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Blue Coat Systems, Inc. F1Q09 (Qtr End 07/31/08) Earnings Call Transcript

August 26, 2008 | about stocks: BCSI

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Blue Coat Systems, Inc. (BCSI)

F1Q09 (Qtr End 07/31/08) Earnings Call Transcript

August 21, 2008 5:00 pm ET

Executives

Dan Levy – Director of IR

Kevin Royal – SVP and CFO

Brian NeSmith – President and CEO

Analysts

Erik Suppiger – Signal Hill Group

Joshua Jabs – Roth Capital

Ryan Hutchinson – Lazard

Richard Sherman – MKM Partners

Scott Zeller – Needham & Company

Alex Kurtz – Merriman Curhan Ford

Rohit Chopra – Wedbush

Michael Bowen – Friedman, Billings

Doug Ireland – JMP Securities

Jonathan Ruykhaver – ThinkPanmure

Rob Owens – Pacific Crest

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to first quarter fiscal year 2009 financial results conference call. At this time all lines are in a listen-only mode. Later there will be an opportunity for questions and instructions will be given at that time. (Operator instructions) I will now turn the conference over to Dan Levy, Director of Investor Relations. Please go ahead, sir.

Dan Levy

Good afternoon and thank you for joining us today. Kevin Royal, Blue Coat’s Senior Vice President & Chief Financial Officer, will begin today's call with an overview of financial results for the first quarter of fiscal year 2009 and the financial outlook for the Company. Brian NeSmith, Blue Coat's President & Chief Executive Officer, will then follow with his commentary and other operating highlights.

As you know, during the course of this call we will make forward-looking statements about Blue Coat Systems, Inc. and our recent acquisition of Packeteer, Inc. These include statements regarding expectations concerning market growth and business opportunities, expectations regarding future revenues, expenses, margins, tax rates, and other financial metrics, and other matters impacting Blue Coat's financial outlook and future business. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including any statements of expectation or belief and any statements of assumptions underlying any of the foregoing.

Risks, uncertainties, and assumptions include the risks that are described from time to time in the reports filed by Blue Coat with the Securities & Exchange Commission, including but not limited to the risks described in Blue Coat's annual report on Form 10-K for the year ended April 30, 2008. No assurances can be given that any of the events anticipated by the forward-looking statements will transpire or occur or if any of them do, what impact they will have on the results of operations or financial condition of Blue Coat. Blue Coat assumes no obligation and does not intend to update these forward-looking statements except as required by applicable law.

Now I'll turn the call over to Kevin.

Kevin Royal

Thank you, Dan. Today we're pleased to announce another quarter of record net revenue of $102.5 million for the first quarter of fiscal 2009, a 16% increase compared to net revenue of $88.2 million reported in the prior quarter. We closed the acquisition of Packeteer on June 6, 2008. Our results for the quarter include Packeteer for the period from June 7, 2008, through July 31, 2008. Excluding net revenue associated with the acquisition of Packeteer net revenue for the first quarter of 2009 was $86.4 million.

Included in the $102.5 million of net revenue is product revenue of $73.9 million, which includes sales of appliances in Blue Coat WebFilter. Product revenue in the first quarter of fiscal 2009 reflects an increase of $7.7 million compared to $66.2 million in the immediately preceding quarter. Included in product revenue is $11.9 million of Packeteer related product revenue.

Now turning to service revenue, we recognized $28.6 million in the first quarter, a $6.6 million increase over the prior quarter. Included in service revenue is $4.2 million related to Packeteer. The balance of the increase was driven primarily by the continued growth in our installed base over the last several quarters. Packeteer service revenue was reduced to reflect purchase accounting adjustments to write down deferred revenue to eliminate acquired profit.

Total Blue Coat WebFilter revenue was $8.7 million in the first fiscal quarter compared to $9.1 million in the fourth quarter of fiscal 2008.

On a geographic basis, net revenue in North America was $40 million representing approximately 39% of total revenue. Net revenue in EMEA and Latin America was $43.1 million representing approximately 42% of total revenue and net revenue in the Asia Pacific region was $19.4 million representing approximately 19% of total revenue.

Gross margin on a non-GAAP basis decreased to 76% in the first fiscal quarter from 76.8% in the prior quarter. The decline in gross margin is primarily related to the write down of deferred service revenue in connection with the acquisition.

