Websense, Inc. Q4 2009 Earnings Call Transcript

| About: Websense, Inc. (WBSN)
This article is now exclusive for PRO subscribers.

Websense, Inc. (NASDAQ:WBSN) Q4 2009 Earnings Call February 2, 2010 5:00 PM ET


Kate Patterson – Vice President, Investor Relations

Gene Hodges - Chief Executive Officer

Arthur S. Locke – Chief Financial Officer

John R. McCormack – President

Douglas Wride –Chief Operating Officer

Avalina Kauffman – Investor Relations Manager


Brad Zelnick - Macquarie Research Equities

Samuel Wilson - JMP Securities

Philip Rueppel - Wells Fargo Securities

Analyst for Sterling Auty - J.P. Morgan

Analyst for Todd Raker - Deutsche Bank Securities

Eric Martinuzzi - Craig-Hallum Capital

Keith Weiss - Morgan Stanley

Analyst for Daniel Ives - FBR Capital Markets & Co.

Analyst for Rob Owens - Pacific Crest Securities


Good day everyone and welcome to today’s Websense fourth quarter 2009 earnings conference call. Today’s call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to Kate Patterson

Kate Patterson

Thank you. Good afternoon everyone, and thank you for joining me to discuss our fourth quarter results. With me on the call today are Gene Hodges, Websense CEO; Art Locke, our CFO, John McCormack, President, Doug Wride, COO, and Avelina Kauffman, IR Manager.

Before we get started on the financials, I want to draw your attention to a couple of items. We’ve added a set of slides to our quarterly materials which are available on the IR section of the website in the quarterly results section as well as the events section. At the beginning of that dec is the earnings release dates for the remainder of 2010 and we’ve also outlined the Investor Relations calendar for the first quarter including the date of our annual Analyst Briefing and a webcast associated with our Triton product launch. We hope to see you at the Analyst Briefing at RSA on March 2.

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

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

The information in this call related to financial results, projections, and other forward-looking statements is based on current expectations and we expressly disclaim any responsibility to update forward-looking statements should circumstances change. Our discussion also includes financial measures that are numerical measures that can't be calculated in accordance with Generally Accepted Accounting Principles.

The company believes these non-GAAP financial measures enhance investors' ability to evaluate the company's operating results and compare current operating results with historic operating results. For more information, please consult the press release that was issued this afternoon and which is also posted on the Investor Relations portion of the company's website.

I will now turn the call over to Gene Hodges, Websense Chief Executive Officer.

Gene Hodges

Thank you Kate. Q4 was a clear demonstration of how Websense can achieve higher growth in 2010 and beyond. If there is a single point that I would like you to take away from the Q4 results, it’s this: these results demonstrate that Websense has passed a positive inflection point. We are seeing growth in our billings and with our pro-rata revenue recognition model, this growth will extend to our revenues and profits in the second half of 2010.

The drivers of this new growth include our broader and more secure product set, better execution in our sales functions, and the larger web security market which is seeing renewed vigor.

These results reflect work over the last three years. We have transformed our product offering from a single application which was in danger of being commoditized to a broader suite with differentiated technology. We increased our scale through the SurfControl acquisition to enable us to compete more effectively against larger competitors.

Then, in 2009 we improved our sales execution to be able to sell and deliver this more complex offering. Our ability to grow is best seen in the metric we call incremental billing. This metric captures upgrades from our web filtering install base, cross sales of our strategic products, and sales of all of our products to new customers.

Billings from incremental business had grown steadily each quarter in 2009 even during the deep recessionary periods. Incremental business in Q4 was $31.5 million, a 42% year-over-year and 51% quarter sequential. Incremental billings were 27% of total billings. In the US, incremental business was up 60% year-over-year in Q4 and US incremental for all of 2009 was up 45% over 2008. We believe the US performance is an important indicator of the competitiveness of our strategic products.

The US tends to adopt new technology early. It was severely impacted by the recession and US results are clouded by foreign exchange movements. 45% year-over-year growth in US incremental business shows a broad and sustained trend that we believe is very positive. We also saw good growth in other markets on our incremental business.

In EMEA, our Q4 incremental business was up by 55% year-over-year and overall, it was up 23% for 2009 over all of 2008. As we look across all of our strategic product lines’ performance in Q4, we see strong growth.

The main driver of our growth continues to be our Web Security Gateway, WSG. Incremental contribution from WSG and associated appliances was up 236% year-over-year in Q4. Total WSG sales including the renewal portion of upgrades were up 163% over Q4 2008. In Q4, WSG accounted for approximately 19% of total billings and we expect it to become an even larger part of our mix in 2010.

Turning to data loss prevention sales, DLP sales were up 61% year-over-year and 110% quarter sequential. We are definitely seeing a renewed interest in DLP as the economy improves and believe we are gaining market share against our largest competitor who is the only other player we consistently see in this market.

Sales of our web and email security as a service or SAS offerings were also up, climbing 71% year-over-year and 40% quarter sequential. We expect our SAS sales to also grow rapidly in 2010.

