Riverbed Technology's CEO Discusses Q4 2010 Results - Earnings Call Transcript

Riverbed Technology (NASDAQ:RVBD) Q4 2010 Earnings Call January 27, 2011 4:30 PM ET

Executives

Jerry Kennelly - Co Founder, Executive Chairman, Chief Executive Officer, President and Member of Stock Option Committee

Renee Lyall - Director of IR

Eric Wolford - Senior Vice President of Business Development & Marketing

Randy Gottfried - Chief Financial Officer, Principal Accounting Officer and Senior Vice President of Business Services

Analysts

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc.

Nikos Theodosopoulos - UBS Investment Bank

Tal Liani - BofA Merrill Lynch

Michael Bauer - FBR Capital Markets & Co.

Mark Sue - RBC Capital Markets, LLC

Scott Zeller - Needham & Company, LLC

John Slack - Citigroup Inc

Troy Jensen - Piper Jaffray Companies

Matthew Robison - Wunderlich Securities Inc.

Jess Lubert - Wells Fargo Securities, LLC

Rod Hall - JP Morgan Chase & Co

Tim Long - BMO Capital Markets U.S.

Jayson Noland - Robert W. Baird & Co. Incorporated

Paul Mansky - Canaccord Genuity

Brian Modoff - Deutsche Bank AG

Jeffrey Kvaal - Barclays Capital

Erik Suppiger - Signal Hill

Rohit Chopra - Wedbush Securities Inc.

Alex Kurtz - Merriman Curhan Ford & Co.

Ittai Kidron - Oppenheimer & Co. Inc.

Jason Ader - William Blair & Company L.L.C.

Simona Jankowski - Goldman Sachs Group Inc.

Operator

Good afternoon. My name is Pia, and I will be the conference operator today. At this time, I would like to welcome everyone to the Riverbed Quarter Four and Fiscal Year 2010 Financial Results Conference Call. [Operator Instructions] I will now turn the conference call over to Ms. Renee Lyall, Director of Investor Relations. Please go ahead, ma'am.

Renee Lyall

Thank you, Pia. Good afternoon and thank you for joining us on today's conference call to discuss Riverbed's fourth quarter and full year 2010 results. I'm Renee Lyall, Riverbed's Director of Investor Relations. Joining me on the call today are Jerry Kennelly, our President and CEO; Randy Gottfried, our Chief Financial Officer; and Eric Wolford, Senior Vice President of Marketing and Business Development.

Before we begin, let me cover some administrative items. A press release detailing our fourth quarter and full year financial results was distributed today at 1:05 p.m. Pacific Time via Business Wire. The press release is available on our website at riverbed.com. This conference call is being webcast live via the Internet at riverbed.com/investors and will be archived on our website for the next 12 months.

Ththe information the presenters discuss today will include forward-looking statements, including, without limitation, statements about Riverbed’s current and future products and partners, our financial outlook, our expected growth in our market, future tax rate, our sales pipeline and our competitive and market position. These forward-looking statements are only predictions and involve risks and uncertainties such that actual results may vary significantly. These risks are set forth in our press releases filed today with the SEC and in our Form 10-Q for the quarter ended September 30, 2010. These forward-looking statements reflect beliefs, estimates and predictions as of the date of this call. Riverbed disclaims any obligation to update any forward-looking statement. Unless otherwise stated, financial information that we review on today’s conference call is presented on a non-GAAP basis. Non-GAAP net income excludes the impact of stock-based compensation, stock-based payroll expenses, amortization of acquired intangible assets, acquisition-related costs and related income tax effects. Non-GAAP financial measures should be considered in addition to results prepared in accordance with GAAP, but not as a substitute for, or superior, to GAAP results. The most directly comparable GAAP information, reasons why management uses non-GAAP information and a reconciliation between non-GAAP and GAAP figures is provided in our Q4 2010 press release, which has been furnished to the SEC on Form 8-K today. Any future products, feature or related specification that may be referenced in today’s call are for informational purposes only and are not commitments to deliver any technology or enhancement. Riverbed reserves the right to modify or cancel future product plans at any time.

I'd now like to turn the call over to Riverbed's President and CEO, Jerry Kennelly.

Jerry Kennelly

Thank you, Renee. Welcome, everyone, and thank you for joining us this afternoon. We are very proud of the results we delivered in the fourth quarter and for all of 2010. Once again, Riverbed is reporting a record-breaking quarter, having achieved the highest revenue, operating profit and net income in our history.

Fourth quarter revenue increased 46% over the prior year to $165 million. For the full year, Riverbed achieved 39% revenue growth. Our year-over-year growth rate for both Q4 and the full year was double that we attained for the comparable periods last year.

Revenue growth in the quarter was driven by product sales, which grew 52% over the prior year, marking our sixth consecutive quarter of accelerating year-over-year product revenue growth. For the full year, product revenue growth was 42% compared to 6% in 2009. Our operating profit in the quarter increased 90% year-over-year and full year operating profit nearly doubled.

Riverbed's financial performance is almost unmatched by our technology peers over the past 12 months. We exit 2010 and entered the new year with significant momentum as the undisputed market share leader following eight consecutive quarters of market share gains. The most recent report from Gartner revealed Riverbed holds 43% of the Advanced Platform WAN optimization market, more than 15 points ahead of the nearest competitor. We believe we continued to gain share in the December quarter as well. Our technology and product leadership is widely acknowledged. The new Gartner Magic Quadrant was released in December and Riverbed once again hold the top spot in the Leaders Quadrant. Gartner describes Riverbed as offering leading vision combined with great brand recognition and an excellent reputation for product and support.