On a non-GAAP basis, operating expenses increased approximately $14.2 million to $68.3 million in the first quarter. This increase was driven by the Packeteer acquisition, which contributed $14.4 million in operating expense for the quarter. Of the $14.4 million of Packeteer expense $4.3 million were related to integration and transition cost. As a percentage of total net revenue operating expenses increased approximately 5%. Non-GAAP R&D expense increased approximately $4.1 million to $17.1 in the first quarter.

This increase also was driven by the Packeteer acquisition. R&D expenses related to the Packeteer acquisition contributed $4.2 million of which $1.4 million was related to integration and transition cost. While we intend to continue to invest in R&D, we expect R&D spending to decrease as a percentage of net revenue as we move through the fiscal year.

Non-GAAP sales and marketing expense increased approximately $7 million to $42.1 million in the first quarter. The increase in non-GAAP sales and marketing expense was due to increased head count as a result of the Packeteer acquisition. Sales and marketing expenses related to Packeteer was $8.2 million of which $2 million related to integration and transition cost.

Our number of sales teams increased from 99 at the end of the fourth quarter to 135 teams at the end of the first quarter.

Non-GAAP G&A expense in the first quarter increased approximately $3.1 million to $9.1 million in the first quarter. The increase in non-GAAP G&A expense was primarily driven by $1.9 of expenses related to the Packeteer acquisition. Of that increase $900,000 related to integration and transition cost. The balance of the G&A expense increase was due to higher legal and accounting fees in connection with our year-end audit and tax claiming activities.

On a non-GAAP basis, the company reported net income of $6.8 million or $0.16 per diluted share in the first quarter of fiscal 2009 compared to non-GAAP net income of $13.1 million or $0.33 per diluted share in the prior quarter. For purposes of calculating non-GAAP earnings per share for the quarter ended July 31, 2008, our fully diluted shares were approximately 42.1 million. On a GAAP basis, the company reported a net loss of $5.8 million or $0.15 per share in the first quarter of fiscal 2009 compared to net income of $12.5 million or $0.32 per diluted share in the prior quarter. As a reminder, a reconciliation of non-GAAP to GAAP financial measures is included in today's press release.

Turning to the balance sheet, we ended the quarter with cash, restricted cash and investments of approximately $76.3 million representing a decrease of $111.8 million from the prior quarter. This decrease was primarily due to cash used in the acquisition of Packeteer. Operating cash flow in the first fiscal quarter was $5.5 million compared to $22 million in the prior quarter. More than $12 million of the decrease in cash flow was due to payments for acquisition related items such as transaction cost, severance payments and other assumed liabilities. Capital expenditures were $3.3 million for the first fiscal quarter and depreciation and amortization was $4.4 million. Our accounts receivable balance increased by $13.3 million during the quarter due primarily to the increase in revenue related to the Packeteer acquisition. DSOs decreased from 60 to 58 days at the end of the first fiscal quarter.

Before we discuss our outlook for the next quarter, I wanted to give you an update on the Packeteer acquisition. The total purchase price was $276.2 million which included cash of $238.6 million paid in our first fiscal quarter and $25.3 million paid in our fourth fiscal quarter of 2008. The purchase price also includes $7.7 million in transaction cost and assumed options valued at $4.6 million.

Turning to our guidance for the second quarter of fiscal 2009, the company currently anticipates net revenue in the range of $116 to $120 million. We expect the core Blue Coat business to generate between $90 and $92 million in net revenue and net revenue related to Packeteer to be $26 to $28 million. We expect Packeteer related product revenue to be $20 to $22 million and associated service revenue to be approximately $6 million.

On a non-GAAP basis, earnings per share is expected to be between $0.15 and $0.20 per diluted share. Non-GAAP earnings per share excludes expense related to the write up of acquired inventory towards assessed fair value to amortization of intangible assets, stock based compensation expense, and expenses associated with matters related to our stock option investigation, but includes $5.5 million to $6.5 million of estimated integration and transition expenses. On a GAAP basis, the company expects a loss between $0.10 and $0.16 per share. For planning purposes we are using a 30% tax rate for the remainder of the year. We continue to target operating profit as a percentage of revenue of the combined companies in the range of 17% to 18% in our fourth quarter of fiscal 2009.

