Netscout Systems Inc (NTCT) 2012 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to NetScout's first quarter and fiscal year 2012 operating results conference call. At this time, all participants are in a listen-only mode . Later we will conduct and question and answer. Instructions will be given to you at that time. As a reminder, this conference call is being recorded. With us today is NetScout's President and CEO, Mr. Anil Singhal, he is accompanied by NetScout's Chief Financial Officer, Mr. David Sommers, and Chief Operating Officer, Mr. Michael Szabados, also with Mr. Singhal is the Director of Investor Relations, Ms. Cathy Taylor. At this time, I will turn the call over to Ms. Taylor. Ms. Taylor, please

Thank you and good morning everyone. Welcome to NetScout's first quarter fiscal year 2012 conference call for the period ended June 30th. Before we begin, let me remind you that during the course of this conference call we will be providing you with a discussion of the factors that we currently anticipate may influence our results going forward. These statements include forward-looking statements made pursuant to the Safe Harbor Provisions of Section 21-E of the Securities and Exchange Act of 1934, and other Federal securities laws. These forward-looking statements may involve judgment and individual judgments may vary. Forward-looking statements include expressed or implied statements regarding future economic and market conditions, guidance for fiscal year 2012, acquisition integration success, and new product releases.

It should be clearly understood that the projections on which we base our guidance and other forward-looking statements and our perception of the factors influencing those projections are highly likely to change over time. Although those projections and the factors influencing them will change, we will not necessarily inform you when they do. Our Company policy is to provide guidance only at certain points in the year, such as during the quarterly earnings calls. We do not plan to update that guidance otherwise. Actual results may differ materially and no one should assume later in the quarter that the comments we make today are still valid.

For a further discussion of risks and uncertainties that could cause our actual results to differ, see the specific risks and uncertainties discussed in NetScout's Annual Report on Form 10-K for the year ended March 31, 2011 on file with the Securities and Exchange Commission. Also in our discussion today, non-GAAP revenue excludes acquisition purchase accounting adjustments for the reduction to fair value of deferred revenue, and the GAAP effect of the early adoption of new accounting principles. Non-GAAP net income excludes the non-GAAP revenue adjustments, as well as share-based compensation expenses, amortization of acquired intangible assets, certain business development costs, and related income tax adjustments.

I will now turn the call over to Anil Singhal, our Chief Executive Officer.

Thank you, Cathy. Our financial results for the first quarter of fiscalof 2012 were a disappointment, especially after we completed a successful 2011, where we grew our business 12%. As we said in our pre-announcement, this is the first time in five years we delivered less than satisfactory results. Our first fiscal quarter ending in June is historically a weak quarter for us, and despite our focus on mitigating the seasonality, the downturn was stronger than we expected. Extroverted by lack of US government new business bookings due to budget holds. In addition, our traditionally strong financial services business was weak due to profit pressures affecting some of our customers.

We went through a careful review following the close of the quarter. Overall, the number of large new business deals over $100,000 was approximately the same as Q1 a year ago. However, the dollars yielded from these deals was down about 15%. This accounts for most of the revenue shortfall. This is why we believe that our business was primarily affected by budget pressures that we think are short term. In our field sales review, that theme was conformed. We saw no changes in our competitive posture or [philosophy].

In our service providers in non-financial enterprise business, the number of large deals increased. In financial, the number of large deals declined, but the deal size decline was a more significant factor. We expect that our financial services business will pick up in the second half, because we expect our customers profit and capital spending pressures to ease.

In the US government business, the decline in the number of large deals was the most significant factor unlike financial. The federal deals that did not close are still in our pipeline. We expect that the US government funding will stabilize in the balance of the year, and bring with it most of the deals that we saw delayed, although we are taking the conservative view that the level of funding will not return to decent levels so the deals will be smaller when they occur. We factor that view into the full year guidance that we issued on July 4th.

As a result of our lower revenue outlook for fiscal 2012, we are implementing expense control on non-strategic projects, and slowing hiring across the Company. The quarter also made it apparent that some areas of our execution can improve. We are addressing these areas now. We are focused on tuning our organizational performance to quickly understand prioritized customer requirements, build new product function, and deliver that function into the market to maintain and extend our leading technology position. We already have made some changes in both product and sales organizations toward these issues.

