Check Point Software Technologies Ltd (CHKP) 2006 Q2 法說會逐字稿

At this time I would like to welcome everyone to the Check Point Software Technologies second quarter 2006 earnings conference call. [OPERATOR INSTRUCTIONS] Thank you.

It is now my pleasure to turn the floor over to your host, Ms. Ann Marie McCauley.

Ma'am, you may begin your conference.

Thank you.

Good afternoon and evening.

I'm Ann Marie McCauley, Director of Investor Relations for Check Point.

Thank you for joining us to discuss the second quarter 2006 results.

As a reminder this call is being webcast live from our website and is being recorded.

To access the live webcast and replay information, please visit the Company's website at checkpoint.com/ir.

The replay will be available through August 1.

If you would like to reach us after the call, please contact the Investor Relations department at, 650-628-2050.

On the call with me today is Gil Shwed, Chairman and CEO;

Jerry Ungerman, Vice Chairman; and Eyal Desheh, Executive Vice President and CFO.

Before we start our management presentation I would like to make the following disclaimer.

During the course of the call the Company will make certain forward-looking statements.

Forward-looking statements include statements pertaining to Check Point's expectations and beliefs regarding operating results for the third quarter of 2006 and for the full year 2006.

The competitive position of Check Point's products trend toward technology consolidation, initiatives for sales of expanded solutions, delivery of product introductions, enhancements, and product acceptance, impact of new products on ASPs, and benefits and plans for customer and partner events.

Other statements which may be made in response to questions which refer to our beliefs, plans, expectations, or intentions are also forward-looking statements for purposes of the Safe Harbor provided by the Securities Litigation Reform Act.

Because these statements pertain to future events they are subject to various risks and uncertainties and actual results could differ materially from Check Point's current expectations and beliefs.

Factors that could cause or contribute to such differences include, but are not limited to the impact on revenues of general market conditions in the Company's industry, the mix of sales of new products and long-term subscriptions, economic and political uncertainties, the impact of political change and weaknesses in various regions of the world including the further escalation of hostilities or acts of terrorism in Israel, the inclusion of network security functionality in third party hardware or system software, any foreseen and unforeseen developmental or technological difficulties with regard to Check Point's products, changes in the competitive landscape including new competitors or the impact of competitive pricing and products, rapid technological advances and changes in customer requirements to which Check Point is unable to respond expeditiously, if at all, a shift in demand for products such as Check Point's, factors affecting third parties with which Check Point has formed business alliances, timely availability, features, performance, and customer acceptance of Check Point's new and existing products, the amount of equity-based compensation charges, the ability to recognize deferred revenues and other factors and risks discussed in Check Point's annual report on Form 20-F for the year ended December 31, 2005, which is on file with the Securities and Exchange Commission.

Check Point assumes no obligation to update information concerning its expectations.

Now let me turn the call over to Eyal Desheh for financial review.

Thank you very much, Ann Marie.

Good afternoon.

Good evening, everyone.

Let me share with you the results of the quarter and provide some more detail on the financials.

Our second quarter of 2006 results were in line with our projection and reflected an encouraging sequential growth in total revenues and in license revenues.

We saw the beginning of a smooth transition to our new perimeter security product line and nice traction given that these solutions were just introduced this quarter.

We also experienced continued adoption of our emerging product which contributed just over 30% of product revenues with strength in high-end products, NGX, and VSX, in VPN-1 Edge, our branch office appliances, and Connectra, our web security solution.

We also experienced continued success of our Smart defense program.

As a reminder, our quarterly results for 2006 include the impact of the -- of SFAS 123R, which is the inclusion of equity compensation expenses in the P&L.

It is in our GAAP financial results.

In our press release, which has been posted on our website at www.checkpoint.com, we are presenting GAAP and non-GAAP results and reconciliation tables which highlights this data.

Now let me share with you the financial details for the second quarter of 2006.

Revenues for the second quarter were $139 million compared to 134 million in Q1 this year and 145 million in the second quarter of 2005.

GAAP net income for the second quarter of 2006 was $66 million, compared with 62 million in Q1.

Equity-based compensation expenses accounted for $9.3 million in this quarter.

Non-GAAP net income excluding acquisition related and equity based compensation charges was $76 million this quarter compared to 75 million last quarter and $80 million in the second quarter of 2005.