And two weeks ago, InfoWorld awarded Riverbed Technology of the Year for Best WAN Accelerator for the sixth consecutive year. Riverbed is the only vendor to ever receive this award. The industry recognition underscores our execution and commitment to our customers to deliver the best products and services. During the fourth quarter, we added more than 500 new customers and almost 2,000 new customers for the full year. Riverbed now claims nine of the 10 largest companies in the world as customers and almost 40% of the Forbes Global 2000 have chosen Riverbed, most of which are still in the early stages of deployment. As an example, an IT director of a large global bank and a relatively new customer recently hosted a seminar with clients where he discussed why Riverbed was chosen for WAN optimization deployment. He believes we'll eventually extend to 1,000 sites.

Excluding customers gain in the fourth quarter through acquisitions, we are approaching 9,300 customers. If we include the installed base and new customer additions from our acquisitions this year, our customer count now exceeds 12,000.

2010 was one of the strongest periods of new product introductions in our history. We brought to market the Steelhead 7050 appliance, Virtual Steelhead, Cloud Steelhead and the Whitewater cloud storage accelerator. We launched multiple new software releases, one each for Steelhead, Steelhead Mobile and Cascade. We also added 10 supported modules to the Riverbed Services Platform. As you know, the 7050 has been the most successful product launch in the history of the company. Introduced in February 2010, 7050 is our largest and most scalable Steelhead appliance. Designed for data center-to-data center optimization, it's also installed traditional hub and spoke deployments.

Virtual Steelhead, released in September, and Cloud Steelhead, released in November, are software-only products to enable the transition to cloud computing. Riverbed is the only WAN optimization vendor to offer a cloud intelligence solution specifically engineered to optimize the WAN for public cloud deployments. Whitewater, released at year end, is a cloud storage accelerator that makes it possible for IT executives to take advantage of the significant cost savings of moving storage to the cloud.

As the only WAN optimization vendor to offer these solutions, we are gaining mind share, as well as market share. You could expect even more product introductions from Riverbed in 2011. We also expanded our distribution over the past 12 months. We added more than 500 new channel partners worldwide and we successfully transitioned to Arrow and Avnet for distribution in North America.

We continue to align ourselves more tightly with service providers such as AT&T and Verizon, global resellers like EMC, cloud-focused providers like Amazon and Nirvanix and technology partners that Microsoft and VMware. As we look forward, it is these larger partners that will help drive increased adoption of infrastructure as a service.

Also, during 2010, we announced two acquisitions, CACE Technologies and Global Protocols. These were both small acquisitions, but strategically important as we look ahead. The combination of CACE with our Cascade product line creates a complete application aware network performance monitoring solution, allowing us to make a strong entry into an adjacent and highly complementary market.

Global Protocols makes Riverbed the leading vendor selling skipware, an optimization solution for satellite networks and very important to the federal market. Riverbed is in an enviable position as we enter 2011. Network spending is expected to increase this year and both WAN optimization and network performance management continue to top network spending surveys. Our addressable market is expanding and the core drivers of our business are strong.

Globalization of the enterprise, collaboration, consolidation of data centers, of servers of desktops, cloud computing, public or private, business continuity and disaster recovery, all these require a high-performance, reliable and fully optimized wide area network. These trends require the WAN to perform as well as the LAN. In addition, there is the goal of IT to increase productivity of the workforce while reducing costs. Riverbed's technology and products are what enable the network to support critical IT projects.

I am pleased by the strength we have seen in the business to date. I am even more excited about Riverbed's opportunity as I look to 2011 and beyond. In 2011, we will bring to market more new products and software enhancements to further promote consolidation of the edge, achieve increased visibility into the network and greater efficiencies and additional cost savings for our customers.

Now I'll turn the call over to Randy Gottfried to revenue the financials and provide guidance for our first quarter.

Randy Gottfried

Thanks, Jerry. As a reminder, unless stated otherwise, the numbers I'll discuss today are non-GAAP. For your reference, in addition to the reconciliation included in the press release, we posted a supplemental reconciliation of non-GAAP financial measures to the directly comparable GAAP measures on the Investor Relations portion of our website.

We're obviously very pleased with our results. And as Jerry said, our investments in our technology and distribution channels are paying off with exceptional top line growth. Fourth quarter revenue increased 12% over the third quarter and 46% year-over-year to a record of $165 million. For the full year, revenue grew 39%, more than two times our 2009 growth rate led by product sales.

Fourth quarter product revenue grew 15% sequentially and 52% over the year-ago period to $118 million. For the full year, product revenue increased 42% compared to only 6% growth in 2009.

In the fourth quarter, 95% of our product revenue was generated by Steelhead and related products. Our data center appliances posted the strongest growth, both sequentially and year-over-year, contributing 38% of our Steelhead product revenue.

Fourth quarter service revenue increased 5% over the prior period and 33% year-over-year to $47 million. For the full year, service revenue increased 34%. Cascade contributed $9 million to total revenue in the fourth quarter and $29 million for the year. In Q4, CACE added about $1 million to revenue and that's included in the Cascade total.

Turning to distribution. In Q4, 95% of our revenue came from indirect channels with the remaining 5% coming from direct sales. About 1/3 of our revenue was driven by our systems integrator and service provider partners with the balance through VAD and VAR channels.