Those and other changes and our recent acquisition of Psytechnics will have a significant positive impact on the second half of this fiscal year. Notwithstanding the slow start to our fiscal year, we remain committed to achieve our topline growth potential, and we believe the second half of our fiscal year will be much stronger. We see continued growth in our high growth service-provider business, supported by the 33% growth in new business year-over-year. We also saw healthy order flow from the non-financial enterprise sector that we expect will continue for the remainder of the year.

Our new products for IP Voice, Video, and Tele presence are gathering a lot of interest, and we see all of the momentum building throughout the year. Our order pipeline is strong, and are go-to-market focus has been sharpened with some of the augmentation changes we have made. In summary, I want to restate that we remain the market leader in unified service delivery management, and that we are solidly committed to serve and expand our customer base. We believe that with our continued market leadership, improving economic and capital spending conditions, and improved execution that will achieve our guidance for this fiscal year.

I will now hand the discussion to Michael.

Thank you, Anil. As Anil said, a major cause of our Q1 shortfall was the delay in purchases by our US federal government customers, although we were involved in many significant opportunities, most of these deals were delayed because of the environment to obtain new budget approval due to the budget crisis in Washington. In addition, we saw some of our financial services customers come under profit pressure and profit and capital spending pressure, as we have all been hearing about in the recent news.

On the other hand, we saw healthy year-over-year growth in our service provider bookings, and by growth in the TF2 service provider segment and international markets, including Southeast Asia and Latin America. We also had growth in our non-financial enterprise business coming from healthcare and retail. We remain focused on new account development and in the first quarter we won15 new customer accounts with the largest being a leading wireless service provider out of Latin America.

I would like to discuss a few of our operational milestones in the first quarter. We delivered a major release to support our dual target markets of enterprise and wireless service providers. This product release includes a significant functionality for managing 4G World mobile telecommunications efforts, and enhancements for mobile user experience monitoring, as well as realtime business intelligence capabilities for the enterprise. This product release includes the next installment of our Adaptive Session Intelligence technology, or ASI.

We have incorporated additional ASI functionality into our service delivery manager dashboard as well. We also released through early field trials, nGenius enterprise intelligence which uses the realtime data mining capabilities of our ASI technology. nGenius enterprise intelligence automates and simplifies the creation of a true representation of an end-to-end user data and voice sessions for expedited troubleshooting.

Also, for our enterprise customers we have announced the availability of our nGenius voice video manager, our first offering from the recent Psytechnics acquisition. In addition, in Q1 we continue to invest in market awareness in both the enterprise and service provider markets. At this year's INTEROP in Las Vegas, NetScout not only had a leadership position at the event in terms of show session presence, we were also able to showcase our capabilities by providing the end-to-end management of service delivery across INTEROPNet, the specialized high speed network that supports exhibitors conference sessions, and attendees at INTEROP.

We were also a lead participant in this year's TeleManagement Forum Management World Conference that is considered one of the most focused events in the service provider space. This annual conference concentrates on providing standards, market research, and development frameworks for BSS and OSS systems. Finally, there are several areas where we are taking action to increase new and performance going forward by driving increased demand generation.

Three examples of this include, first, our 10-city seminar series focus on protecting the end-user experience which is co-sponsored by Cisco. Second, given our strong interest in our recently-released nGenius voice and video manager solution. We are targeting business development resources to accelerate field pipeline growth and among rapidly-growing enterprise voice and video deployments. Finally, we are continuing to position our product offerings to the Application Performance Management, or APM market, leading with our service delivery manager and voice video products both for the large enterprise and the mid-deal enterprise markets.

Thank you, I would like now to turn the call over to David.

Thanks, Michael. Our quarterly financial results are included with our earnings release. We report our results on a GAAP basis as well as a non-GAAP basis. Our non-GAAP results eliminate the GAAP purchase accounting effects of our acquisitions by adding back revenue related to deferred revenue revaluation and removing the amortization of acquired intangible assets. In addition, we remove the GAAP effects of stock-based compensation.

Our non-GAAP results also exclude certain extraordinary business development expenses for outside services that we incur from time to time in pursuit of potential acquisitions. We exclude the related impact of all of these adjustments on the provision for income taxes. The differences between GAAP and non-GAAP are disclosed in reconciliation tables in the press release financials. We believe these adjusted financial measures will enhance your overall understanding of our current financial performance and our prospects for the future. We use these adjusted financial measures internally for the purpose of analyzing, managing and forecasting our business.