The growth in incremental business has been achieved through both upgrading existing customers and winning new customers who had not previously purchased from Websense. In Q4, approximately half of our incremental business came from winning new customers. The billings from new customers had significant contributions from Websense whitespace customers, typically in emerging markets who own no web security solutions and from new customers buying DOP.

Very positively, however, many of the new customers came from mature markets where we displaced web security competitors. Competitor displacements are being driven almost exclusively by WSG.

The recession and overall market conditions still had significant impact on our business in the fourth quarter. When we analyzed the impact from what we call distressed customers, those still feel a negative impact from the recession. The impact was about the same on a percentage basis as in Q3. The biggest impact continued to be from shortening of subscription contracts.

Pricing held well year-over-year and competitive loss rates against strategic competitors, very importantly, decreased. Seat loss in these distressed customers also decreased on a percentage basis from Q3 and we believe this positive trend will continue into 2010 as hiring starts to slowly pick up.

The overall recessionary impact on our performance did decrease slightly in Q4. The decreased impact was mostly seen in customer willingness to increase investment to buy WSG or DOP. This increased spending is seen in the incremental business metric. We did not see any appreciable budget flush in Q4.

The deals closed have been in the works for several quarters and there were no unusual large orders. Customers worried about the future, however, would not necessarily complete these purchases; hence, Q4 incremental billings growth does reflect increased competence by well performing companies about investing in their future.

The one positive impact from the recession is that many renewal customers shortened one year subscriptions in 2009 which means they’ll be up for renewal and hopefully for an upgrade in 2010. The combination of 2009 customers who shortened to one year subscriptions and the minority of customers who bought our strategic products on one year subscriptions improves our renewal outlook for 2010. Overall, the renewal base in 2010 is mid-single digits higher than it was in 2009, inclusive of FX changes.

Our billings guidance for 2010 assumes we’ll capture this increase renewal base at equal or higher yields than in 2009 plus have growth and incremental business driven by the now fully-online productivity of reps we hired last year.

As we look to 2010, we are increasingly confident about our ability to continue to increase sales from our strategic product lines while maintaining sales from our URL filtering and install base.

We start 2010 much better prepared from a sales perspective than at the start of 2009. We’ve been putting a great deal of energy into bringing on a more senior sales team. We’ve been hiring higher level reps, and building the skills of our sales force across the year.

In July, we hired Didier Guibal to lead our worldwide sales team and in October we hired Ken McDonald to lead our worldwide SE team. These two hires gave us worldwide leadership capabilities in these key functions and they are already having very positive impact on our execution.

Our recent sales management restructuring was driven by a desire to keep our sales organization flat and through that approach, ensured changes we make and sales process and execution are implemented as rapidly as possible to maximize performance. We need to keep the communication lines short to maximize our growth and nothing else should be read into these recent changes.

You may remember that in Q1 2009 we made significant investments to expand our sales teams. Specifically, those focused on enterprise and mid-market customers. These investments seemed very risky at that time but Q4 shows they’ve paid off. We’re not planning to expand our sales force in the short term. The sales people hired in Q1 2009 are now fully productive and this results in additional sales capacity for 2010.

We’ll use this additional sales capacity to expand further outside of our install base, specifically again in enterprise and mid market accounts. This new customer initiative is important to Websense long term growth. We have a large install base we can upgrade for years but our product set is competitive enough to win customers we don’t serve today. In other words, we believe we’re in a position to grow even faster by taking market share.

Our analysis of large enterprises shows that we are the primary web security supplier to about one-third of these customers. We have a small departmental position in approximately one-third of these customers, and we have no position in about one-third of these customers.

With such a highly competitive product set, we believe we can win more of these customers and to give us the ability to approach to win them, we’ve shifted some manpower to focus on these segments.

Now I will turn the call over to Art who will give you more details on our results and present our 2010 guidance. Then I’ll return to give you a closer look at our exciting upcoming product launch.

Arthur S. Locke

Thank you, Gene. I’d like to start by summarizing what our key takeaways are coming out of 2009. We exited the year on an upswing. Record billings for the quarter and the year, strong cash flow driven by billings growth and improved collections, P&L performance in line with expectations, and a solid balance sheet with record current and total deferred revenue.

Our strong fourth quarter year-over-year growth in billings and cash flow were due to the strength of our new product cycle coupled with improving economic conditions. We see this billings and cash flow trend continuing into 2010 leading to growth and revenue in EPS later in 2010 and continuing into 2011.

Now turning to a review of Q4. Our Q4 billings increased 12% year-over-year to a record $118.3 million. The increase in billings was driven by an increase in our incremental business, particularly subscriptions sales of our Web Security Gateway data loss prevention and SAS security solutions. From a geographic perspective, we saw strengthened demand for our products in all major geographic regions with the US up 11% from Q4 ’08 and international up 13%.

Changes in foreign currency rates compared to the fourth quarter of 2008 contributed about $4.5 million or 4% to our year-over-year billings growth. Our renewal rates were in the range of historic norms. Our average annualized contract value increased to a record $9,800, up 17% from Q4 ’08, and 20% from Q3 ’09. The increase in our average annualized contract value was attributed to our ability to offer multiple security products in each transaction as well as an increase in the number of large global deals.