Now let me turn it over to Brian for his perspective on the quarter and our business going forward.

Brian NeSmith

Thanks, Kevin. Good afternoon and thank you for joining us to discuss the results of our fiscal 2009 first quarter. I am pleased to say that we saw a solid quarter in which we combined the revenue of Blue Coat and Packeteer for just a portion of that quarter and made excellent progress on our integration strategy. As we think most of you know, we agreed to acquire Packeteer on April 20th, and then completed the acquisition on June 6, a period of just 47 days. As a consequence, much of our focus during this past quarter was on aggressively integrating the two companies. While this presented a number of challenges, we believe that we have made excellent progress on the integration activities and in creating a foundation that is stronger than simply the sum of the individual companies.

One of our most significant integration accomplishments during the quarter was our work in combining in the two sales teams to create an organization that can market and sell both Blue Coat and Packeteer products. We implemented a massive training program which included worldwide, regional, and individual sales and channel training to ensure that our extended sales team could sell products and services reflecting our new value proposition, one which combines visibility with acceleration and security. As a result, we met one of our first key integration milestones, which was to achieve a fully integrated and trained sales team by August 1.

We gained about 1400 channel partners from Packeteer and have been pleased with the strength and consistency of these partners in selling WAN optimization products as demonstrated by our PacketShaper sales for the quarter. Because the Packeteer channel has less than 10% overlap with our channel, we believe that this new channel will considerably extend our reach in the WAN optimization market. During the quarter, we also continued to invest in our channel partners and channel organization not only to achieve our integration objectives but to achieve a new level of channel effectiveness and productivity. During this past quarter, we conducted a 55 city worldwide road show to personally meet with over 3000 former Packeteer channel partners and customers to listen to any of their concerns and suggestions and to help them understand our product offerings, vision, and future direction. We also combined the best aspects of both the Blue Coat and Packeteer channel programs to create an even more exciting opportunity for all our partners. This response from former Packeteer channel partners has been quite positive. They see the combination of ProxySG and PacketShaper appliances as a comprehensive solution that they can profitability and immediately sell to their customers. Customers are responding enthusiastically to the value Blue Coat delivers with the ProxySG and PacketShaper solutions. As an example, a large software company that has relied on PacketShaper throughout its network now wants to match those appliances with ProxySG appliances. Similarly a major hotel chain and a global architectural firm each decided to go with ProxySG and PacketShaper appliances soon after the acquisition was completed. We recently won a deal with a financially related global company, which will use our appliances at 2000 locations worldwide. As well, we have recently announced that Capital Energy in Spain has selected Blue Coat for a high visibility deployment across Europe, Latin America, and parts of Asia Pacific.

Italian Banca Popolare is another company that selected Blue Coat for its organization. It has roughly 630 branch offices and required a combination of application acceleration, security and control for direct Internet access in branch offices and internal video distribution all in a single appliance. While the Packeteer acquisition brought immediate benefits in terms of sales and channel, we believe that its long-term value will be to support our vision of a new kind of network, an application delivery network which offers visibility, acceleration, and security of business applications and which will become the preferred way for organizations to provide a consistent and positive end-user experience.

Our vision of the application delivery network builds upon the packet delivery network. During the last several decades network administrators have built packet delivery networks to move data on a packet by packet basis from here to there. However, those networks provide no information on the conditions users are actually experiencing and how applications are actually performing. Additionally, as the packet delivery network is designed primarily for transport, it is difficult to segregate and separate and control information. Simply transporting data without providing visibility control is insufficient for mission critical applications. Greater application understanding and traffic prioritization is increasingly important for customers.

Applications are rapidly becoming more complex with multiple components and middle ware. Service oriented architectures or SOA type applications contribute to this complexity. Delivering applications in this complex environment requires better insight and understanding of applications and greater range of control than a packet delivery network provides. The application delivery network can offer the visibility, acceleration and control that is necessary to delivery mission critical applications with efficiency and safety.

To close, I would like to announce that we recently passed a key engineering milestone in our integration plan. We released a feature that allows the PacketShaper and the ProxySG appliances to work together with more synergy. This feature enables IT to see traffic running on both devices from a single management solution. This capability is simply the first step towards offering visibility acceleration and security in one solution from one company. We plan to continue further product integration as we move forward to deliver the most comprehensive application delivery solution on the market today.