GAAP earning per diluted share for the second quarter of 2006 were $0.27.

This compares to $0.25 last quarter and $0.31 last year.

But last year we did not include equity-based compensation in our expenses.

Had we done that, earning per share results for Q2 this year and last year would be the same.

And finally, non-GAAP earnings per share excluding acquisition related and equity based compensation charges was $0.32 compared to $0.31 last quarter and the same when compared to $0.32 in the second quarter of 2005.

Deferred revenue this quarter were $176.5 million, an increase of 22 million, or 14% over Q2 2005.

We did increase our operating expenses this quarter.

Total operating expenses were $75 million.

Excluding equity-based compensation and acquisition-related charges of $11 million, operating expenses were 64 million.

This compares to $59 million in Q1 this year and $61 million in Q2 last year.

The increase is a result of growth in headcount mostly in sales and technical services, bringing our total headcount close to 1500.

Total operating income was $64 million.

Excluding equity-based compensation and acquisition-related charges of 11 million, operating income was $75 million.

Similar to last quarter and compared to $83 million in the second quarter of 2005.

Our effective income tax rate was stable at approximately 18%.

For the second quarter our day sales outstanding, DSO, were 55 days.

This compares to 61 days in the first quarter of this year.

We saw similar trends in the timing of orders in the quarter as we have seen for the past few quarter as the business continues to be more back end loaded.

Roughly half of our business occurs in the last month of the quarter.

Cash collection and cash flow continued to be strong.

We generated strong cash flow from operating activities of $87 million, compared to $85 million for the same period last year.

Our cash and investment balance at the end of the quarter was 1.730 billion.

During the second quarter we purchased approximately 7.4 million shares for a total cost of roughly $138 million, as part of our expanded share repurchase program.

A portion of these shares were purchased under a 10b5 program which was introduced in June 2006.

Our second quarter revenues again were well diversified with Americas leading the way contributing 47% of revenues.

EMEA contributed 40%, and the Asia Pacific and Japan region contributed 13% to our revenues this quarter.

In the second quarter, our large orders which are greater than $50,000 accounted for roughly 28% of total orders.

We also had seven deals greater than $1 million this quarter.

We continued to grow our installed base bringing the total to over 500,000 security gateways.

In summary, we're pleased with the financial results we've posted this quarter.

Our market environment has not changed dramatically from Q1 which means that it remains challenging.

While we believe that our performance and execution has improved.

And we head into the second half of the year with a robust product portfolio.

I will now let Jerry and Gil speak more about our business and our plans.

Jerry, please go ahead.

Thank you, Eyal, and hello, everyone.

I appreciate your taking your time to be on the call with us today.

I would like to focus my comments on what we're doing relative to improving our execution as we discussed during our last call.

Hopefully, this will provide some insight into our actions and activities we initiated this past quarter that will impact our performance going forward.

As I mentioned, our focus has been and continues to be on execution.

As you have heard us mention many times, our strategy revolves around providing our customers a unified security architecture enabling them to manage from a single console a wide range of integrated security solutions that share the same code base, can be updated dynamically, and be deployed across multiple layers of in network architecture.

We believe we are the only vendor with a fully integrated set of solutions to meet the broad security needs of our customers.

While we continue to extend our strategy, which we did with the latest product realignment that we announced this past quarter, we have also focused on the need to execute on our total business objectives and capabilities.

During our first quarter earnings call, I mentioned we had a number of new initiatives we were working on that would make it easier and more cost effective for our customers to buy our expanded solution set sooner rather than later.

So let me recap what we have accomplished in the second quarter in the area of packaging, positioning, pricing, and promotions.

During the second quarter we again introduced new products and technologies across the various security segments we address through our expanding portfolio of security solutions.

We have done this based on what we have heard from our partners and customers, telling us what they need to better secure their network.

The input I get during my travels and subsequent conversations with the partners and customers is that they want to minimize the number of vendors they use, but they don't want to have to compromise their security.

This is what we have done this quarter.

We announced first VPN-1 power which features integrated firewall, VPN, and intrusion prevention along with our patented SecureXL acceleration technologies for enterprises with demanding performance requirements.

Second, VPN-1 UTM, our new unified threat management product which combines firewall, VPN, intrusion prevention, antivirus, and more in a fully integrated, easy to manage solution.

And VPN-1 Power UTM which combines the full integration of the new UTM version and the performance of the Power version.