Duration increased slightly on a sequential basis to 24.2 months, reflecting increased sales of our Web Security Gateway software, V10K appliance, and our DLP solutions. We view this increase as a positive development as we are extending the term of our customer relationships and increasing our opportunity to expand our business through the sale of additional product offerings in the future.

Product seats were up approximately 700,000 sequentially to $43.6 million as DLPs and SASs increased and we sold to more new label customers. Keep in mind that although Web Security Gateway accounts for a significant portion of our incremental billings growth, the sale of an upgrade to Web Security Gateway to one of our install base [inaudible] filtering customers does not increase our overall seat count.

On this note, this will be the last quarter we report our product seat count. As we have grown and our product offering has expanded, our seat count metric has become less meaningful as an indicator of business performance. As Gene will discuss in further detail, we plan to release integrated product offerings in Q2 2010 whereby our customers will be able to purchase a product as multiple built in security capabilities that were previously counted as individual product seats.

For example, with the upcoming Triton launch, web DLP functionality will be embedded in our Web Security Gateway product. Additionally, customers will also be able to switch their employee security coverage between our SAS solution and our on premises solution as needed. So you can see, the seat count metric is more complicated and less meaningful pretty quickly. We believe our other metrics, including incremental business, average annualized contract value, and average duration, will continue to provide the meaningful information that is helpful in monitoring our business performance.

Getting back to our financial results, cash flow exceeded our expectations for both the quarter and the year. For the quarter, we generated more than $29 million in operating cash flow, up 22% from a year ago. Included in our Q4 operating cash flow were net tax refunds totaling $3.8 million. This brought operating cash flow for the year to $94.8 million, up 44% from 2008.

Adding back the $18 million in one-time 2008 cash outflows associated with the integration of SurfControl to get a normalized comparison with 2009, operating cash flow was up 13%. Capital expenditures during 2009 were approximately $12 million resulting in free cash flow of $82.8 million.

Turning to the income statement highlights, our quarterly P&L performance was in line with expectations consistent with the high level of visibility in our subscription model. Non-GAAP revenue of $82.5 million was near the high end of our implied guidance range of $80.6 to $82.6 million for Q4.

This was down about 3% from Q4 '08 and flat with Q3 ’09, reflecting the negative billing trends we experienced from Q4 '08 to Q2 ’09 when the economic downturn was at its peak strength and foreign currencies were weaker against the dollar.

Our gross margin percentage in Q4 '09 was flat sequentially and down about 2 percentage points from Q4 '08, primarily due to the decrease in revenue and an increase in the amortization of appliance costs as a result of our increased appliance sales.

Sales and marketing expenses were up sequentially due to higher expenses associated with our higher level of billings while other expense categories were down modestly on a sequential basis. Total operating expenses increased about $1.8 million compared to Q4 '08 but decreased as a percentage of billings by nearly 4 percentage points demonstrating the success of our cost reduction measures implemented during Q3 ‘09. Total expenses of approximately $65 million during Q4 '09 included a $2.3 million increase associated with changes and foreign currency exchange rates as compared to Q4 '08.

Other expenses was approximately $1.3 million and our non-GAAP effective tax rate was about 30% for the quarter and 33% for the full year. Our non-GAAP effective tax rate decreased from an expected 33.5% due to a shift in taxable income outside the US to lower tax jurisdictions.

Non-GAAP net income for Q4 was $11.3 million or $0.26 per share compared to implied guidance of $0.22 to $0.25. The lower tax rate in Q4 added about $0.02.

Now turning to the balance sheet. Our cash balances of $82.9 million were up $18.8 million from the end of 2008, finishing just above our target range of approximately $70 million to $80 million.

We spent approximately $12 million on share repurchases during Q4 and repaid $12 million of principal on our term loan, reducing the outstanding balance to $87 million at year end. We are pleased with our strong DSO performance of 62 days reflecting our solid customer relationships and an improving economy. Total GAAP deferred revenue of $380.1 million was up more than $38 million or 11% from year end 2008 and is at the highest level in our history.

Current deferred revenue of $239 million also stands at record levels, up nearly 7% from the prior year end and a good leading indicator coming into 2010. Non-GAAP deferred revenue is at $385.2 million and reflects the remaining $5.1 million of SurfControl add back of deferred revenue written off as part of the acquisition.

We expect to recognize the majority of this add back in 2010 with only $847,000 remaining at the end of 2010. After considering what has been the worst economic downtime in our lifetimes, we feel pretty good about our performance for the year as we were able to grow billings from $343 million in 2008 to $352 million in 2009. We generated $94.8 million in operating cash flow for 2009 and bought back nearly 35 million of our stock at an average price of $15.08 and reduced our term loan by $38 million.

On that note, let’s turn to the future. For 2010, we will provide annual guidance ranges on billings, GAAP, and non-GAAP revenue, non-GAAP earnings per share, GAAP cash flow from operations, and capital expenditures. Also, given the visibility of our subscription revenue model, we will provide guidance ranges for GAAP and non-GAAP revenue and non-GAAP earnings per share for the coming quarter.

Additionally, due to the lag between our billings and revenue growth, we are also providing some directional guidance on our expected quarterly progression for the revenue and earnings per share for 2010. Our billings guidance for 2010 of $372 million to $388 million implies growth of 6% to 10% from 2009 and reflects anticipated continued strength in our incremental business and renewals trends in line with historic ranges.