We saw a strong growth both sequentially and year-over-year across the major regions. The U.S. represented 55% of total revenue in the quarter, EMEA contributed 26% and rest of world was 19% of revenue. Our business remains diversified across all major industry verticals. Government sales, which were especially strong in Q3, were seasonally lower in the December quarter but still notably strong at 18% of revenue. Other significant verticals for us in the quarter and for the year remains financials, manufacturing, technology and healthcare.

In the fourth quarter, we had one partner contributing more than 10% to revenue with Arrow coming in at 16%. No partner or customer contributed 10% to revenue for the full year.

Shifting to costs and expenses. Product gross margin was 80.5% in Q4, up one percentage point compared to the third quarter and up almost two points compared to the fourth quarter of last year. The improvement can be attributed to favorable product and channel mix. Service gross margin came in at 73.4%, down one point compared to Q3 and down slightly from 74% last year. While we had some quarterly variation, we're in the targeted range for service margins. Combined, our gross margin was 78.5%. For the full year, gross margin was 77.8%, up almost one point compared to 76.9% in 2009.

Total operating expenses were up 14% sequentially. R&D and G&A came in, in line with our expectations at 11% and 5% of revenue, respectively, while sales and marketing expenses were higher than our forecast at 35% of revenue. We typically experience an uptick in sales expense in the fourth quarter, but this year's variable sales compensation was greater given the revenue out-performance throughout the year. In the fourth quarter, we saw a broad-based out-performance relative to quota targets with more sales reps in commission accelerators than we've forecasted. We ended the year with 1,244 employees, an increase of 83 compared to Q3 and an increase of 231 compared to Q4 last year.

Operating margin for the quarter was 27.7%, down slightly compared to 28.1% in Q3 and up significantly from 21.3% one year ago. The slight sequential decline is due to the higher sales commission expense I mentioned a minute ago. For the full year, our operating margin improved more than six percentage points to 25.6%. The tax rate in the fourth quarter was 31%, reflecting the retroactive reinstatement of the federal research tax credit.

Looking forward to 2011. With continued strong growth internationally, we've decided to expand our international operations and restructure ownership of our intellectual property assets. While in the past all orders worldwide were transacted out of the U.S., we expect to begin servicing international orders out of Singapore in mid-2011. These changes strengthen our international footprint and will result in a lower global tax rate. In 2011, we expect a non-GAAP tax rate of approximately 30%, which reflects transitioning to a new structure part way through the year. Beginning in 2012 and beyond, we're pleased to announce a more meaningful reduction in our non-GAAP tax rate to 25%.

Net income was a record $32 million or $0.19 per diluted share in Q4. Net income increased 19% sequentially and 97% year-over-year. On a pre-split basis, using the tax rate and share count guidance we provided on our Q3 call, we have reported earnings of $0.36 per diluted share compared to our guidance of $0.35. For the full year, net income increased 85% to $92 million or $0.59 per diluted share on a post-split basis.

Moving to the balance sheet and cash flows. We ended the December quarter with cash and investments of $501 million, an increase of $32 million over the balance at September 30 and an increase of more than $175 million over last year. We continue to have no debt.

Cash flow from operations was $32 million in the fourth quarter and $146 million for the year. Strong collections resulted in Q4 days sales outstanding of 28, up from 27 in the third quarter. Inventory totaled $15 million at December 31 compared to $13 million at September 30. Total deferred revenue was $116 million, a sequential increase of 7% and a year-over-year increase of 34%.

Let me shift over to our first quarter outlook. Our guidance is non-GAAP. For the March quarter, we expect typical seasonality with revenue declining slightly on a sequential basis to $159 million to $161 million, but are growing robustly, 41% to 43%, year-over-year. Gross margins are expected to be roughly flat with the fourth quarter.

We're planning for operating expenses to be roughly flat from Q4 and given the seasonal revenue pattern, we'll see a slight operating margin decline quarter-to-quarter. We're forecasting more than a 400-point improvement in operating margins on a year-over-year basis. We're targeting a tax rate of 30%. This results in forecasted earnings per share of approximately $0.18, assuming a weighted average share count of 167 million.

Before I turn the call back over to Jerry, here are a few thoughts on our model going forward. Overall, we continue to be pleased by the leverage we've shown in the business, more than surpassing the original long-term goal of 25% operating margins we established prior to going public. Our goal is to increase operating margins on a year-over-year basis with a midterm target of 30%. As I've said many times, our primary focus is on growing the top line and profits as we continue to enhance our sales reach and product portfolio for the long term. I'll turn the call back over to Jerry for his closing comments.

Jerry Kennelly

Thank you, Randy. 2010 was an incredible year for Riverbed by any measure and we are equally optimistic as we enter 2011, which promises to be another year of significant revenue growth and market gains. Web optimization is really a narrow term for what we do and for what our products truly enable. Mobile IT continues down the path of centralizing more capabilities, whether its internal or in the public cloud where applications and storage area accessed globally across a wide area network. Riverbed is at the forefront of this wave with the technology and products to make it all possible to enable the benefit of this new world of global computing.

As the market technology innovation leader, we are confident in our ability to grow in this expanding market. With that said, Eric, Randy and I would now be happy to answer your questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question will come from Jason Ader with William Blair.

Jason Ader - William Blair & Company L.L.C.

Just one quick clarification on midterm, Randy. Does that mean by the end of 2011? And then my question, I guess maybe for Eric is could you give us an update on Whitewater? What's the customer feedback and why should we expect that to have material contribution to the business in 2011?