I am proud of our progress on our integration plans. I believe we will continue to execute successfully and offer strong value to our customers, partners, and shareholders. And at this point I like to thank everyone and pass the call back over to Dan.

Dan Levy

That concludes our prepared remarks. We will now turn the call over to the operator for questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And our first question comes from Erik Suppiger with Signal Hill. Please go ahead.

Erik Suppiger – Signal Hill

Good afternoon. Congratulations on a solid quarter.

Kevin Royal

Thanks Erik.

Erik Suppiger – Signal Hill

First off, maybe you could just clarify the integration charges or costs. Should we look at those as one-time in nature, I think you say in the press release that you have got $5.5 to $6.5 million in the – in your estimates in your numbers for the October quarter. Does that – if we look at that on a normalized or on a recurring basis would it be appropriate to assume that that there is an additional $6 million of expense in there that would be one time.

Kevin Royal

Related to the second quarter Erik that is correct. Those are costs such as transition costs associated with employees who are helping us with the integration but after the second quarter will no longer be with the company.

Erik Suppiger – Signal Hill

Would they be old employees of Packeteer or would they be consultants?

Kevin Royal

Those would be employees of the company, either the former Packeteer Company or Blue Coat.

Erik Suppiger – Signal Hill

So, this is part of just the transition period. It is kind of a normal reduction in cost process.

Kevin Royal

Exactly.

Erik Suppiger – Signal Hill

You had noted – it sounds like you added 36 sales teams during the quarter. I think you had talked about Packeteer having maybe – bringing over 45 to 50, was there fewer sales teams to join or why it seems as though the number of sales teams is lower than I was expecting?

Kevin Royal

A couple of things. I think it is a fair statement. We – as we combine the organization there was a few places we found more redundancy then we originally expected and rather than keeping duplicate redundant resource in those areas we expected to hire back to get better geographical coverage. So, we will see that number from an overall sales team standpoint going up again next quarter with new hires that we will be doing.

Erik Suppiger – Signal Hill

So, to be clear you add some that you cut, but you are going to be filling those spaces, is that correct?

Kevin Royal

Yes, in general.

Erik Suppiger – Signal Hill

Okay. Then on the revenues, my sense was that Packeteer product revenue would be in the range of $25 million or so going forward. It sounds like you are looking for $20 to $22 in the October quarter, is that a – is the reason that is lower is that one time in nature or is this kind of a starting point where we should start building from?

Kevin Royal

Two parts is, the Packeteer had products that are redundant with what Blue Coat. So they had some iShaper, iShared products and so that – the revenue number that we are talking about with Packeteer is really specifically the PacketShaper revenue. There is a part of the revenue I don’t know how you account for it, where you are going to have former Packeteer reps that are going to be selling Blue Coat WAN optimization products. So I think we will be more than that number combined that you highlighted in Packeteer but we are speaking specifically and what (inaudible) Packeteer number as PacketShaper only.

Erik Suppiger – Signal Hill

So to compare the $25 million that you had talked about before, that would not be a comparable number to the $20 to $22 that you forecasted for the October quarter is that correct?

Kevin Royal

That is right. They are not exactly the same. So the total product revenue that Packeteer had included iShaper, iShared and another product called SkyX and if you add those up you get basically back to that same overall product revenue number. We discontinued those products and are replacing them with ProxySG equivalent products. So, we are not seeing a reduction in combined revenue between the two organizations, but it is – we are going to obviously some giving some insight into the PacketShaper revenue, which was the majority of the Packeteer revenue but not all of it.

Erik Suppiger – Signal Hill

Very good. I will pass it on. Thank you.

Operator

Thank you and next we will go to Joshua Jabs with Roth Capital. Please go ahead.

Joshua Jabs – Roth Capital

Hi, good afternoon. Can you hear me?

Kevin Royal

Yes.

Joshua Jabs – Roth Capital

Okay, Brian have there been, in looking how you talked a little bit about the integration, have there been any changes for the roadmap regarding an integrated product line sort of as we get into next year?