We expect that our quarter by quarter seasonal billings trends will continue to follow our historic seasonal pattern for the year. As a reminder, in the past 3 years, our normal seasonal Q1 billings trend is to be down sequentially from our seasonally high Q4 by 35% to 40%.

Billings drive our operating cash flow and we expect cash flow from operations to increase between 10% to 20% to a range of $105 million to $115 million. Our capital expenditures are expected to be between $10 million and $12 million resulting in a 15% to 25% increase in free cash flow compared to 2009.

Regarding our plans for our free cash flow, we expect to maintain cash balances in the range of $70 million to $80 million and use the cash generated in excess of this range to continue to buy back stock and retire our term loan. We will continue our 10b5-1 stock buyback plan of $7.5 million per quarter and will consider increasing our stock buy back above this amount on a quarterly basis depending on cash balances, interest rates, limits under our credit agreement, and market conditions.

Looking ahead to the first quarter of 2010, we anticipate total repurchases of $12 million to $20 million. As we continue to retire our term loan, we expect to be net cash positive by the end of Q1 2010, meaning that we expect our cash balances to be higher than the outstanding balance on our term loan.

Turning to revenue, we are looking for non-GAAP revenue in the range of $338 million to $346 million, representing growth of 2% to 5% from 2009 and GAAP revenue in the range of $334 million to $342 million. Our current deferred non-GAAP revenue of $243 million at the end of 2009 represents approximately 70% to 72% of our non-GAAP revenue guidance for 2010, illustrating the P&L visibility we have with our subscription based financial model. The difference between non-GAAP and GAAP current deferred revenue is the add back of SurfControl deferred revenue of approximately $4 million that was written down as part of purchase accounting.

For the year, the non-GAAP revenue growth rate closely reflects the billings growth rate of the prior year due to the lag effect for our subscription revenue recognition model. For 2010, we expect that our [cogs] expenses will increase by approximately 1 percentage point and our gross profit margin percent will be in the range of 87% to 88%.

From an operating expense perspective, we expect to roughly maintain the Q4 expense exit run rate of approximately $55 million through the first three quarters of the year. It’s important to note that this run rate absorbs the investment in quota carrying headcount we made in early 2009, increasing commissions associated with our expected increase in billings, and the increased expense associated with changes in foreign exchange rates as compared to a year ago.

We are planning for a minimal headcount increase in 2010, primarily in China, totaling approximately $700,000 for the full year. We expect to see the normal seasonal increase in expenses for Q4 2010 due to the seasonal sequential increase in Q4 billings. We believe our current business structure is appropriate to support our 2010 billings growth, assuming a modest improvement of sales productivity over 2009.

With approximately 50% of our business outside the US and nearly 40% of our billings in foreign currency, our financial results are affected by fluctuations in foreign currency exchange rates. Our guidance for 2010 is based on recent foreign currency exchange rates and we have not attempted to anticipate foreign currency movements.

Foreign currency exchange rates have experienced a greater degree of volatility over the last six quarters. For example, the US dollar has weakened against two of our major foreign currencies, the Euro and British pound, as compared to a year ago, but has strengthened over the last two months.

When looking ahead, I’m thinking about the impact of foreign currency exchange rates on our business. Keep in mind that a strengthening dollar will cause our billings and expenses to be lower while a weakening dollar causes our billings and expenses to be higher.

To summarize, for the full year 2010, we are providing non-GAAP earnings per share guidance in the range of $1.16 to $1.23. This range takes into account the lag impact of our subscription revenue recognition model and the expense run rate coming in to 2010 as discussed earlier.

For Q1 2010, we expect non-GAAP revenue to be in the range of $81 million to $83 million and EPS to be in the range of $0.24 to $0.28. As you may recall, we hit an inflection point in Q3 2009 when we returned to year-over-year billings growth and we now have two quarters of billings growth behind us.

Further, as we expect billings growth to continue into 2010, we expect that our subscription revenue will return to year-over-year growth in Q2. As we exit 2010, we expect that our Q4 revenue will be in the range of $87 million to $91 million, approximately 5% to 10% ahead of Q4 2009.

We see this trend leading to continued growth in revenue in EPS in 2011. In closing, we feel good about our performance in 2009 under very difficult economic conditions and we are excited about our prospects in 2010.

With that, I will turn the call back to Gene to tell you more about our product plans and strategy.

Gene Hodges

Thanks, Art. On previous calls we mentioned our upcoming 7.5 product wave. These products have been in the hands of customers for some time now and the feedback is very positive. We plan to announce these products on February 9 and make them generally available in early Q2.

The core of this new wave is the innovative Triton management console with true hybrid capabilities. Triton true hybrid is focused on the opportunity we see from the cloud. As investors, you hear a lot about the cloud. Some of the discussion identifies realistically how money can be made with this next wave in computing, but most of it is hype. Triton is real.

Triton true hybrid solutions let customers deliver security functionality to uses through a unified content security system. This system integrates both SAS cloud based and on premise appliance based delivery mechanisms. This mixed cloud and on premise deployment is managed through a single management console with a single policy that can be used for all users.