Last year we reported current and historical GAAP and non-GAAP revenue results because we adopted along with many other technology companies, new revenue guidance that scopes certain tangible products sold with software components out of the software revenue recognition guidance. Starting in fiscal 2012, the difference between GAAP and non-GAAP revenue is not material and we have discontinued the reporting of historical GAAP and historical non-GAAP revenue. Now to financial results.

For the first quarter revenue was $63.3 million, down 5% year-over-year. Product revenue was $29.5 million, down 13% year-over-year. Service revenue was $33.8 million, up 3% year-over-year. Our GAAP gross profit for the quarter was $49.4 million. GAAP gross margin was 78%, flat year-over-year. On a non-GAAP basis, gross profit was $50.6 million and gross margin was 80%, flat year-over-year. GAAP income from operations was $4.3 million. Gap operating market was 7%, down 10 points from a year ago. GAAP net income for the quarter was $2.4 million, yielding earnings per diluted share of $0.06. GAAP net after tax margin was 4%, down 7 points for a year ago.

Our non-GAAP income from operations was $8.7 million and operating margin was 14%, down 7 points for a year ago. Non-GAAP net income was $5.5 million, or $0.13 per diluted share. Non-GAAP net after tax margin was 9%, down 4 points from a year ago. Non-GAAP adjustments to our GAAP results are summarized as I said in the reconciliation table included with the press release.

The provision for income tax is recorded based open a full year effective tax rate of 34.5% on a GAAP basis. Our GAAP tax rate in the quarter is 38.4% due primarily to a Q1 discrete tax adjustment from the Psytechnics acquisition. We have used the statutory tax rate of 38% to tax effect the non-GAAP adjustments. Our long-term model which is subject to regular review remains as follows, non-GAAP gross margin is 78% to 81%, R&D expense to revenue was 13% to 15%, sales and marketing expense to revenue 33% to 35%, G&A expense to revenue is 6% to 8%, yielding an operating margin range of 24% to 27%. This model applies for the full year results and of course individual quarters may be outside of the range. Similarly, our long-term revenue growth target remains high teens.

We exited the first quarter with cash and short and long term marketable securities of $209 million, down $19 million in the quarter, and an increase of $18 million year-over-year. We intend to use our cash judiciously, with a focus on M&A activity. Free cash flow was $2.7 million, capital expenditures were $3.7 million, depreciation was $2.2 million, amortization of acquired intangible assets was $1.6 million.

Marketable securities include investments and auction rate securities valued at $17.2 million. As of June 30, 2011, the value of these securities includes a temporary decline in the value of $2.3 million below par to reflect liquidity concerns. All of these investments have a AAA investment grade rating with underlying support by the Federal government by the Federal Family Education loan program. We believe they have no credit issues, only short-term liquidity. We classify these securities as long-term on the balance sheet, with the offset to accumulate at other comprehensive loss. Our strong cash position and positive cash flow make the illiquidity of these securities no overall liquidity problem for us.

Accounts Receivable net of allowances was $41.4 million, down from $62.8 million last quarter, and up from $40.3 million a year ago. Days Sales Outstanding were 59 days for the quarter, modestly above our typical DSO range of 45 to 55 days. This is down from the prior quarter of 71 days, and above DSO of 55 days last year. Inventories were $9.6 million, up from $8.9 million last quarter, and down from $10.0 million a year ago. Inventory turns were 1.9 times.

Turning to other metrics. Revenue contribution for the quarter from direct customers was 46%, and reseller revenue 54%. Revenue from international sales was 27% of total revenue, up 6 points from last year. Europe delivered 12%, up 3 points from last year, Asia came in at 7%, up 3 points. Other international sales were 8%, up 1 point compared to last year.

Summarizing large deals. 118 customers gave us orders of $100,000 or more, an increase of 16 customers over the same period last year. 22 customers gave us orders of $500,000 or more, down from 25 last year. We received eight orders over $1 million, of which five came from telecommunications, and one from financial services, one from retail, and one from healthcare. This compares to eight $1 million orders we received last year, including four from telecom and four from financial services.