Brian NeSmith

There has been fine-tuning. I think as the two product teams are coming together and starting to highlight where we could get efficiencies we made some adjustments in that. A couple of things are clear as we are going to continue to see – you know, we see a lot of opportunity for selling PacketShaper products for a very long time. There are obviously aspects of what the two, both PacketShaper and ProxySG do together as a combined platform and we are integrating the aspects that make sense to come together but we are going to continue to sell PacketShaper products for a very long time.

Joshua Jabs – Roth Capital

Okay, and then in looking at further the preliminary guidance that you had provided for the companies, due you still see sort of that 17% to 18% range on the year margins actually exiting fiscal ’09 as achievable?

Brian NeSmith

I think as Kevin highlighted, we saw that by the fourth fiscal quarter we would get back to 17% to 18%, as we believe on echoing his guidance that he said and he is highlighting. So, I guess that does count as a reiteration of guidance but it is a short, narrow window, but I think that will be okay.

Joshua Jabs – Roth Capital

Okay and then the last piece, I would actually my phone had dropped of here so I could have missed this on the call previously, but last quarter you had given some sort of rough guidance – given some insight as to how you came up with your guidance given the conditions primarily in North America. You know, looking at next quarter you had backed a lot of big deals out of this quarter’s guidance is that the approach being taken into the next quarter’s guidance as well and can you give us any additional color on how you guys came to the guidance for next quarter?

Kevin Royal

Well there is two parts, as obviously the traditional business that Blue Coat has done and I think as we highlighted we expected North America to stay flat and was duly challenged as I said last quarter for 2 to 3 quarters and so we are really on the second quarter of that activity. So, we are not expecting a lot of growth out of North America in our traditional business. We are offsetting that somewhat with much better growth in Europe and Asia. So, we – those factors that we are already starting to adapt and what we think the changes are there. So, I think we are okay there. With this former Packeteer revenue, we put a lot of energy to understanding what they are doing from a pipeline perspective and run rate. They – Packeteer historically did a lot more Notouch [ph] revenue from the channel. So, a lot of that comes from the channel, but we rolled up that forecast and then obviously with some of the channels that we got going on, wanted to make sure that we did as accurate as we could in the guidance and that is why you see the range there. I don’t know if it is specific to saying that we backed out large deals. In general, I would say for the last couple of quarters, we have been a bit more conservative on the large deal closure rate that we have been historically, and I think that continues in the quarter we are in right now.

Joshua Jabs – Roth Capital

Okay, and then the last question, in looking at – heading into the acquisition I think there was some opportunities to bring sort of the outsourced manufacturing process that Packeteer had into the more integrated for the Blue Coat and then maybe some margin improvements reflecting improvements there longer term, is that still the case, have you had a chance to really dig into what Packeteer has.

Kevin Royal

I think we will probably get more benefit just out of the volume purchasing arrangements than we will necessarily from the pulling out of subcontract manufacturers. That consolidation in that area, even if does happen, it is going to – yes, I think take a fair amount of time. Most of our cost savings is primarily going to be around just volume on common components and other things like that.

Joshua Jabs – Roth Capital

All right, great. Nice quarter guys. Thanks.

Kevin Royal

Thank you.

Operator

Thank you. We will go to Ryan Hutchinson with Lazard. Please go ahead.

Ryan Hutchinson – Lazard

Hi, guys. A few questions here. Just – Kevin you provided some expectations on the Packeteer product and service next quarter, but as you look at the model in the report here today, it looks like Blue Coat core revenue on a product basis was down sequentially and you see some nice growth in the services side. So, just trying to get an understanding, as we look into the October quarter what the expectations are there for both those line items?

Kevin Royal

I think that in our guidance there will be modest improvement in the service revenues. So, it should be on Blue Coat only a couple of million dollars, but fairly significant growth on the Blue Coat product side.

Ryan Hutchinson – Lazard

Okay, and just a clarification from a product question, to put into context, just the historical run rate at the PacketShaper product line what has that been, you know, in the prior life?

Kevin Royal

It was – it ranged anywhere from about $18 to $22 million typically.

Ryan Hutchinson – Lazard

Okay, and so I guess the question is would you expect to see that PacketShaper product line grow beyond the $22 million over the next couple of quarters or is this a business that is going to tap out at that sort of range there and the rest of the growth will come from the core business?