Reporting in measurement of effectiveness has brought together for both types of users in the Triton console on one pane of glass. Websense is the first and only vendor to deliver such an offering for web security. In the past, customer users were either cloud based on served through on premise solutions. If a customer wanted to move users to a cloud based service, they had to make fairly drastic changes and sometimes in a short time frame, these could be wrenching.

Websense believes this old all or nothing approach to the adoption of cloud based services falls far short of meeting the true needs of the market. Customer want to use cloud based solutions more in the future, but they need a practical evolution path. They need to be able to take their time and transparently shift users over time. Large enterprises will probably serve mobile workers and remote branches through to cloud over time, and large sites to run on the premise approach.

Triton will allow these customers to achieve the significant total cost of ownership reductions that cloud based implementations deliver without having to make wrenching changes.

We believe Triton true hybrid delivers a new and practical path to the cloud and believe that Triton will establish Websense as a leader in cloud based security services. The first Triton true hybrid deliverable will be called WSG Anywhere. Triton true hybrid based WSG Anywhere lets customers enjoy the full power of Websense’s innovative real time content classification technology from an appliance or in the cloud.

The Triton management console and WSG Anywhere gives customers a single unified view of web security effectiveness for users deployed either way, letting them decrease their total cost. In addition, WSG Anywhere will include tightly integrated data loss prevention for web traffic. Websense is the first and only supplier to have a tightly integrated web security and DLP capability and the use of the Triton architecture and console on our appliances extends our integration lead.

We’re the only vendor also seen by top industry analysts like Garnter and Forrester as being leaders in both web security, DLP, and integration. Even if a web hacker gets through the real time characterization protection we provide, our customers’ critical information will still be safe. This built in suspenders approach to web security will take a while for competitors to match. Upgrades to our full DLP suite including email and in point DLP will also, we believe, give us additional growth opportunities over time.

It will take a while for customers to understand this new hybrid approach but by late 2010, we think true hybrid WSG Anywhere will start contributing to growth. We believe customers will respond more quickly to the Triton integrated on premise appliance offerings in WSG Anywhere. We think the tightly integrated [prop sheet] traffic control web security and DLP are the base for a new type of unified threat management system.

The Websense UGM is focused on content as opposed to protecting network infrastructure. We think customers will be attracted to an approach that allows better consolidation and simplification in deployment of content security functions, just as they have showed such interest in consolidating such functions in their infrastructure security protection.

Websense is the first and only company with tightly integrated SAS and on premise web security and with tightly integrated web security and DLP. Cicso, Symantec, and McAfee recently acquired companies that deliver web security from the cloud. The web security these acquired companies deliver is based on last generation URL database technology, comparable to our legacy URL filtering offerings.

These solutions offer no real time classification, no on premise or DLP integration. Our competitors will follow, but Websense is far ahead in the lead just as we have been in the lead in developing real time characterization technology which is mandatory for safely accessing Web 2.0 sites.

WSG Anywhere is the first of several releases that will utilize the Triton true hybrid management console and architecture. In less than a year we will add true hybrid email to this offering which will generate additional growth in 2011 and complete our content UTM appliance.

In the future, we also plan to add additional solutions developed organically to the Triton family. As you can see, the Triton true hybrid management console and architecture is a strategic initiative which we think can help drive growth for several years. Triton true hybrid is the culmination of the strategic plan we started executing 3.5 years ago. We’ve stayed focused on the same strategy for all this time. We seem to have anticipated most of the strategic trains correctly and now we’re delivering these final major pieces of our vision.

It’s tough for you to evaluate such an important initiative as Triton with only introductory comments on an earnings call. We will have excellent opportunities in the next few weeks for you to learn more and to get your questions answered. We’ll announce Triton true hybrid and WSG Anywhere on February 9 via webinar. We encourage you to attend the webinar.

Next, we’ll hold our Analyst Day on March 2 at RSA in San Francisco and we will cover this in detail. We hope you’ll be able to attend. Triton true hybrid isn’t a dream on slides, it’s real. We’d love for you to come see it in action.

Before I turn the call over to questions, let me offer a final summary. Websense Q4 performance and our guidance for 2010 shows that we are on a new course with higher growth. We recognize that we have to deliver this growth quarter after quarter and we as a team are very focused on realizing the strategic progress through multiple quarters of sustained growth in execution.

Our pro-rata revenue recognition model introduces a lag between improved billings growth and growth in EPS. You don’t see this flag in most of our competitors, but you do see it in other subscription based companies, especially SAS service providers. We understand that this makes it harder to value Websense accurately, but cash flow is the critical metric which shows our progress, normalizing differences in business models. Q4 results and 2010 guidance clearly demonstrates that our cash flow growth is strong.

In summary, we believe we fundamentally transformed Websense from a single product line company which was vulnerable to commoditization to a strategic player in security who can compete effectively with tough competitors of much larger scale. Importantly, our core web security market has evolved as we anticipated and customers now see that web access is a core security issue, not just a matter of blocking porn or managing employee productivity.

This means that we expect customers to accelerate their spending for web security overall. Websense has the best security solution for the web available today and our lead over competition is increasing.