We saw a total bookings from the following sectors in the quarter, the enterprise sector was 52%, telecommunications was 34%, government was 14%. Within enterprise, the financial services sub-sector was 23%. A year ago enterprise was 62%, telecom was 22%, and government was 16% with the financial sub-sector 40%. Total bookings in Q1 were $52.8 million, down $1.8 million, or 3% year-over-year. New business bookings were $37.5 million, down $6.6 million, or 15%.

New business bookings are strongly influenced by the lumpiness of our telecommunications service provider business, and increasingly our enterprise business, and by the size of the lumps. Serve provider new business bookings were up 33% year-over-year in the quarter. In the enterprise, our new bookings were down 26% versus Q1 last year. The financial service subset of enterprise was down 47%. The rest of the enterprise sector was up 18%. New business from the government sector globally was down 49% year-over-year, lead down by the US Federal government which was down 68%.

Service contract renewal bookings were $15.3 million, up $4.9 million or 46% year-over-year. Adjusting for the early renewals bubble that occurred in Q4 fiscal 2010, renewals bookings remained flat year-over-year. Product backlog at the end of Q1 remained immaterial. Deferred revenue was $91 million, flat compared to last year.

And now for our guidance for fiscal 2012. As we announced on July 4th, we expect revenue to be in the range of $300 million to $315 million. GAAP net income per diluted share is expected to be in the range of $0.84 to $0.97, and non-GAAP net income per diluted share between $1.07 and $1.19.

We do not regard the Q1 shortfall to be indicative of the level of our performance for the remainder of fiscal 2012. Because of the low Q1 numbers, revenue seasonality will be exaggerated from our normal pattern of 20%-plus higher revenue in the second half than in the first half. This will be driven by stabilization of federal spending at higher levels for us than in Q1, the return of more normal seasonal buying patterns in financials, and continued growth plus normal seasonality in telecom service provider and non-financial enterprise demand.

In addition the second half will benefit from the market acceptance that we anticipate from our new voice and video product line, and from the internal execution improvements that we are making. Expense reductions will affect the second half positively, causing our expenses to grow modestly from Q1 through the rest of the year. The fiscal year 2012 non-GAAP net income per diluted share excludes forecasted share based compensation expenses of approximately $7.3 million, expected amortization of acquired intangible assets of $6.4 million, business development costs of approximately $1.2 million, which includes costs associated with the integration of Psytechnics, and the related impact of these adjustments on the provision for income taxes of $5.4 million.

That concludes our financial discussion this morning. Thanks for joining us and we look forward to taking your questions. Krista, will you please go ahead?

(Operator Instructions). Our first question comes from the line of Mark Kelleher. Your line is open.

Thanks a lot. I was just wondering, there are some great confidence that you are portraying her that the back of the half of the year will come back, and that the financials are coming back, and the government is coming back, where do you get that confidence from, particularly the government sector?

I will let David add a couple of more comments, that was similar to what, a little bit less pronounced last year, and so first of all we traditionally do a lot of business in the second half versus the first half, as David mentioned, but the confidence is coming from talking to the customer, and realizing we have not gotten the benefit of the new acquisition, and that our customers are still interested in spending money on NetScout products, and the competitive pressures are minimal.

That is right. In addition, of course, as you have heard us say in the past, we have a pipeline that generally proves pretty reliable as a measure of future business. We were surprised in the federal government by the budget, extraordinary budget process that they are going through. As we said, we expect that those deals that didn't close that are still in the pipeline will be there in the back half of the year. It is a little hard to predict exactly which quarter they will fall in, whether the budget process will resolve itself quickly enough to have a normal major impact in Q2, but certainly we expect in the back half of the year that they will be there,albeit at perhaps a reduced size as we said.

The answer is we expect our business in general, as Anil said, to continue to grow, we expect the federal government budget process to resolve itself, hopefully soon, and therefore those projects, all of which still retain support in the federal government, the projects haven't changed, haven't gone away, they are just being constrained by the budgetary issues that right now are intense and very uncertain, and we expect that uncertainty to be resolved, although perhaps at a lower spending level than we have seen in the past.

If that were not to materialize, if there were some delay in that, are you contemplating more aggressive cost containment moves?

It is always possible to find more efficiencies in your business as you think harder about it, but we have done the major expense reductions that are manageable for this year, by pushing programs, billing programs, delaying hiring, so we would be careful about making further cuts in order not to damage strategic initiatives going forward. Having said that, we are not prepared here today to say exactly what would happen if things are better or worse than what we expect today, but we have cut pretty hard in what we have put into the guidance so far. So not an awful lot more to do I think without damaging the strategic growth.