Brian NeSmith

I think that the PacketShaper revenue itself as a standalone platform will, probably it is not going to grow a lot. I think it might grow a little bit, but it is not definitely not going to grow in any significant way. What we do expect is that taking the Packeteer channel and the sales reps in that organization and putting the Blue Coat product through, it is going to help drive the growth. But it will be probably more around the ProxySG and the WAN optimization side of things.

Ryan Hutchinson – Lazard

And then on the – Kevin on the strengthening dollar that we are seeing here, what is your view as it relates to your guidance in terms of the impact that could have on your business?

Kevin Royal

You know, I don’t really think that we have given it a whole lot of thought with the recent development and the recent strengthening. Certainly, you know, you can make the case that we benefitted from having a weaker dollar as far as purchasing power strengthening in EMEA and APAC, but I think our guidance reflection of that, we expect growth for the quarter and we have no indication really that the currency fluctuation will have any impact on our second quarter.

Ryan Hutchinson – Lazard

And I guess just as a follow up to that, I mean, we are starting to see some signs of a potential spillover effect from US and the Europe, and obviously you stated the bulk of your growth this year is going to come outside the US. So, I guess, outside of adding Packeteer into the mix, have you seen any slowdown in Europe and how much I guess of that growth is coming from Europe versus say Asia and the Middle East? And that is it from me, thanks?

Brian NeSmith

There is a little bit on by quarter-by-quarter basis, you know, Europe and Asia both have been growing pretty solid. I think Europe a little bit more in this past quarter and then the rest of the areas, but they both if you look over in the last year have been growing at a fairly good pace. So, it is a balance between the two. Our European business is bigger as a percentage. So, that is also a factor in that.

Kevin Royal

Next question please.

Operator

Thank you. That will come from Richard Sherman with MKM Partners.

Richard Sherman – MKM Partners

Hi, good afternoon guys. A couple of questions here. First maybe on the government side, when we talk about how a government business has been trending and what factors of government are you seeing the most amount of business in?

Brian NeSmith

So, the government business in general on a quarter-by-quarter basis is very seasonal. So, there is very much volume patterns related to the fiscal year of the government and it goes up or down. Also, a fair amount of more larger deal opportunities would also (inaudible) to make it more bouncy. In general, it has been fairly solid this last quarter, I would say it was down a bit, actually down probably quite a bit in general from what it was in previous quarters. And it has been I would say probably more heavily weighted towards military and intelligence than it is civilian sector side of things. So it is probably more heavily weighted in that direction.

Richard Sherman – MKM Partners

Good. And then it looks like the expense controls were pretty tight here coming out of a fairly complicated acquisition. As you look ahead then on the revenue side, in the longer range plans you already mentioned you have some integration initially at least at the console level between the two products, what are you telling the channel and your channel partners about next level of integration and timing for that, and if you could share some of that with us?

Brian NeSmith

So, we – the first thing we wanted to do is get our sales integration organized and have it working as a single organization. In this coming quarter, we are looking to make a lot of progress in the integration of our all our back end systems and try to consolidate into the a single set of systems and infrastructure and process. And then there is a stage series of production integration steps, one that we have already completed, some more that will happen this fall and continuing through calendar year 2009. So, all those things are occurring in those different steps. We have actually as part of our 55 city road tour did a lot of work in educating the channel and make them aware of how those transitions were going to take place. For the most of the channel partners the next 3 months will be the majority of the work for them in making the transition and there is actually some work for some Blue Coat partners as well as we combine into a single integrated channel program going forward.

Richard Sherman – MKM Partners

Okay, and then maybe exiting calendar year ’09, what would the product portfolio look like with the PacketShaper product. Will you continue to sell it as a standalone or it would be a module on the SG product, how does that look and what is your thoughts about sort of that go to market with the technology in the medium to longer term?