Thank you and now we’ll turn the call over to the operator for your questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Brad Zelnick - Macquarie Research Equities.

Brad Zelnick - Macquarie Research Equities

Just as we think about the sales force and the changes that you’ve made over the year, in the beginning of the year you added capacity and that at the midpoint we had some leadership changes as well as at the end of the year. I guess the question there would be as we think about that process, where are we in that process and besides seeing good quarters like you’ve put up here on Q4, on the expense side of the equation as it relates to sales compensation plans or even as we think about incentives to the channel, is there anything that we should think about that’s changing year-on-year as you roll out new comp plans?

Gene Hodges

As a tip of the hat to Didier Guibal, we are stable. The management changes that we’ve made either eliminated levels or we’ve made placements with I think one or two exceptions in lower levels. Those replacements are in place. We rolled quotas and territories at our sales kick off a couple of weeks ago, the first time we’ve ever been on the ball enough to actually get them out there and qualitatively, I think we’ve definitely seen higher intensity from the sales force in January than we ever have before.

Our comp plan for 2010 is different. We are both focusing short term and trying to plan long term so the core of the plan is now monthly and reps are very motivated to get to the number early, get above it, and get into accelerators and from again a qualitative perspective we think we’re seeing good pursuit as well as better planning from the sales force already.

Brad Zelnick - Macquarie Research Equities

You talked in the prepared remarks a bit about contract length over this past year and customers opting for shorter duration renewals, creating a greater renewal opportunity going into next year. On the other side of that equation, you also have WSG leading to longer duration contracts. The net of all this as we renew in what we hope is a healthier economic environment, should we expect contract duration to elongate, and what are your exact assumptions for your guidance?

Gene Hodges

We do expect duration to go up slightly. Art, do you want to speak to the detail about it?

Arthur S. Locke

Our guidance for 2010 is based on a duration of 23 to 24 months and I think that’s in line with what we experienced in Q4 and Q3.

Gene Hodges

We are changing some pricing policies that might affect duration and as you probably know, we have a pretty typical program we’ve used which we call the three-for-two program that allows a customer to buy a three year subscription for the two year price. We are removing all of our strategic product lines from that program. We’re keeping it in place in the URL filtering area because there’s obviously more competition there. Effectively this is a price increase but you do it without changing the price on the top line and we see that we’re getting pretty good value out of these products so we want to make sure that even if duration increase, we continue to get annualized contract revenue which allows revenue and EPS to grow along with billings.


Your next question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

A few questions for both of you actually. On WSG, the product has been a pretty solid success here. Can you talk a little bit about a couple things – one, are you selling mostly to your installed customer base or are you selling mainly to new customers and if you’re selling to new customers, who’s leaving? Who’s the competition you’re seeing when you’re selling WSG?

Gene Hodges

We are selling to both, I think the mix is about two-thirds, one-third, somewhere around there.

Samuel Wilson - JMP Securities

Two-thirds being which one?

Gene Hodges

Two-thirds being install base upgrades, one-third being what we would call net new customers. The net new piece is growing a little bit faster as we start to venture outside of our install base. In Q4 we did very well against all of our strategic competitors and saw our win rates against them improve. I’d rather not call out specifics but you know who they are and we did a little bit better.

This I think is an indication of first, our sales team and our [SCE] force becoming more effective with WSG, and secondly, it reflects that WSG is maturing, especially in its appliance form factor, because the biggest weapon our strategic competitors who’ve been appliance based for a while had to use against us is that our appliances are fairly green. So that one is going away.

Samuel Wilson - JMP Securities

[inaudible] gross margins dropped in the fourth quarter, can you give me some sense maybe qualitatively how much of that was WSG related and how much of that was related to a lower revenue run rate?

Arthur S. Locke

It’s almost all WSG and SAS cost of goods. That’s the makeup of [cogs] and WSG amortization is increasing in our cost of sales and again as we are looking at 2010, that is the primary factor for the increase of 1 percentage point in our gross margin.

Samuel Wilson - JMP Securities

On the debt, can you just talk a little bit or give us an update, in 2010, what stops you from paying it off completely vis a vi share buyback or are you precluded from paying it off in chunks? Is there a penalty? What’s the time period on that?

Arthur S. Locke

Basically we’re required to make about $12.5 million in principal payments and then the next gate or the next hurdle that we have to cover is that we have a 25% of free cash flow requirement, so given our free cash flow for 2010, it looks like that’s really going to be the amount of principal payments that we’re going to have to make at a minimum. Right now the term loan interest rate is pretty favorable to us. On average I think it’s going to be about 4%.

So really when we’re looking at our free cash flow right now, we’re leaning a bit more towards stock buy backs then we are to repaying the term loan but we are going to continue to make additional payments on the term loan as well just out of concern of future increases in interest rates and whatnot, so that’s what we’re thinking about right now. So I don’t anticipate that we’ll repay the term loan by the end of 2010.


Your next question comes from Philip Rueppel - Wells Fargo Securities.

Philip Rueppel - Wells Fargo Securities

Increasingly strong move to WSG as a percent of revenue. Did we see any special promotions in the quarter or is pricing in the uplift and deal size, has that been relatively stable over the last couple quarters?