Randy Gottfried

So I'll start off with the margin question, Jason. We haven't defined exactly midterm, but I would say for 2011 our goal is for each quarter to grow revenue faster than operating expenses on a year-over-year basis each quarter and make some progressive improvement. Eric?

Eric Wolford

We're really pleased with the market reaction to Whitewater. And, in fact, both of our cloud products' position is great. We're getting into a lot of great conversations. It's early as you know, GA right at the end of the quarter. So as we've said before, the revenue contribution relative to Steelhead and all of other products isn't really going to be material in 2011, but the response has been very positive and evals and funnels are filling right now.

Operator

The next question will come from Rod Hall with JPMorgan.

Rod Hall - JP Morgan Chase & Co

One is on the -- you beat against guidance. You guys have now beat against guidance for several quarters running. And I wonder if you could talk a little bit about whether you're changing your forecasting methods to compensate for that at all, or just give us some color on what you're thinking in terms of your forecast given that it's been so far below your actuals? And then the second question I have is on the tax rate. The rate was lower than we expected this quarter. I was assuming that was because of R&D tax credits, but then now you're guiding for, I think I heard you say, 30% in Q1 which is below what I expected. So if you could just give us some color around what's going on with the tax rate there?

Randy Gottfried

Sure, this is Randy. I'll take both those questions. First, we are very pleased at the revenue overachievement we've seen this year. Every quarter you obviously try to recalibrate and learn from your experience during the quarter. We're obviously pleased we again beat both our expectations and I think most outsiders as well on the top line this year. On the tax rate question, in Q4 we did benefit from the reinstatement of the R&D tax credit for 2010. In 2011 and beyond, we are doing some different things operationally that will result in a lower tax rate for us as a company. So what had been our sort of model tax rate was about 37%. In 2011, we're forecasting 30% for each quarter through the year. Then it would step down in 2012 and beyond to 25%.

Jerry Kennelly

Nice impact in net income.

Rod Hall - JP Morgan Chase & Co

On Q4, can you tell us what the R&D tax credit impact was, the one-off impact just so we can understand what the underlying earnings look like?

Randy Gottfried

Sure. The EPS impact was about $0.01 versus the guidance tax rate.

Next question?

Operator

The next question will come from Jeff Kvaal with Barclays Capital.

Jeffrey Kvaal - Barclays Capital

I was wondering, Randy, if you could give us a little bit more insight into your new operating model. Are there revenues or gross margin targets that underlie that operating margin trajectory?

Randy Gottfried

Yes. As we think about that 30% midterm target, that's made up of a few pieces. We're thinking gross margins about 78% to 80% or in that range. Sales and marketing in the low 30s, say, 32% to 34%. R&D in the low teens, G&A 4% to 5%.

Jeffrey Kvaal - Barclays Capital

And then what are the drivers in the gross margin line that will get you up that incremental tick?

Randy Gottfried

Well in general we've seen some nice growth over the past few quarters. We see just product mix improves. We do have some newer products that have a higher software component and that could help improve the blended average gross margins. We also get some economies of scale in the service side over time, though that's pretty much in the long-term range for that component.

Jeffrey Kvaal - Barclays Capital

And is there a revenue target where you feel that you can get there, like $200 million a quarter or $220 million or what have you?

Randy Gottfried

It was not attached to a specific number. It depends on how fast we're growing. Right now, we're growing very fast. And you do incur a bit of a tax of adding new employees or earlier in the productivity cycle, but our goal right now is just to make incremental improvement every quarter, growing revenue faster than expense on a year-over-year basis.

Operator

[Operator Instructions] The next question will come from Jess Lubert with Wells Fargo Securities.

Jess Lubert - Wells Fargo Securities, LLC

On the top line guidance, I was hoping you could give us some incremental detail on how we should we be thinking about product revenue versus service revenue relative to your overall outlook to be down sequentially? And then the 7050 had a good quarter. I was hoping you could give us a sense of how much the 7050 represents as a percent of product sales? And maybe discuss where you're having the most success with that product, is it in data center-to-data center deployments or more as a hub platform and data center-to-branch deployments?

Jerry Kennelly

Jess, this is Jerry. The service revenue will actually tick up slightly, Q4 to Q1. And then the delta will be in the product revenue line, which is the natural way this happens with our seasonality. On the product side, the 7050, we class that. We have a series of products that we call data center boxes and we put them in that class. So I think we said that was 38% of our revenue in Q4. We expect that to continue to be a strong category and that will give you an outlook for that for 2011.

Eric Wolford

And your question with regard -- this is Eric, with regard to data center-to-data center versus hub-spoke, split pretty evenly between those two.

Operator

The next question will come from Jayson Noland with Robert Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated

Maybe if you could talk about strength and weakness by vertical. You mentioned financial services, manufacturing, tech, healthcare, anything you saw unusual in there or pretty normal Q4?

Jerry Kennelly

Jayson, it was a relatively normal Q4, one of the beauties of our model and risk mitigators is that we're a horizontal application that attracts in virtually every vertical and our usual five or six strong ones were strong again, just minor variations between them. So I think one thing you could say is the enterprise this year has been particularly strong. Government's done well, but enterprise has really caught fire in 2010 beyond what we've seen the last couple of years. So we feel very good about that.

Operator

The next question will come from Ittai Kidron with Oppenheimer.