Brian NeSmith

When you look at PacketShaper, we definitely see lots of opportunity for that product and we are going to continue to sell that not only for 2009 but I think even into 2010 as we look out to the future. We are continuing to make enhancements to the product. So, we view it as an area that would investment we can sustain that revenue for a very long time. Selective aspects of what PacketShaper does around application classifications specifically and probably from a priority standpoint is the area that we want to integrate into ProxySG first and then we will get into some of the more some of the pioneering QoS and other capabilities that will be more of a more of a secondary integration activity, but PacketShaper, we are going to be selling PacketShapers for a very long time. The customers that have purchased them prior to Blue Coat acquiring Packeteer and that have purchased them after Blue Coat has acquired Packeteer, you know, we have mapped out 4 development plans for them and really given them I think a clear path for that products as we go in the future as well as how the two are going to combine.

Richard Sherman – MKM Partners

Okay, thanks for taking my questions.

Operator

Thank you. We will go next to Scott Zeller with Needham & Company.

Scott Zeller – Needham & Company

Thank you. The first question is on the sales force. You had some commentary and comments earlier about cross training of the sales force and you did say they were combined. I just want to be clear that there is a single sales force and you are not operating two different parallel sales forces now.

Kevin Royal

That is correct. There is one sales force, one geography coverage structure; both former Blue Coat and former Packeteer sales reps and SEs [ph] are selling all the combined products. So it is a single sales organization.

Scott Zeller – Needham & Company

Okay, and then next on the guidance. It actually looks pretty good except that I was expecting more of a “cross-selling”, because when you look at with some client when you guided for each side of the business, Blue Coat versus Packeteer it actually looks pretty close to what that was before on an organic basis for each company and I was wondering when we would start seeing more of the “cross-selling” revenue?

Kevin Royal

Part of what you are going to see here is that in a confusion of an acquisition is everybody pauses a bit. We are still investing a fair amount of energy in both of the sales organizations ramping up and the full understanding of the products. So, we have completed the cross training, but I think it would be – it will be an overstatement to say that every person in the organization is equally competent in selling both sets of products. So, I expect this quarter to be fair amount of learning still going on in some of the detailed areas. So, as we look out to Q3 and Q4 as reps and sales engineers get more comfortable with both sides of the technology, I think we will continue to see some of the efficiencies and some of the leverage of the combined organizations.

Scott Zeller – Needham & Company

So, it sounds like cross selling beginning in the second half of the fiscal year?

Kevin Royal

It is already starting right now. It is just that you get the benefit of cross selling but you know, you lose some in the sense there is still a learning curve that the sales organization is going through and the two somewhat cancel each other out this quarter.

Scott Zeller – Needham & Company

Okay, thank you.

Operator

Thank you. Our next question is from Alex Kurtz with Merriman Curhan Ford. Please go ahead.

Alex Kurtz – Merriman Curhan Ford

Thank you. Just as a follow up question about the core Blue Coat product and the sequential decline from Q4, was that – were there some seasonal factors there or there is some push out by some existing Blue Coat customers that were just taking a look at what was out of the Packeteer acquisition. Can you just like bit more color on that?

Kevin Royal

You know my sense of is right now I don’t have an analytical view of this, but my sense of it isn’t talking to the sales management as well as some part of the sales channel. You know, the Packeteer acquisition was a – although I think going to be worth a lot with a large distraction and a big investment. The sales management had the combined two organizations redivide geographies, go though the cross-training process and help ramp – I think we fell a little bit shy of what we have originally forecasted in our own product revenue from a guidance standpoint, but not I think in a huge way and as we go forward I think that as we get some of these integration tasks behind us we will get – we don’t lose some of that effort from just from an efficiency standpoint. So, I would put probably more of that on the rapid pace that we have been trying to integrate the two organizations to cause a bit of extra problem. No, I don’t think there is much around the seasonality.

Alex Kurtz – Merriman Curhan Ford

And as far as that internal sales force manager, you feel like you in your next quarter you will be through that integration and feel like everyone is clicking on all cylinders going into Q3.

Kevin Royal

That I think yes. I think it mostly we are going to see ourselves there. I am sure we are going to have a few selective cases where that it not true but we are rapidly moving up the learning curve both as an organization and the individuals. We have done a lot of things to try to facilitate that process with the training, online and in person. We have also in some cases combined Blue Coat sales reps with Packeteer SEs and Packeteer sales reps with Blue Coat SEs to get cross training. So as those – all part of those things start to fully match and operate I think we will start to see some of the benefit of that company combined. But like you said, we will still be learning a fair amount this quarter and hopefully in Q3 we will look to get more of that leverage.

