are trying to do is handle the mix with many, many new entry level programs. And the entry level program that we did with Q3 was much higher than in any year before; we almost doubled it than the year before. I think we hired more than 200 people in entry level programs in the last few months and that’s been pretty significant, a pretty big investment in training and an investment in the future. I think it’s true to the products organization, for the services organization and we even have an entry level sales program now which is running in New York.

Keith Weiss – Morgan Stanley

Got it. And then if I could maybe sneak one in on the geographic mix: you spoke to strong double-digit growth, or double-digit growth in the US I believe. Americas is 45% of revenues – I believe that’s in-line with what you talked about last year in Q3 when you had 45% of revenues. Is there an offset to the US in the broader Americas, perhaps in Latin America or Canada that is dragging down growth for overall Americas to be pretty much in line with the entire company?

Gil Shwed

Nothing is dragging down the overall company but Latin America is much smaller than North America and the US right now.

Keith Weiss – Morgan Stanley

So the growth was much lower than the US in Latin America?

Gil Shwed

In Latin America, of course it’s pretty small so remember that.

Keith Weiss – Morgan Stanley

Got it, excellent. Thank you guys.

Operator

Our next question is from the line of Tal Liani from Bank of America-Merrill Lynch. Please proceed with your question.

Tal Liani – Bank of America-Merrill Lynch

Hello. I have a question about strategy more than the quarter. You’re clearly growing below the segment. Cisco, [Fortinet] and others are having double-digit growth and in the higher end of double digits, or high end of teens I mean. And if I look at your product revenue growth or even if I add back the changes in Q3, your growth rate decelerated from plus 20% to negative levels this quarter; and the deceleration is pretty consistent. The product revenue growth was zero this quarter. So the question is what will you do or are there any plans to do something different in order to reaccelerate the growth or is it just economy-dependent? And if you plan on doing something will it require a greater investment in OPEX in a way that will reduce operating margins? Thanks.

Gil Shwed

First, there are many differences but I just want to refer first to your facts. I think we are growing in the last few years much, much faster than Cisco and much faster than many other players in the industry, so saying that some of the larger players in our industry are growing faster than us is absolutely not the case. We actually had very, very nice growth in the recent year and in the previous year. This year we did have a shift in the product line but the unit numbers that we have are growing very, very nicely, and that’s a very good sign and that’s been actually accelerating this year – the growth rate in unit growth. So if everything continues well next year it should produce some very good results because then we will have accurate comparisons with growing numbers of units and with the same ASP or hopefully increasing ASP, which is the opposite of what we had this year.

In terms of internal operating plans we are doing a lot in that. I don’t want to reveal all of that; a lot of that is the [very same] strategy of working with our partners and the sales force in different ways. There is a big investment in the headcount in Q3 and we are seeing that new sales reps are producing very good results, so we are doing a lot of investment in getting more people, more feet on the street to expand the sales. And we are not seeing much decrease in productivity; quite the opposite – we’re seeing that our salespeople are remaining very productive so we are making a lot of efforts to add more salespeople whenever it makes sense, wherever the potential market.

And I think that Tal also referred to it when we spoke about the increase in headcount – it’s very important. Some of it is done with seasoned people that have already shown results in two to three quarters; some of it is entry level programs with people that will hopefully be part of our future generation salespeople in the year timeframe or more. And I think we are trying to put as much as we can in that. Again, I think some of it we’ve already done in changing the product lines and I think it hopefully will have a positive effect next year on the booking line; and some of it is already in the making and we are doing it these days.

Tal Liani – Bank of America-Merrill Lynch

So if you just look at, well no guidance again for ’13 but if you look at your plans, again at a very high level for 2013 would you say that your main focus now is go to market sale marketing as well as services, that that’s where the bulk of spending, the bulk of attention? Or will you also focus on expansion of the product lines into either different segments or different verticals within the segments, etc.? I’m trying to understand whether the focus of the company is more on the sell side or on the R&D side for next year.

Gil Shwed

I think it’s both. We are expanding both sales and marketing and the R&D side, and we are doing as much as we can on both sides. And we are doing it I think in the most responsible and innovative way on both sides.

Tal Liani – Bank of America-Merrill Lynch

Thank you.

Operator

Thank you. Our next question is from the line of Scott Zeller with Needham & Company. Please proceed with your question.

Scott Zeller – Needham & Company

Yes, hi, another question on deferred: can you tell us again, we’ve heard several comments on it but how is it that we’re not seeing subscription revenue that actually is being sold not showing up in deferred; and why is it not being billed?

Tal Payne

I’m not sure I understand the question.

Scott Zeller – Needham & Company

Well, I think we heard earlier that not all the Annuity subscription revenue actually shows up in deferred because it’s not billed. Can you give us some more color on that and why it is, and perhaps how much of the subscription Annuity revenue is not billed?