Ittai Kidron - Oppenheimer & Co. Inc.

Randy, I wanted to talk to you about the operating expenses, specifically the sales and marketing in the fourth quarter. You had an increase sequentially of $17.5 million in revenue and $8.5 million in the sales and marketing, that's 50% of the incremental revenue. To the extent that those are commissions from previous quarter, it should have been something you were very much aware of and able to calculate. So I'm a little bit confused on why is the incremental sales and marketing in this quarter that much higher than your plan despite the fact that your top line is ahead?

Randy Gottfried

Let me sort of parse that question a little bit. When I look at the actuals, Q3 to Q4, you got a little bit of impact. We have a couple of acquisitions that have some sales and marketing increase into the model. But again, the biggest driver was actually sales commissions in the fourth quarter. At the end of the day, revenue came from a much broader group of people in accelerators than we expected. So as a result, commissions were about two points higher as a percent of revenue than we've forecasted. The good news there is that business was extremely strong in the quarter and the year, which feeds the momentum into 2011. And as we do every year, we've made adjustments that should allow us more leverage in the future.

Ittai Kidron - Oppenheimer & Co. Inc.

Should I take that to mean that the upside came from the newer products? I would assume that at least initially on the newer products providing higher payouts to sales people?

Randy Gottfried

No, I wouldn't say that. It's just the composition of where the revenue came from which was in volume mostly, our core business, some of our historical products. The people who are generating that were in accelerators -- a bigger group than were accelerators than we originally had forecast. That was the biggest difference from our original guidance.

Ittai Kidron - Oppenheimer & Co. Inc.

And lastly, on the 38% that came from data center, can you remind us what was it in the third quarter? And how did your non-data center revenue performed in the quarter? Did it see that much strong growth as well? Or is it more flattish going from the September to December quarter sequentially?

Eric Wolford

This is Eric. There was strong growth in remote office boxes, as well as data center boxes. So it's very healthy across both of them. It's just that the data center boxes were even stronger.

Operator

[Operator Instructions] The next question will come from Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc.

What percent of your sales was from new customers versus existing customers?

Randy Gottfried

Sure. The percentage in Q4 was about 32%, which is up from about roughly double from the Q3 level.

Operator

The next question will come from Eric Suppiger with Six Signal Hill.

Erik Suppiger - Signal Hill

Just real quickly on the Cascade product. How much of that is product versus service, the Cascade revenue?

Randy Gottfried

It's mostly product, although there's a chunk of service in there that grows. All base grows every quarter.

Erik Suppiger - Signal Hill

Any comments about deal size? Did you continue to see that grow in the quarter?

Jerry Kennelly

Yes.

Randy Gottfried

Yes, we haven't been specific, but it's grown slightly. The business in general -- we have a lot of transactions. Most of our transactions are still under $100,000, but it did edge upwards a little bit in Q4. And, again, the bigger news and the great part of our story is that our deployments for our customers continue to grow. So even if they buy in small increments, they keep buying and coming back for more.

Operator

The next question will come from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC

Jerry, at a high level, do you think you can duplicate your success with almost 40% top line growth this year, considering all the market share gains and also Whitewater and also all the pending new products? And does it also feel like you're distancing yourself even further from competitors? And then Randy, just the other income was down a lot, if you could give us some thoughts there?

Jerry Kennelly

So we only give guidance for one quarter and that's the first quarter. So that guidance is for 40%-plus growth year-over-year. In fact, we do expect to take more market share. At the same time we believe the market is extending. And really I kind of think we're approaching what I consider a tipping point where it really turns into a Riverbed gain in the whole WAN optimization and sort of cloud acceleration world. So I feel we're in a great spot going into the 2011, in fact, and for the next 10 years where there's sort of a global access to IT across networks is really going to be the paradigm that every big corporation or every big government network could use. So we have a peerless market position in my opinion.

Randy Gottfried

There are a couple of pieces to the other income line and it is a very small number regardless. One is the interest income that we get. We make almost nothing on all of the cash we have. We are oriented towards capital preservation and very low-risk securities. So the interest income is very low and has been. Some of the variation we see quarter-to-quarter is the other piece, which is foreign exchange on intercompany items which again is very small, but it can swing and because there's not much interest income to offset it, it does sometimes tick out as it did this quarter.

Operator

The next question will come from Tim Long with BMO Capital Markets.

Tim Long - BMO Capital Markets U.S.

If I could just follow up a little more detail on the deal sizes. I'm curious if you could maybe break that down for us a little bit between the data center and the remote office boxes. So is there a meaningful difference or has there been a meaningful, even more of a separation in deal sizes in the two pieces of the business?

Eric Wolford

This is Eric. In aggregate, over the past few quarters there has been an increase as a percent of our product revenue that comes from what we call our 3U or data center boxes, although they can be deployed in remote offices. The 3Us are the ones that have been growing nicely, but there's been growth across every one of our products. And it's been strong growth across everyone of them, just more in the data center boxes. And then data center-to-data center deals do tend to be, of course, bigger because you're using bigger boxes. So generally speaking, data center-to-data center deals are bigger than some of the remote office deals on average. But some of the remote office deals also are huge when you deploy to 100 or 200 sites, they're also very large, too.

Jerry Kennelly

To expand on that, Tim. The data center boxes are limited to the data center market for us. We put big data center boxes in the center so people can have a big fan out to hundreds of branch office boxes. And so they're not separate markets per se in the way that you might think about it.