Alex Kurtz – Merriman Curhan Ford

Okay, and one last question for your Brian, it is pretty well known that some of your competitors have been calling into the Packeteer partner and customer base, I just want to get a little color from you about what you are doing to defend against that and sort of what your internal approach towards sort of external efforts to pluck some of those customers and partners?

Brian NeSmith

Pretty much what you would expect. You have lot of education to help those partners – the partners understand there is specific ways that partners can get capture more margin by combining the sales of 2 products and getting a leverage and benefit of that and we have been showing a number of those sorts of things. And the other things is well as that we – we actually took both the Packeteer partner program and the Blue Coat partner program and combined I really think the best features of both and have been rolling out a new channel program across both of those organizations. But all that aside partners tend to go where the money flows and I think what we provided for them is better ways for them to earn more operating margin and more operating revenue and those are the sorts of things that they keep partners loyal and invest in what you are doing as an organization.

Alex Kurtz – Merriman Curhan Ford

Okay, thanks Brian and one question for you Kevin, can you just give us a feel for gross margin on the product and services side, obviously you are going to have full quarter of Packeteer on the product and services side in October. I was modeling some sequential decline because you are going to incorporate a full quarter there of margin levels, can you give us a better feel on that and thanks a lot?

Kevin Royal

Just to give you an idea, for planning purposes for the second quarter we are reflecting a bit of a decline due to little bit higher service cost. So, we are modeling about 75.5%, but then we would expect gross profit to increase for the remainder of the year back up to the level of about 76%.

Alex Kurtz – Merriman Curhan Ford

Okay, thank you very much.

Operator

Thank you. Our next question is from Rohit Chopra with Wedbush. Please go ahead.

Rohit Chopra – Wedbush

Hi, guys. Just a couple of questions here. One just going back to that gross margin question. Are there price increases involved and also improving the gross margin line I think there was some talk about passing through some price increases for the Packeteer product?

Kevin Royal

There is nothing right now that we model for doing that. That maybe a possibility as we go forward in the future, but there is no specific plan or time frames for doing that.

Rohit Chopra – Wedbush

And then I just want to get a sense on new products on the core business, are there any new product scheduled over the next couple of quarters or have you some software upgrades that are coming through on the SG product?

Kevin Royal

Nothing that I can talk about from an announcement standpoint, might be (inaudible) marketing sitting next to me throwing some elbows so I can’t pre announce anything.

Rohit Chopra – Wedbush

All right. And one – just ask this one quick follow-up, last quarter you gave a little bit more color on some of the verticals out there and maybe if you could talk a little bit about that and also some maybe some slipped [ph] deals that are being closed or something like that if you can give us a sense of what you are doing here or what you are seeing out there?

Kevin Royal

Probably the only thing from a color standpoint I think is relevant, as we have just seen the federal sector was a bit down from what it was previously. I think that in general any deals north of $0.5 million takes longer. It is – we have definitely seen a pattern that if you get up into anything that is a larger deal size it seems to go through either an extra loop of signatures or just seems to take a bit longer to actually get to close. So, we have continued to see the pipeline grow and do very nicely. It is the close rate especially in the larger deals that continues to be a challenge.

Operator

Thank you. We will go to Daniel Ives with Friedman, Billings. Please go ahead.

Michael Bowen – Friedman, Billings

Hi, guys. This is actually Michael Bowen for Daniel. Just a follow-up question on the large deals, the closure rate has not improved or has been pretty much steady, I mean, the same?

Kevin Royal

I think for the last couple of quarters it has stayed about the same.

Michael Bowen – Friedman, Billings

Okay, and then – and finally just on operating margin, what type of ramp can we see going over the course of FY09, I know you gave the color for 17% to 18% for the fourth quarter but any additional color on what potential ramp you can see with that? Thanks.

Kevin Royal

I think as it relates to (inaudible) we really only provide full guidance for the current quarter, which is the second quarter. We have, however, expanded that because of the acquisition and the target for the fourth quarter is 17% to 18%, but we haven’t given any guidance and don’t intend to give any guidance on the ramp to that 17% to 18% target.

Michael Bowen – Friedman, Billings

Great, thanks a lot.

Operator

Thank you. Our next question is from Samuel Wilson with JMP Securities.