We also announced a new version of our NGX platform which integrates end point security with perimeter internal and web security through our unified security management console and introduces centralized real-time updates of all Check Point security products to guard against the latest security threats and vulnerabilities.

And finally, we announced ZoneAlarm Internet Security Suite 6.5, a new solution which defends consumers against identity theft and advances spyware prevention.

All this comes with new price points and expands the markets we serve and improves our competitive position for customers looking for high performance and integrated solution, or both.

Generally speaking, most of our solutions are now packaged to include more capability at a lower overall package price, effectively increasing the value customers receive.

As a result, we anticipate these changes will result in an increase to overall ASPs while making our solutions more competitively positioned in the market.

During Q2 we also held our annual partner and customer events.

Check Point Experience in both Europe and the United States with almost 2,000 attendees.

The focus of the events was to train the attendees on our new offerings and to receive feedback regarding additional needs or requirements they have that we can address with new versions currently under development.

I believe both events were very successful and of mutual benefit.

This quarter we will be doing the same with our Asia Pacific regions.

In addition to bringing new solutions to market and holding our major partner and customer events during the quarter, we also continued to work on the restructuring of our field organization.

I have previously mentioned that last year we restructured our operations in Asia and have seen a positive upturn in business the past two quarters.

We also have communicated that we would be doing the same in Japan and that process has resulted in a new country manager joining us on August 1.

And just two weeks ago we created a new executive position responsible for both sales and service globally.

The person we selected to run this field operations organization, which combines sales, service, and sales operations into one team is [Amnon Barlett].

Amnon has been with us for almost a year now and has been managing our worldwide technical services group.

In addition, earlier this year he picked up responsibility for managing our international operations group.

He brings a very strong and impressive background to the position.

He was a founder and CEO of a very successful systems integrator for over eight years, so he understands the market, security, and the channels.

This combination of knowing the needs of the customer, understanding the channel and its motivation in business are important and of value to our execution efforts.

In summary we have taken a number of steps this quarter to improve our ability to execute against our business objectives.

We have done this by addressing the positioning, packaging, pricing, and promotions of our products.

By communicating with our partners and customers, and by restructuring our field organization.

And we will continue to do so, as these are steps in a process and not one-time events.

We need to continually focus on our solution set to ensure it is in in line with the needs and requirements of our customers which is why we will continue to hold events around the globe that allow us to get feedback.

And we will continue to focus on the organizational structure we have in place and take steps to improve our ability to execute effectively.

Thank you again for being on the call with us today.

Now let me turn the call over to Gil for additional comments and insights.

Thank you, Jerry, and good afternoon, everyone.

Our second quarter business reflected many of the trends we've seen over the past couple of quarters where our market environment continues to be challenging and business is more back end loaded than it was a couple of years ago, we're pleased with the sequential increase in many of our key financial metrics this quarter over the first quarter and enthusiastic about the product and organizational initiative that Jerry just mentioned.

We attribute some of the trends we are seeing in the macro security environment to what we have dubbed security sprawl.

The security market today is awash with solutions that address security threats and vulnerabilities either on a reactive basis or for a string of point product offerings.

While the volume of disparate security solutions in the market today can lead to confusion we believe it will drive technology consolidation as customers recognize the value of having an integrated, comprehensive set of security solutions.

With our unified security architecture, we believe we are well positioned to help customers proactively address the rapidly changing security threat environment.

During the second quarter we extended the next phase of our strategy with our latest version of the NGX platform and the consolidation of many products in our VPN-1 Power and UTM product line.

So while many companies continue to provide their multipoint product, our strategic direction we focus on innovation and creating a unified security architecture to address the markets evolving security needs.

Now let me share with you our thoughts on financial targets for the third quarter and the full year of 2006.

We expect Q3 revenues to be in the range of 135 to $144 million.

GAAP-based EPS in the range of $0.27 to $0.30 per share, and non-GAAP EPS excluding the effects of stock based compensation and acquisition related charges to be in the range of $0.31 to $0.34

For the full year 2006 revenues are expected to be in the range of 570 to $600 million, GAAP EPS in the range of $1.12 to $1.20, and non-GAAP EPS, excluding the effect of stock based compensation and acquisition related charges, to be in the range of $1.33 to $1.40.