Operator

The next question will come from Brian Modoff with Deutsche Bank.

Brian Modoff - Deutsche Bank AG

Jerry, what would you see the contribution from data center and cloud expansion opportunities to revenues this year? How would you parse that out?

Jerry Kennelly

We haven't called those out specifically. Like we said, our data center size box is approaching 40% of our revenue. Our entire market really is addressing access to IT across the network. And we define the whole thing to be cloudy to public or private. We believe it's an expanding market. We think it's the direction that everyone's going and we think it will continue to drive a robust revenue stream for Riverbed.

Eric Wolford

This is Eric. Just expanding on that. The trends toward consolidation, whether it's private cloud or public cloud, is fueling all of our products, all of our product sales. So there's data center-to-data center, data center-to-remote site. There is this mega trend toward consolidation of data in fewer and fewer locations. And so without a doubt, that is wind in our sale.

Renee Lyall

And just to clarify one thing, the 3U, the data center box is approaching 40% of the Steelhead appliance revenue, not total product revenue, just for your modeling.

Randy Gottfried

Next question?

Operator

The next question will come from Daniel Ives with FBR Capital Markets.

Michael Bauer - FBR Capital Markets & Co.

This is actually Mike for Dan. Just a quick question on the product revenue front. I know you mentioned that the data center boxes were particularly strong. Was that the out-performance basically on the product front, mainly from that or across the board? And then also in terms of linearity, how did that actually perform in the quarter? Do you think you've benefited from a year end budget push on overall in 4Q?

Jerry Kennelly

So I think we said, Mike, that the product revenue was robust across the product lines. It was good in the branch offices. It was good for the big center boxes and it was a strong quarter from October 1 through December 31. We started strong and we ended strong. It felt great, the whole quarter.

Operator

The next question will come from Alex Kurtz with Merriman and Company.

Alex Kurtz - Merriman Curhan Ford & Co.

Randy, could you repeat what the sales and marketing target was for that midterm operating margin? And inside of that, what are your thoughts around Arrow and Avnet as far as their ability to provide sort of, some kind of leverage upside over the coming year?

Randy Gottfried

When we're thinking about the midterm target of 30% operating margin, for sales and marketing I think I've phrased it as low 30s, but that's probably 32 to 34, something like that. On Arrow and Avnet. So we've got channel partners worldwide. Arrow and Avnet handle a lot of the VAR channels here in the U.S. Our first priority with them is to continue to see top line growth. That's why we brought them on as we get into more partners that we weren't necessarily involved with before and with them, more end users that maybe we didn't have a connection to. As far as the model impact, that's part of how we get leverage. Right now we're still investing on getting everybody self-sufficient. If we can lower the touch involved in the sales cycle, that means lower sales and marketing expense and overall more money flowing into the bottom line.

Alex Kurtz - Merriman Curhan Ford & Co.

You still see those two distributors as sort of in the investment phase, right?

Randy Gottfried

Yes, I think they're sort of in the midterm. We basically went live with them really just a couple of quarters ago in the second quarter, so three quarters ago actually. But I think what we said when we first transitioned our relationships, we thought it would be a year or so before we started to see the benefits. So we're may be in the transition part right now but the real pay-off we think still comes in 2011 and beyond.

Operator

The next question will come from Paul Mansky with Canaccord.

Paul Mansky - Canaccord Genuity

Going back to the 7050, I think a lot of the questions are politely asking how much leg do you think is left selling that product into the installed base given that's a segment you haven't directly addressed previously. Recognizing the prior comment, consolidation is pulling demand across the portfolio, do you think there's risk that 7050 normalizes in terms of contribution over the next couple of quarters, maybe growing more in line with the overall product portfolio? Or do you think that has leg throughout the next year?

Eric Wolford

Paul, it's Eric. You said it, as the trend toward consolidation cloud continues, the future of the 7050 and anything that might come after it is fantastic because the workloads are just getting bigger and bigger and bigger in those data centers. And so right now in terms of demand we see, the desire for bigger and better is there and doesn't seem like it's about to ameliorate anytime soon.

Paul Mansky - Canaccord Genuity

You haven't talked about your manner services business in a bit. Can you maybe comment on how that exposure has been trending? And then whether or not Terremark is an existing customer. I see they've just been acquired by Verizon?

Eric Wolford

So as you know, service providers are a big part of our go-to-market strategy. I think what's happening is inside of our service provider relationships, they are moving from resell relationships with customers selling Steelhead boxes to more managed services. So instead of reselling Riverbed boxes, they're managing it on behalf of the customer and that trend is happening globally across all service providers. So managed services through our partners, the big service providers, that is something I think that is increasing.

Randy Gottfried

In general, they're doing great.

Paul Mansky - Canaccord Genuity

And Terremark?

Jerry Kennelly

Terremark specifically? I don't know that we have them on. Big statement on Terremark. I don't think they're acquired by Verizon. Our relationship with Verizon is great. We just launched a managed service with Verizon. I don't recall Terremark being part of that launch.

Operator

The next question will come from Matt Robison with Wunderlich Securities.

Matthew Robison - Wunderlich Securities Inc.

I wanted to know if you could maybe give us some clarity of what you think the relative size of your market segments will be next year? And who your best competitor is for Whitewater?