Gene Hodges

It’s been very stable and our close rates against our major competitor did improve a little bit but luckily and surprisingly, Q4 was pretty good from a pricing perspective.

Philip Rueppel - Wells Fargo Securities

You talked a little bit about sort of the product capabilities of Triton and the WSG Anywhere. Could you at least give us a little bit of flavor for sort of any kind of pricing or revenue implications? Is it the kind of thing where current customers will have a migration path to or are they going to have to renegotiate subscriptions if they’re a DLP customer, things like that. I realize it will take a while for customers to understand this but do you expect some billings impact soon after it is released or [G8].

John R. McCormack

The Triton architecture is built off of the same platform, it’s an extension of the platform we have with WSG today so the migration path for customers should be pretty straightforward in terms of moving up to WSG. In fact, we call the package WSG Anywhere because we see that as the next step up. We hope to see something in or around the 25% uplift between the two packages and the DLP customer that’s using a WSG today can continue with that integration or more importantly they can use the built in integration we have into WSG for better network reliability and resiliency. So we think it provides a pretty compelling and smooth upgrade path for our customers.

Gene Hodges

On the question of timing, appliances and multi function appliances are well understood by the market so we would expect to start seeing some fairly good uplift by the middle of the year. I’m not saying Q2, I’m saying the middle of the year plus or minus from the appliance side. We have been talking to a reasonable number of customers about this and testing it for several months so they are longer sales cycles but they’re already underway.

We can’t be sure about the hybrid piece in terms of adoption. Our thinking is that it will take them a little longer to get that piece and be motivated by it and we’ll sure sell hard to try to move that in.


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

Analyst for Sterling Auty - J.P. Morgan

This is Lauren [Yue] for Sterling Auty. I think you talked about that you didn’t see any significant budget flushes but can you just talk about maybe linearity in the quarter, if there was anything going on there?

Gene Hodges

Linearity on a monthly basis was pretty normal. Linearity within the months as we start to move to a monthly operation in sales was much improved. Another tip of the hat to Didier, this was the smoothest quarter I’ve seen in my for years at Websense. We got out ahead early and we stayed ahead through the entire quarter and that hasn’t happened I think since 2006.

Analyst for Sterling Auty - J.P. Morgan

Regarding the international business, you mentioned that emerging markets saw good WSG traction. Can you just talk about maybe each of the segments, Europe and Asia, did you see stabilization, are you more positive in any of these locations?

Gene Hodges

We saw very good WSG traction, both in Asia and Europe. We’ve been seeing a surprising uptick in DLP traction out of Asia as well as the US but Europe lags in that a bit.

Analyst for Sterling Auty - J.P. Morgan

What about just demand overall, are you seeing stabilization in Europe?

Gene Hodges

I would actually characterize it as acceleration. Pipelines for our strategic products grew very strongly in both Europe and Asia in the fourth quarter and we like what we see for Q1.

Analyst for Sterling Auty - J.P. Morgan

The confidence that you have in your guidance for 2010, the 6% to 10% growth in billings, can you just kind of help me understand what you have in there? First of all base line case renewals, maybe a little better recovery, but how much of that is WSG and then I guess the new product release?

Gene Hodges

If you look at the guidance and note that our renewal base is up mid single digits, and then factor in the productivity increase that we get from having a very large number of people that we hired at the beginning of last year coming on board this year, that gives us quite a lot of confidence.

We are not assuming the economy gets better. We are not assuming higher win rates with the new products and we are not assuming extensive duration extension or upgrades from that slightly higher renewal base. So you put all that together, it makes this deal pretty good.

All that said, man, in 2009 the economy certainly threw us for a loop and the lower end of that guidance is a view towards decreasing or changing FX rates. We’ve seen the dollar move I think 2% over the last month. In terms of billings impact on our plan, it helps out EPS, it makes billings more dangerous. We’re going to be pretty careful about getting ahead of ourselves to makes sure we don’t have a W recession and that we can continue a smooth climb out from 2009.


Your next question comes from Todd Raker - Deutsche Bank Securities.

Analyst for Todd Raker - Deutsche Bank Securities

This is [inaudible] for Todd Raker. How was momentum in S&B [inaudible] was the large enterprises?

Gene Hodges

I’m sorry, would you repeat the question?

Analyst for Todd Raker - Deutsche Bank Securities

How was the product momentum in S&B [inaudible] was the large enterprises?

Gene Hodges

It’s not as strong in S&B. We are seeing WSG penetration fairly strongly down to about 1000 users and somewhat spotty down to 500 users. The biggest issue there is that at this point, we only have a large appliance in our range which is well above the size needed for those S&B users and as part of our launch that’s upcoming, we will introduce a much lower cost appliance which we think can accelerate that S&B growth.

Analyst for Todd Raker - Deutsche Bank Securities

What push [inaudible] control basis [inaudible]? Is there still some push on the base that you expect in the near term?

Arthur S. Locke

The SurfControl install basis is probably less than 10% of our overall install basis. It’s a pretty limited part of our install base at this point in time. In terms of what ultimately renewed, I think we saw probably about two-thirds of that ultimately renew, right around there.