In summary we've executed on a number of strategic initiatives round our security solution and improved our operation during the quarter.

We believe that with that should have positive impact on our business performance going forward.

With that I would like to open the call for your questions.

Thank you very much.

Thank you. [OPERATOR INSTRUCTIONS] Your first question is coming from Robert Breza of RBC Capital Markets.

Please go ahead.

Hi.

Good afternoon.

One quickly, talking about the operating expenses, you did increase operating expenses this quarter.

Clearly the partner events played a part in that.

How should we think about it as a base line going forward as you continue to evolve the pricing and packaging of the new products?

Our pricing expects -- I think the level of operating expenses that we have this quarter is a good basis for the future.

There will be some activities that won't take place in the first quarter.

At the same time, we are investing a lot in adding people and having the right infrastructure, especially around the sales force, hiring many people and so on.

So that will have some impact moving forward.

The pricing, the packaging that we have should have right now a small impact on expenses.

They will have pricing, will have hopefully effect on their revenue lines.

Gil, as you look at the investments you're making in sales and marketing, when do we see the kind of inflection point, and should we think about that more on the core product side or more on the emerging side?

I think the investments that we're doing is on both sides and our sales force use single serve for all our product, so it shouldn't have much.

Usually when you hire a sales person you should expect results in roughly six months, but that also depends on the market conditions and many, many other things.

We do believe it develops potentially in the marketplace and that's why we are accelerating the hiring of salespeople.

We actually for the first time that I can remember, we are ahead of our hiring plan for sales people, and I think that says something about our belief in the market opportunity and the fact that we want to capture as big a portion as we can out of that.

One last housekeeping item.

Eyal, the 38 million in expenditures on the cash flow statement, what was that for?

For the buildings.

Okay.

Thank you.

In Tel Aviv, our new headquarters.

Thank you.

You're welcome.

Your next question is coming from Dino Diana of UBS.

Please go ahead.

Thank you.

You can tally your product line into two primary lines.

Can you give us some early color on what you've noticed so far from this move, given that they group together, can you just give us first VPN-1 UTM and then VPN-1 Power?

I think overall we got very positive acceptance and very positive feedback from our customers and channel partners.

They found the new product lines to be a very competitive, address really the market segments which we're trying to address, be relatively easy to sell because it's becoming simpler, and I think we consolidated five to seven different product life under these two brands, the VPN-1 Power and VPN-1 UTM.

So overall some of the pricing has stayed and is becoming more and more competitive.

So generally the feedback and the acceptance that we got so far is very, very positive.

Okay.

And we're still seeing kind of double-digit growth in deferred revenue.

I've noticed the second quarter where subscription revenue is kind of in the high single digits, 7, 8%.

Can you talk about what the dynamic is over there?

Well, first, let's not for get that our deferred revenue increased by $10 million, which is a very large number, in Q1.

So we do have to look at this as an anecdote for perspective.

It grew 14% year -over-year, $22 million.

The majority of the deferred or our EBS, our subscription and technical services contracts have very little of product that we need to defer for accounting reason, but the majority of the mix has not changed.

And what we see is that our customers are synchronizing and combining all their EBS into a single, annual renewal date which is good.

It's easier to control.

It's better and more efficient for us in terms of having them renew it.

Most of these contracts are shifting towards either Q4 or Q1 or around year end.

Some closing in December, some in January and that's where you see big increases in the deferred revenues in both Q4 and Q 1.

Yes.

December 31, and January 1, are target dates for a lot of companies but we do have, as you can see, we do have also pretty nice numbers that are renewed in Q2 and Q3 and of course we continue to sell the solution together with new product that we're selling.

That happens all the time.

Okay, thanks.

Thank you.

Your next question is coming from Ed Maguire of Merrill Lynch.

Please go ahead.

Yes.

Good afternoon.

Could you talk about any regional differences particularly in Europe of what you're seeing on the ground there in terms of the spending environment?

Yes.

We saw strength in Asia again, we saw strength in the United States, and I think it's a little bit softer in Europe right now.

The only thing -- it's not meant to be facetious, but I saw it one time before is what's the impact of the World Cup with the activity in Europe?

It does have an impact on business which is interesting.

I think overall the market is just a little bit softer in Europe right now than it is in the other parts although we still struggle with Japan which hopefully, with our change there on August 1, that would help us revitalize that business unit I hope that explains it.