Okay, thanks.

Thanks, Mark.

Your next question comes from the line of Jonathan Ruykhaver from Morgan Keegan. Your line is now open.

Yes, good morning, thank you. Curious, how important are our unified communications to the improvement in activity that you expect in the second half within financial services?

We are getting a lot of interest from both partners, as well as customers in the voice and video space, and I think that completes the story of having a common solution for our data, voice and media. We think they are very important. We are getting a lot of interest from the sales force and the customers. Pipeline is increasing everyday, so we think that having a solution for the unified communication including all of these three things is going to be an important factor, and will be very competitive in the marketplace.

Okay, that is built into, or that contribution is built into your assumptions of financial services for the second half?

It is.

It is both our financial services, it is basically throughout our customer base, including financial services.

Okay. A little bit more within that vertical, financial services. You have talked a lot in the past just around the need for network monitoring around these high speed trading networks, and I am just trying to get a sense for the breadth of use cases for your technology in that vertical. Is that use case an application for your technology really been the main driver to your growth within financial services over the last several years?

No, that is the smaller portion, that is much smaller niche space, and that is a much smaller, we have a separate product for that marketplace, but that is a very small portion of the total financial services apps banking services and banking business.

I mentioned that because it seems like the Company has called that out in the past as a driver for that business.

May I just try to close that apparent gap, Jonathan? Yes, we have. It has been a new driver, and additive driver to our historical financial services business, as algorithmic trading has grown. That is why we have pointed it out in the past. It has been an assist in driving that business, particularly when the rest of financial services were struggling during the recent financial crisis, that is why we called it out in the past but as Anil said, it is a smaller portion of the demand from financial services for our product.

Okay, good, I appreciate that elaboration, Dave. On the mobile side, you commented on strength within Tier 2 carriers and on some international markets. Can you comment on the status of your relationship with AT&T? How has that business ramped, and is it within your expectations?

Well, the decisions on the AT&T, and some of the Tier 1 vendors for LTE are still in the state of flux. I think we have a good chance of getting a live number of Tier one carriers, either as a full vendor or in a shared vendor capacity. That means that they will use multiple pro vendors for their solutions, but it is too early to say what the impact from AT&T is going to be moving forward.

Is that a change at AT&T in terms of your expectation relative to let's say 6 months ago or 12 months ago, in terms of being a shared vendor with other companies?

No, not really. Obviously, as you go into a competition which we have been in, you hope that you are going to achieve the greatest success possible. What we have ended up with which is what we have ended up with most of the major carriers, right, and this is typical of their buying, their vendor relationships, we will be one of one or two or three vendors, and that is where we expect to end up, that is where we are with virtually all of the Tier one carriers.

What we offer to all of the mobile carriers is the unique functionality to do realtime data analysis, application-level analysis that the legacy vendors that they are also buying from cannot match, and so as we have said in the past, there are some things that we can't do as well as they do that they have been doing for a long time, and so that remains the posture where we expect to do significant business with the Tier one carriers, continue do significant business with the Tier one carriers because of our strengths, as well as some of our competitors will do significant business with them because of their strengths. That is not a change. You always hope for more, Jonathan, but we have ended up in that we are going to be one of several.

Exactly. Okay. That is great. I appreciate that color, David. That's it for me, thank you.

Your next question comes from the line of Eric Martinuzzi from Craig-Hallum. Your line is now open.

Thanks. One of the things I was curious about on the federal shortfall, was when you sort of went to a scorched earth impact for the fiscal year, historically federal had been about 15% of your business, and I see here in Q1 it was off roughly half from a year ago, is that to imply then that federal will be 7% to 8% of what you hope to achieve in FY12 on the product booking side?

No. We expect something in the middle, between those numbers. It won't be as high as historically because we expect the federal budget resolution to cause more constrained spending than there has been in the last several years, but we don't expect it to be at the levels of disarray that we saw in Q1, where it wasn't really a stable budgeting or spending situation. It was basically emergency stop on a lot of projects while they figured things out. We don't expect that to continue. So acceleration from Q1, but not back to the levels of the recent past.