Eric Wolford

Ye, sure. This is Eric, and obviously WAN optimization is the one we spend the most time talking about. And our main competitor there by two to three times is of course Cisco and continues to be Cisco by all statistical measures, who we battle and who Gartner says is the number two position 15 points behind us is Cisco. And that market Q3 to Q3 according to Gartner's numbers Q3 '09, Q3 '10 grew about 32%. And I know we grew faster because we gained quite a bit of share on Cisco. Then we have two other adjacent markets. One is the market that Cascade is in with our CACE acquisition, which is the application ware network performance management space which has, I think, $1 billion addressable market. And then we have just started with our Whitewater products to address cloud storage with our cloud storage accelerator. Now that market is understandably a bit more speculative. But there are quite a few forecasts about that market in the future being a very large market.

Matthew Robison - Wunderlich Securities Inc.

Who is your best competitor for Whitewater?

Eric Wolford

Yes, and for Whitewater there's like three or four startups. So we haven't run into what I would consider a leading brand competitor right now. So there's about three or four VC-funded startups that we end up competing with, or nothing at all. I'd say the main competitor is nothing at all, don't go to cloud. So it's either go to cloud or don't go to cloud is probably the number one alternative.

Operator

The next question will come from Rohit Chopra with Wedbush Securities.

Rohit Chopra - Wedbush Securities Inc.

I'm just wondering if maybe Randy you can address this one. Do you have to adapt the new accounting standards? And what's the impact on the guidance if there is? And can you just talk about close rates?

Randy Gottfried

So the new accounting for revenue, we actually early adopted back in Q1 2010. So all the impact has been in our numbers and the impact was minimal. And the second part of your question was?

Rohit Chopra - Wedbush Securities Inc.

Yes, just close rates. Just wanted to get a sense of how they transpired throughout the quarter.

Randy Gottfried

I would say all the pieces of close rates, which includes win rate percentages, sales cycle times, all of those pretty much improved in the quarter. It's a very solid quarter. And as Jerry said really from October all the way through the end of the year, very solid throughout.

Operator

The next question will come from Tal Liani with BoA Merrill Lynch.

Tal Liani - BofA Merrill Lynch

I have a question on expenses, sequential expenses. So what I did, I calculated the sequential increase in revenues versus sequential increase in operating profit to calculate the incremental operating margin. And it went down substantially between 3Q to 4Q from 51% to 24%, which means that incrementally in fourth quarter, your incremental profits were below your average, which is probably seasonal. But I want to understand where it's coming from. Now the issue is it could be year end bonuses payment exactly what you explained. But when I do the same calculation for Q1, the implicit growth I see the same issue, which means that your OpEx is growing and your guidance is growing quite substantially also in Q1 versus Q4. So maybe you can repeat -- I know you touched on this topic but maybe you can repeat the question on leverage. How much leverage is left in the business and what could happen throughout 2011 and particularly in Q1 with operating expenses and can also spend a few seconds on gross margin, what could happen to gross margin?

Randy Gottfried

So there's a few pieces to what you had asked. I think as you think about Q3 to Q4 operating expenses, the real big drivers were sales and marketing, a little bit of M&A, the additional expense from M&A. But the bigger driver was commission, sales commissions, which do end up typically going up at the end of every year. It was higher than we expected, frankly, and we recalibrated some of our efforts internally as we look to 2011 to avoid some of the things we ran into in Q4 of 2010. That said, as you think about Q1 2011, the drivers of expense are a few. You have sales commissions that typically go down quarter-to-quarter. But offsetting that, you end up with payroll taxes like FICA that restart for a lot of people in January 1. We have our sales kickoff, which is in the first quarter, we have just the regular hiring. So we're growing very, very fast and so therefore, continue to hire robustly to help fuel that growth. And then lastly, the Singapore operations center I mentioned before has a bit of an impact for the first quarter as well. So while commissions are down in Q1, operating expenses are up. To summarize a little bit from your question, we were in the high 20s at the end of 2010. We aspire to get to a midterm target of about 30%. So we don't have far to go. We think there's definitely more leverage to go. And as we go forward, we're just trying every quarter to make improvements, adding revenue faster than expense on a year-on-year basis to march towards those medium-term targets.

Operator

The next question will be from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS Investment Bank

Let me ask a question about HP, the relationship there. I think if I go back a couple of years ago, you announced together that you were going to develop a soft-based lock I believe for one of their switches. And they recently, I think, spoke at an investor conference talking about wanting to do more in the space organically. Is that something that is still an opportunity for you? Can you give us an update on that? And then I would just ask as a clarification on this tax rate guidance. Is it fair to say that all the cash now is domiciled in the U.S. but going forward, most of it is going to be domiciled overseas as you lower your tax rate?

Eric Wolford

Nikos, this is Eric, I'll take the first part of that and then pass it to Randy. First of all, the HP. HP is a very good partner of Riverbed. They continue to be a top reseller for us. With regard specifically to the software running on a ProCurve switch, yes, that is something that we developed. That is something that HP did launch. But probably as you know with their acquisition of H3C, they are doing their own set of work around their product suite. And so we still do hold out optimism for what may come of that. To this point in time, it hasn't been a big contributor but it is something that looks like upside for us in the future. And then was there something with products that you asked?

Randy Gottfried

On the next question. So you're correct in that. Most of the $0.5 billion of cash we have now is domiciled in the U.S. The vast, vast majority of it almost all. As we go forward, the U.S. continues to throw off a lot of cash. But internationally, we will have more cash as a proportion over time than we have now as part of this restructuring.

Operator

The next question will be from John Slack with Citigroup.