Okay.

And just moving on to product mix, could you comment a bit on the -- what you are seeing on the consumer market?

Are you happy with what you see in terms of the zone labs product?

We are very happy with the climate we have.

We are receiving excellent reviews.

We also continue to produce good results on the consumer, and this is one opportunity that we have which we are -- which is much bigger than where we are today and we can grow it, and we're looking forward to continue to do that.

Thanks very much.

You're welcome.

Thanks, Ed.

Thank you.

Your next question is coming from Phil Winslow of Credit Suisse.

Hi, guys, just wanted to dig in just a little bit further on the deferred revenue line.

Eyal, just wondering if you can give us a sense for what your expectations would be for the back half as far as deferred revenue growth?

Should we think of it as being sequentially up as well in the September quarter?

Yes, I think that we -- if you look at our records for the past few years, September quarter is always -- somewhat down on deferred revenues and we make it up and more than that in the fourth quarter.

I don't expect this to be any different this year.

Have you seen any changes just when you guys go out, renewing subscriptions to the pricing environment on that maintenance side?

Or has it remained pretty stable?

I think it has remained pretty stable.

Large customers with large contracts always want to get better price and that's not something surprising.

We did raise the price of our subscription this year for the first time and the general acceptance of of [Inaudible] and we're also coming up with new subscription programs that add more value, buying more support services and others which we continue to sell very well.

You can see with the support line that we have been growing in the faster way, if it's bowed together with a subscription, but that's something that is getting more acceptance.

So we kind of balance those two trends and so far it's done -- again, it's very hard to judge it in a single quarter because we are talking to you about the year-long contract, but so far the acceptance seems relatively positive and as you can see for the last few quarters and even few years we consistently keep growing the subscription element of our business.

Then just one last question, just, Eyal what are you using for share count for Q3?

For what?

Share count.

Share count.

We continue to buy shares.

And as you've seen, we've bought this quarter more shares than in any other single quarter in the past, and we plan to continue to do that.

I don't think that I can really accurately forecast a number.

There are a lot of parameters.

It is influenced by the stock price, as you know, and I'm not going to even try to forecast it.

But anywhere between 235 to 240 million shares would be a good number.

Your next question is coming from Georgy Grigoriyants of Thomas Weisel Partners.

Couple of questions.

First of all, on pricing, what do you see?

It seems like as pricing pressure increases in some of the segments like UTM appliances, for instance, I've been picking up, can you give us any color what you see in terms of pricing pressure?

Is it increased or stable?

I don't see a big pricing pressure.

What I do see is a very competitive market.

That's two different things.

And I think what we are focusing on is improving our position about that and improving our position about what is not necessarily by the way reducing prices.

In many cases it's offering more price points so we can compete in more and more segments.

I think just generally been the situation for long time.

We are in a competitive market.

Customers do want the right value, but customers are also very much willing to pay, and if I try to summarize what we are seeing is in the low price points, the pressure -- or not the pressure, the competition is a little bit tougher.

On the high price point that we have, customers are fully willing to pay for getting the full value of what we offer.

Again, the way we address it is having more price points on the lower part of the scale.

You made a comment you're increasing the sales and R&D headcount.

Can you give us any numbers around that?

What does that mean?

You can see the overall headcount in the sales I don't know how much we increased the sales headcount this quarter.

By about 30 sales people.

Net additional 30 positions.

And R&D?

R&D hasn't grown in a huge way this quarter I think it's grown only a little bit this quarter, and it's about -- year-over-year it's 10, 15 people more this year compared to last year.

Gil, on the share buyback, have you guys considered at all just stepping in, in a major way, and maybe making a tender offer and buying a lot of shares back, or has that been the subject of discussion at all?

Well, first of all, I think we stepped up our program substantially and last quarter when the Board approved a $600 million program.

As you can see we continue -- we began to execute this very quickly.

We added a 10b5 program also that we buy throughout the quarter using that, and all the other options are open so let's not make any statement now, only that we have accelerated the share buyback and we will continue to buy at least similar quantities in Q3.

The last quick question, how many gateways you guys ship this quarter?

23,000.

23,000, and that's a record number for--.

The last two or three years.

The longest we have on our sheets.

Thank you.

Thank you.

Your next question is coming from Horacio Zambrano of Wedbush.

Please go ahead.

Thank you.