Your next question comes from Eric Martinuzzi - Craig-Hallum Capital.

Eric Martinuzzi - Craig-Hallum Capital

I’m curious to know, you’ve restructured the sales force, at least the management part of it, I’m curious to know as far as what the value added reseller changes are, and that go along with that, you’ve got a little bit more complex product line, you’ve retooled your sales force incentives, but could you address the channel changes for 2010?

Gene Hodges

The channel strategy in 2010 is going to be a continuation of some activities where we saw great success in 2009. We’ve been increasingly focusing on partners who can handle the more complex product set, especially from a technical and services capability and who are willing to take us in to new customers that we don’t currently have. Doug Wride let that activity in 2009 and we saw some significant impact so we’re going to open that spigot up very wide for 2010 and I think as you do your channel checks. You will see those partners being fairly optimistic about their growth for Websense product lines because they’re investing more heavily and we’re investing more heavily.

Eric Martinuzzi - Craig-Hallum Capital

As far as any incentives, any changes in tiering levels as part of that, payouts, that sort of thing?

Gene Hodges

We are investing more. I don’t want to go into specifics because I think we have a good thing going here and don’t want competitors to copy it. In margin, in training, in ability to get hardware for [inaudible] concepts, for those channel partners who can bring us new customers and technical and services capability and those investments are significant above a typical platinum partner. In return, the growth rates that are being committed to by those partners are significantly more than we would typically see.


Your next question comes from Keith Weiss - Morgan Stanley.

Keith Weiss - Morgan Stanley

I wanted to drill down into the guidance a little bit, particularly the cash flow guidance. It looks like if I’m calculating this correctly, at the midpoint you guys are looking for something close to 20% free cash flow growth in 2010 which would be very impressive. Is there anything in that number, outside of the core billings growth and expense control, is there anything in that number that would make it something less than sort of like a sustainable cash flow number on a going forward basis?

Gene Hodges

No. It’s a pretty normalized number.

Keith Weiss - Morgan Stanley

On the concept of, and I’m pushing this a little bit, of there not being much of a budget flush at year end, so when they look at the billings growth between 6% and 10% for next year versus where you’re ending up this year, is the variance between that growth rate sort of like the 12% that we’re ending up at, is that really just currency, the currency effect between the kind of growth we saw in 4Q versus what’s being expected for 2010?

Gene Hodges

Generally we didn’t anticipate any changes in FX during 2010 but there is a impact from 2009 to 2010 that’s built in that’s part of that.


Your next question comes from Daniel Ives - FBR Capital Markets & Co.

Analyst for Daniel Ives - FBR Capital Markets & Co.

This is Mike Bower for Daniel. Just a question around your contract values. Do we anticipate that to contain declines because you guys integrate additional solutions and how should we think about that going forward?

Arthur S. Locke

That is certainly a key goal of ours as we continue to sell additional products into the install base and we have additional products to sell to new customers. So that’s definitely a focus of ours going forward and it’s something that we would expect to see.

Analyst for Daniel Ives - FBR Capital Markets & Co.

In terms of guidance, is that anticipated to stay on the level that it is right now or is it expected to maybe come down?

Arthur S. Locke

When we set our guidance we pretty much use the assumptions that we’re aware of and that we exist today so there isn’t any significant growth anticipated in that into our guidance.

Analyst for Daniel Ives - FBR Capital Markets & Co.

Around large deals, how was it in the quarter and then how’s the pipeline looking on that front?

Gene Hodges

We have not traditionally been a large deal company. We had I believe one $1 million deal in the fourth quarter. We did have more and more reliable six digit deals. It was a great $100,000, $200,000, $300,00 deal quarter both for WSG and for DLP in sales cycles that we could manage well. So we think that’s going to continue. We’re not quite ready to talk about elephant hunting yet although over time we’ll probably run into a couple of those big pachyderms.

Analyst for Daniel Ives - FBR Capital Markets & Co.

On the DLP front, how much of that is that in terms of billings right now on a percent basis?

Gene Hodges

You can calculate the number with $6 million in the fourth quarter, calculate it from the growth rate. That was a record DLP quarter.


Your next question comes from Rob Owens - Pacific Crest Securities.

Analyst for Rob Owens - Pacific Crest Securities

This is actually Kelly McCloud for Rob. Are you getting the anticipated price lift with the shift to the WSG and could you quantify what the lift from the new solutions might look like?

Gene Hodges

We are on existing WSG and as John McCormack mentioned, the uplift to WSG Anywhere from WSG is about 25%.

Analyst for Rob Owens - Pacific Crest Securities

Did you see any Federal uptick during the quarter at all?

Arthur S. Locke

Q4 was not a big Federal quarter for us. It wasn’t a weak one either. The benefit that might come from stimulus money is still ahead of us. There are a couple of deals out there but golly, it’s a weird procurement environment so we’ll kind of believe when we see it.


That concludes our question and answer session. I’d like to turn the conference back to our speakers for any closing remarks.

Kate Patterson

Thank you very much. We’ve run a little bit over so we are going to hang up. We will be available if you have any further questions. Thanks. Bye.


Thanks everyone. That does conclude today’s conference. We thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!