John Slack - Citigroup Inc

I was wondering if you could give us a flavor for what your plans are in terms of headcount additions over the next -- maybe in the next quarter and then the next year?

Jerry Kennelly

We've not really ever given guidance on headcount. I would say the OpEx that we described in our guidance is largely correlated to headcount, but we don't actually call out specific numbers. In general, we're hiring across the company hopefully in a prudent way.

John Slack - Citigroup Inc

Could you talk a little bit about RSP maybe as a revenue generator? Or is it just still -- it's more of a deal differentiator?

Eric Wolford

This is Eric. RSP continues to be a fantastic competitive weapon for us. It provides us with a lot of uniqueness and expands our addressable market by allowing us to consolidate more things on to this single box. This branch office box concept has a lot of appeal to customers in the marketplace. We do have now 18 different approved modules where we've qualified them and are selling them. And attach rates are strong and revenue is ramping. And it's really a positive thing for us.

Operator

The next question will come from Troy Jensen with Piper Jaffray.

Troy Jensen - Piper Jaffray Companies

Quick question for Eric. I just want to focus a little bit on VDI. In to my knowledge, I think you guys do not accelerate UDP traffic, and if that is true, is that in your roadmap here?

Eric Wolford

Sure. We do not, at this point, accelerate UDP Traffic. You are correct, but I wouldn't say that means we don't accelerate VDI Traffic. Much VDI Traffic, in fact, most of it tends to come from Citrix's applications, XenApp, XenDesktop and those applications we definitely accelerate. In fact, we think we have a leading solution in accelerating that VDI Traffic, which is the largest portion of VDI traffic on networks today. At the same time, you're absolutely right in pointing out that we are going to do UDP and that's something that's important to us looking forward.

Operator

The next question will come from Sanjiv Wadhwani with Stifel.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc.

Randy on the government side, you said 18% of revenue. I wanted to confirm that was 18% of revenues, 18% of product revenues just given that you've given as a percentage of product revenues before?

Randy Gottfried

It's 18% of product revenue.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc.

And then on the data center products, 38% of revenues, I wanted to see what that percentage was last quarter and then also confirming that there are a host of products that go in there and not just the 7050?

Eric Wolford

Yes, sure. This is Eric and as I've said before that the 3U or data center products did grow faster than any other size product, but all of the products grew fantastically. I think it grew from like mid-30s to 38%. So if you're looking for a number to put on it, and that's percent of Steelhead revenue. I think there was a part b to your question. Could you repeat that?

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc.

Just wanted to make sure that it encompasses a bunch of products not just the 7050.

Eric Wolford

Definitely. The 3U encompasses the 5050, the 6050 and the 7050.

Operator

The next question will come from Scott Zeller with Needham & Company.

Scott Zeller - Needham & Company, LLC

You knew the time in the field has been relatively short. Could you give us some color around how often the Virtual Steelhead and Cloud Steelhead come up in sales discussions? Or is this something that people are looking to do down the road, and don't want to talk about at this point?

Eric Wolford

It's half true on both of your points. So first, it always comes up. You can't hardly have a conversation with a senior person in an IT organization without talking about some aspect of the cloud. Whether it's public cloud or private cloud, it definitely comes up and it's a key part of the long-term positioning. How many people are now like acting on it and doing it, as you pointed out it is smaller. I think people are dipping their toe in and testing it, and we do have real sales. We have dozens of customers that are trying Virtual Steelhead right now and using that so the sales ramp is starting. But I would say that the talk and planning is way ahead of the purchasing and doing.

Operator

Ladies and gentlemen, we do have time for one final question and that question will come from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS Investment Bank

I wanted to follow up on -- if I did the math right, it looked like sales through your largest distributor went up meaningfully sequentially and I've realize all the comments you made about sales accelerators and so forth. But why wouldn't that have had been an offsetting fact to sales and marketing expense as you saw more, more product go through those types of channels and just -- I thought part of the rationale in doing that was to help bring down some of the OpEx for the company?

Randy Gottfried

I think there are a couple of different points in there. I think first regardless of channel we have people in the field that are working closely with our channel partners and with end users to close deals. So regardless of channel admissions on those transactions. Now long term, we do expect to be less touch and the compensation issue aside, we think there is absolutely leverage as partners like our U.S. VADs and others worldwide get more self-sufficient, we have to go to fewer meetings, they can close evaluations on their own, that's where the real payoff comes as we move forward.

Nikos Theodosopoulos - UBS Investment Bank

And just an extension on that. I would assume the midterm target you gave of 30% operating margin does not assume any impact of cloud-based business model, sales impacting your income statement, it's basically just selling hardware and services as you do today?

Randy Gottfried

Everything we know is in that guidance and in those targets. We'll see our assumption in general for cloud and some of the software-based products we've talked about is that it's a slow ramp, it takes time, but those are in our numbers. Long term if those numbers become a much bigger proportion of our total than we're expecting, well maybe there's some upside to the totals. But right now, we're focused on just making incremental improvement every quarter.

Renee Lyall

Thank you again for joining us today. During the first quarter, we will be participating in the Stifel Nicolaus, Goldman Sachs and Morgan Stanley Technology Conferences in February. In March, we will be participating in the Pacific Crest, Signal Hill, Wedbush Morgan, Lazard, and William Blair Conferences. Our next quarterly conference call to discuss our first quarter fiscal year 2011 results will be on Thursday, April 21. If you have any questions about this call or Riverbed in general please contact Investor Relations. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. You may now disconnect.