Just a question on the geopolitical environment.

Obviously with the attacks going on in your part of the world in Israel, what do you guys -- in terms of your shipping or use of force, are you concerned about how far this could escalate and what sort of issues could happen -- could disrupt business in your mind if this were to escalate any further?

Well, we clearly hope the political environment settles down and we get more peace.

So far we haven't seen any effect of the situation on our operation.

As you know, Eyal and I live in Israel.

We've been there two days ago.

Our colleagues and families are there.

Life is very usual where we live.

Jerry has been to Tel Aviv actually last week, as well as the rest of the management.

They can testify about that.

Let's remember that most of the Check Point business activity, sales, marketing, support, are done outside of Israel, 98% of our sales in this kind of business activities are out of the region.

But we feel pretty well about the way we operate the business and this kind of thing.

Just a real quick question between license and subscription.

As I look at the first half of the year, sort of down double -- in the mid-teens on the license line, but up in the higher single digits.

Do you expect -- how does that shift for the second half of the year?

Do you expect further growth year-over-year on subscriptions to sort of maintain itself and the license growth to sort of continue on in the current trend line?

We expect to grow both.

But if you look at our guidance and see, we have saw improvement in our license revenues in Q2 compared to Q1, as we said.

We believe that some of it has to do with the new product, but not a lot as we only introduced them.

We expect this to be a more dominant factor in the second half of the year, and we hope to sell more licenses.

At the same time, grow our subscription, add more new subscription, new programs, and new combined services and subscription programs that we believe and we hope that will be more meaningful in the second half of the year.

So we believe that both will grow.

We have to remember that the revenue line that we are reporting on the subscription, most of it is created in earlier quarters, because we -- this is something that we recognize over the lifetime of the program.

So since we are increasing our booking of EPS and subscription and support almost every quarter from one to another, then this is expected to grow during the second half of the year.

These numbers are already in.

Most of them are already in.

Thanks.

Thank you.

Your next question is coming from Michael Turits of Prudential.

Please go ahead.

Hi, guys.

Good evening.

You did bring down both revenue and EPS guidance relative to what you were guiding to last quarter.

So what -- you said that the environment is relatively the same.

What's changed that you trimmed guidance a bit?

I don't know -- I don't remember -- I don't think we gave guidance for Q3 last quarter.

We usually give one quarter--.

I just mean for the full year.

First, for the full year were the changes that we got the results for this quarter and they do narrow the -- they do narrow the guideline moving forward.

We did operate in a challenging environment, and I think we are acknowledging that, and the environment is still challenging.

I think we have high hopes out of the second half of the year and out of 2007, but right now we do have to take into consideration the run rate that we are in and the general seasonality that occurs in Q3.

The DSOs dropped five or six days I think this quarter.

Got a nice contribution to working capital from that reduction.

Is this the right level going forward, or how should we look at DSOs for the rest of the year?

I think it's up generally.

We have range.

I think our DSOs are relatively stable.

Sometimes high DSO means that we got a lot of business at the end of the quarter.

Low DSO might mean that we actually had a lot of collection from the previous quarter.

So I don't think that you can attribute to these numbers.

Last question.

You had two fairly significant executive changes both Kevin Maloney, I believe, left this quarter, and so did Ken Fitzpatrick, so both a sales and a marketing change.

Whatever you can tell us about what precipitated those and what the transition plans are.

I think our policy is never to discuss any personnel or issue.

We treat them s internal and that's why we won't comment except for saying both on Ken and Kevin that they are great guys.

I don't think you'll hear much more from us about that.

About the transition plan, I think Jerry did talk a little bit about the process that we've started long ago which is restructuring of our sales and marketing operation in the sales organization, which is the bigger and the very important organization that we have, we've created the worldwide field operations and we've nominated the [Inaudible] has been with us for about a year, to head that organization.

I think it's going to have a good impact on our ability to drive more programs, more changes, and better organization.

For the marketing department, Jerry's acting as the head of marketing.

And he has done this for many, many years so he's very well valued and has a great contribution to the activities in marketing and provides now a lot of energy to the marketing staff and we are looking for a new VP of marketing.

Thanks, Gil.

You're welcome.

Thank you.

Your next question is coming from Ehud Eisenstein of Oscar Gruss.

Please go ahead.

Hi, and congrats on a nice buyback in the quarter.