Tal Payne

Sure, yeah. Every quarter we have slightly less than $10 million that are not [part]. Accounting-wise the part that is part of the deferred revenues is only the part that are invoiced, so if it was not invoiced yet you do not see it as part of the deferred. So it shifts between quarters and this quarter it’s actually increased.

Scott Zeller – Needham & Company

Is there any way to share some color about how much of it is not invoiced percentage-wise?

Tal Payne

No, but I gave you already the numbers – slightly less than $10 million. So that is as much color as I can give.

Scott Zeller – Needham & Company

Okay, thank you.

Operator

Our next question is from the line of Brian Freed with Wunderlich Securities. Please proceed with your question.

Brian Freed – Wunderlich Securities

Good morning, two quick questions: first, on your Application Control blade you mentioned that Application Control and Anti-Bot were two of your best-performing blades. But can you give us some qualitative or quantitative commentary on those, perhaps uptake relative to past blades such as IPS?

Gil Shwed

I think they are all doing well in our lines; and both the Application Control and the IPS are bundled. So we are thinking the overall growth rates are doing quite well. IPS is a little bit more seasoned so it has a bigger install base and a bigger portion of the revenues; the Application Control is a little bit newer but it’s doing extremely well; and the Anti-Bot is completely new. We already had many, many hundreds of installations of that which is pretty good traction for a new software blade in a brand new category and a new technology so we are encouraged about that. On the other hand it’s still fairly small being in a new category and so on. And the Anti-Bot is all ala carte; the Anti-Bot is not bundled with anything. It’s all things that people choose to buy rather than get bundled and decide to renew.

Tal Payne

Yeah, I just wanted to make sure and try to clarify: the strongest ones in sales of growth in dollars, the top one is IPS. IPS is number one, Application is number two, and number three is probably one of the UTM ones – the URL filtering probably. The Anti-Bot is very small in terms of dollars but since it started only a quarter or two ago it started quite impressively. We already have low hundreds of customers and mid hundreds of units or blades that are already sold, so it’s quite a nice beginning again taking into account that it’s sold not as a bundle in the appliances but actually as a separate blade, an ala carte blade alone.

Brian Freed – Wunderlich Securities

So if you look at the trajectory of adoption for Application Control, would you say it’s following a similar trajectory to the pace of adoption you saw in IPS or better or worse?

Tal Payne

Well our IPS was a huge success, so I would say similar and it’s closer to around 100% growth. It’s quite fast.

Brian Freed – Wunderlich Securities

Okay, and then your assumptions on the Euro/Dollar exchange rate embedded in guidance?

Tal Payne

It’s the same exchange rate that we saw in Q3. I have no other assumptions in that.

Brian Freed – Wunderlich Securities

Okay, thanks.

Operator

Thank you. (Operator instructions.) The final question is from the line of Gregg Moscowitz of Cowen. Please proceed with your question.

Gregg Moscowitz – Cowen & Co.

Okay, thank you – sorry, my line got disconnected earlier. Just one follow-up to Tal’s question: your R&D expense went up by $2 million sequentially which we haven’t seen in a long time, and that would have grown by more if not for currency. Gil, can you talk a little bit more about your product development strategy going forward and specifically whether it’s different now than it has been previously?

Gil Shwed

I don’t think that our development strategy in many ways is different. I think that we continue to strengthen that and this quarter alone was a very important quarter in that. And I think we began this year, I mean these are very tactical things that are internal to [product development] but this year we actually became much more aggressive in getting many more excellent students and graduates out of universities here in Israel and we’ve started some new programs that so far have been extremely successful. We’ve been able to [create] (inaudible), nothing short-term – we’re talking about getting sort of the top talent from around here and these people will produce products that will be in the market a year or two years from now, maybe even two or three years from now.

But I think there’s a lot of strategic initiatives in the products that I won’t reveal here but which will bear fruit next year. This year, by the way, alone was very, very important in what we did with the product infrastructure. We have GAiA, the Unified Operating System. We had the full 64-bit (inaudible). We are having now the IPv6 full support in our products – that’s coming up soon. So we have a lot of infrastructural things in our products which enable us to win larger projects in very interesting environments. Again, this technical stuff is not necessarily a big new product but it tends to do a lot with what we’re doing.

In terms of new products, again, when you look at the Anti-Bot and we look at some of our Cloud offerings today – these are brand new things that can be very, very important in the future and provide a lot of innovation in the marketplace. And some of them are quite unique. When we look at things like the Anti-Bot, I think we are very, very different from anything else in the industry today.

Gregg Moscowitz – Cowen & Co.

Okay, thank you.

Kip Meintzer

Thank you, guys, for joining us and we look forward to speaking to you next quarter. Take care and have a great day. Bye-bye.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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