Can you just give us some color on the slight decline in the gross margin, is this part of the new four P's initiative?

No, I think that the gross margin again is not a target on its own.

We are -- we do have one of the highest operating and I think gross margins in technology sector, and we'll -- hopefully will keep doing that.

I think the main change in margin this quarter is the fact that we invested in the business, we hired more people, and that hopefully will have a good effect moving forward on growing revenue.

Most of the cost in our cost of sales that impact the gross margin is the cost of technical services.

We mentioned at beginning, we added people in the technical services group, and this is a majority of the increase that you see over there.

And you also can see actually on the perspective, we did grow our services business nicely from a year ago, and we've deferred revenue.

It will even grow further moving forward.

So we are setting up the right staff levels to continue and drive the support and service programs to our customers.

Very good.

Thank you so much.

Thank you.

Your next question is coming from Sean Jackson of Avondale Partners.

Please go ahead.

Yes, just wanted to drill down a little on Europe again.

Was the weakness that you said, was it a function of deals that didn't close at the end of June, or did you see a -- just a weakness in your pipeline overall?

Just to remind everyone on the line that we did grow our revenues in Europe from Q1 to Q2.

So the direction is in the right direction.

We had I think a 2 or $3 million increase in revenue, so that's a positive.

Europe is kind of a little sleepy towards the summer months.

The World Cup in Germany probably added to that a little bit.

There are always some deals that slip from one quarter to another, and that will continue to happen.

It's part of our business.

But I think if there's anything significant that we can point out and say, hey, this is not functioning very well.

It is functioning, and we believe that we'll see that and get it on track.

I think there's a lot of companies that seem to see the same environment in Europe.

It's not bad.

Okay.

And just on your emerging products, if you had to pinpoint one or two that you felt was exceeding expectations which ones would those be?

Probably the web security, the Connectra product line, it's been working pretty well, the branch office gateways are doing very well, the VPN-1 Edge family is doing very well, just to name two out of the entire spectrum.

Thank you.

Thank you, Sean.

Thank you.

Your next question is coming from Shaul Eyal of CIBC World Markets.

Please go ahead.

Thank you.

Hi, good afternoon.

Just one quick question from me.

What's the current status with the Source Fire even though the acquisition was rejected a few months ago?

What has been the level of work for this in the past couple of months?

We are evaluating different options in that space of adding signature based technology for our IPS capabilities and our products in general.

Source Fire remains a candidate, we also have additional candidates for different levels of technology partnerships.

Okay.

Thank you very much.

You're welcome, Shaul.

Thank you.

Your next question is coming from Sarah Friar of Goldman Sachs.

Good afternoon, guys.

Actually I want to follow-up a little bit on Michael's question around guidance.

Although you did drop it for the year if I just take the midpoint you're still showing a pretty sharp hockey stick in the fourth quarter, I think it comes out around 170 million for the fourth quarter which is about 11% year-over-year growth.

As you look at your pipeline, do you see the pipeline shaping up that way where there's definitely a very back end loaded nature to the year?

And the confidence level, as you think to the fourth quarter, has that increased because there's naturally more renewals and more maintenance that comes in in that quarter, that we should be able to feel more confidence, even though that is a hockey stick for fourth quarter revenue?

The short answer to what you said is, yes.

The bigger answer is, it's always hard to predict the future and it's always hard to predict the market trend.

But we do have a healthy pipeline.

We did see in the past year and every quarter that business is becoming more back end loaded, and those levels of revenues and business are not unreasonable given what we've seen in the past year, and again, to ventilate the regular caveat that predicting the future is always a risky thing.

Sure.

Totally understand.

Then just in terms of driving new product sales, you talked a little about some of the products you're excited about, Connectra, the branch office gateways, and so on.

Are you making any changes in how you go to market with your channel or your direct sales force in terms of really trying to drive new product sales over just renewals and maintenance?

In terms of driving new product sales, yes, we are making many programs and many things.

You can actually see that it's even working.

We have grown this quarter our new license revenues.

We've grown -- We have implemented many programs internally to drive it, and actually they're working pretty well.

Our field organization has met some of our corporate targets for a new business, so I think we are -- we're pretty happy about that change.

It still depends a lot on the conditions in the general market and not just our execution, but at least from an execution standpoint and sales execution we've made the right incentives, we've built a new sales plan, we've put separate targets for new business and subscription renewal and I think at least the initial indication that we are getting is that these targets are well understood and are starting to work out.

Is that true -- you talked a loot about it being the internal sales force, but does the channel also have those new incentives in place?

I think the channel wants to grow their business.

The question is how we work with them and how we motivate them.

We all want -- let's be very clear.

We all want to grow the business, both the subscription line and the new business what.

We want to make sure is that we set the right focus to both things and not focus on only one part of it.

Okay.

A very quick question for you.

Could you give us the FAS 123R impact for the third quarter?

The what?

The FAS 123R, your stock option impact for third quarter.

And the guidance.

You gave us GAAP and non-GAAP but can you give us the portion that's--?

I think you heard me say, and it's in the reconciliation table for our press release, that the stock base or the equity base of compensation expense for Q2 were about $9.3 million.

The number for Q3 are similar.

Okay.

More or less the same, give or take $0.5 million.

Perfect.

That's great.

Thank you.

Thank you, Sara.

Thank you.

Your next question is coming from Katherine Egbert of Jefferies.

Please go ahead.

Hi, good afternoon.

Thanks.

So just back to the margin side, your gross margin has been down a little bit, you said because it was the cost of technical services, i.e. hiring.

The pro forma operating margin was also down.

I know you go through this every quarter, but if you don't mind, again, just talk about where that operating margin can go, say by the end of the year?

Well, first, let's all remember, I think we run the highest operating margin in our industry, and we're pretty proud of that.

We're using resources to drive business, and that's the important part of it.

We are hire where we need to hire, we spend on marketing where we believe that his will generate additional business, we create channel programs to incent the channel where we believe that will add more business coming over and revenues.

We've always tried to avoid making long-term predictions on our margin.

They are exceptionally high because of our business model, but margin can also change.

The important thing is revenue growth, net income growth, and earning per share growth, it's all designed to do this.

Maybe a different way to get at this is, you've been making this transition from product sales to subscriptions.

How much more do you think your mix can shift towards subscriptions over time?

I don't know.

It's a good question.

I think we can grow the subscriptions but we also work very hard to grow the new products.

So I don't have any -- the target that I have is to grow both, it's not to grow one at the expense of the other.

By the way, if I can add something to your understanding of our business model, that mix is not a major -- it doesn't have a major impact on our margin.

But how many resources we use to drive the business, I think we have a pretty balanced picture.

Okay.

Thanks, Eyal.

Thanks, Gil.

You're welcome.

Thank you.

Your final question is coming from Gregg Moskowitz of Susquehanna.

Please go ahead.

Thanks and good evening, guys.

Wanted to ask, on Zone Labs, you talked about consumer and the 6.5 security suite product.

How did Zone Labs do in the enterprise and more broadly what are you seeing in the end point protection and policy enforcement market?

I think on the integrity product line on the enterprise line we still see a nice pipeline, we still see a lot of interest, but that's the market, that's very long term in that regard.

I think we are a little bit gaining traction there because we don't have very much competitors that do the kind of capabilities that we have today, but at the same time this market is not producing yet the right level of results that I would expect it to generate.

Okay.

And then I guess just one follow-up, Jerry, just getting back to the challenging market environment, I think last quarter you commented on high interest levels, but a longer than expected cycle for customers, replacing point products with a broader deployment.

Is it more or less a continuation of that, that you're seeing in Q2 or has there been any incremental change one way or another?

It's still the same, this is a longer term positioning.

It was just reinforce being at the partner conference in both Europe, and U.S., we're going to go to Asia in a couple of weeks.

I think they'll hear the same thing there.

They just basically reinforced, or repeated back to me what I had said to you guys just prior to going to the conferences.

So it's a very similar kind of environment that's still unfolding over time.

Thanks very much, guys.

Thank you, Gregg.

Thank you.

I'll now turn the floor over to your host for any closing statements.

All right.

Well, thank you very much, everyone, for your participation.

If you want to speak to management or to Investor Relations following this call please call our Investor Relations department in our Redwood City office at 650-628-2050.

Again, area code 650-628-2050.

We'll be very happy to take your calls.

Both Gil, Jerry, and I are in our Redwood City office right now, so we're here in your time zone and we'll be very happy to talk to you next month -- next quarter.

Thank you very much, everybody.

This concludes today's conference call.

You may now disconnect.