Okay. On the bank side, maybe you have covered this but I am still having a hard time getting my arms around it. Your comfort level with the back half of the fiscal year returned. It almost sounds like you guys are Wall Street analysts here predicting the profitability and CapEx availability of your financial services customers two quarters out. Can you get a layer deeper there? Is that customers telling you that? I am just concerned about how much hope there might be versus reality?

Let me see if David can add a couple of things to it, but pipeline is still very strong, and I think that is the primary reason for thinking that we will do better in the second half, and the projects will come back and the budgets will come back.

I don't have anything. That is the reason. Regarding your semi-facetious remark that we are trying to act like Wall Street analysts, we could use some help. If you guys have a view of our financial services customer's outlook, please pass it along. But no, we are not really trying to predict that profitability. We are trying to analyze what happened, and why the customers that we had expected perhaps might do more didn't do it in Q1. That is the analysis. And once we look at that as we have done in Federal, the question then is do we think that is likely to continue and that is the point that we're trying to answer. If you think, if you have any insights either now or later in that, we would be interested.

That is just for paying clients, David. One last question.

Forget that lunch I was going to buy you, forget it.

One last question here. Virtualization has just been a huge multi year trend and doesn't show any signs of letting up, based on the success and VMWare has been having. I know you guys have talked in the past about how NetScout plays well in virtualized environments. Someone else who is having good success benefiting here, Cisco has made a big play in their UCS product, which is servers and switches optimized for VMware. What have you seen from just a virtualization impact on NetScout's business, and do you feel like you have got the right product set to address it?

We have not seen any direct impact or measurable impact, but overall , and we do have a product in that space called Wipro, but the net impact of virtualization on our business is the traffic will basically be the back end servers, is increasing dramatically, and that puts more pressure on the end user experience, and other quality measures, so that is how we think we will be benefiting from that. It is different than from what the use case for VMware is, but we think that virtualization and cloud computing trend is going to be very useful for us as the complexity in the infrastructure

At another level, every time that the data centers are being touched and reconstructed to support the green and virtualized environment or perspective, we have a chance to reinstrument those data centers. At a technical level, that helps drive out data center business. It is a big chunk of both financial and internal enterprise business.

I see. Thank you.

Thanks, Eric.

Your next question comes from the line of Alex Kurtz from Sterne Agee. Your line is now open.

Thanks for taking the question. I am being told that Labor Day is on September 5th, David. I think as a follow-up to Jonathan's question about AT&T, I just want to clarify on that. Is there a step backwards or sideways in that account?

No, no, it is not a step backwards. As Anil said, we are still working with AT&T on our position in their ongoing network, and that work is very promising, so no. But we don't have full resolution of the ongoing process yet.

Okay, because I think originally, about a year ago it seemed like you were becoming a prominent solution for some of their iPhone congestion and data congestion, and just to clarify, is your role around that product and sort of finding a solution around the iPhone still in place, or is that changing in any way?

Yes, we did do some additional business over the last year with AT&T, not as big as a couple of years ago. So yes, we are still in that environment, and probably there will be additional buying in that area. Plus we are bidding for the bigger LD products, 4G projects. That is where we mentioned that it could be a shared vendor approach, or multiple vendor approach by AT&T and other T1 carriers.

Okay. David, in the past, it seems like your guidance is always a number that for the most case you don't typically upside very often. It seems like you guys have, except for what happened this year, you guys have guidance that you always seem you want to hit in the midrange. Based on your commentary about some of these government deals sort of not really being in the updated guidance and maybe it materializes in the second half. Is it fair to assume there is upside guidance that you sort of baked that into your thinking? What are your thoughts on that?

Well, we try to position the guidance as you guidance as you suggested, Alex, to hit somewhere in the middle of the range, and that is what we have done here as well. There is obviously, the reason it is a range is obviously there is uncertainty and risk, but we don't think we have positioned this so there is a built-in upside that is different than in the past.

Okay. And just that last question for Anil here. Have you considered, when you are looking at sales execution over the last couple of years, I do understand it has been a tough macro environment for a lot of different vendors, but it seems like at some level the understanding of pipeline has been missed in multiple quarters, and sort of lack of visibility at times into deal flow and timing of closing of larger transactions. Do you feel like there needs to be changes in sales leadership at this point? How do you think about that?

Yes. No, we don't think that is any reason for us to be concerned. I think that execution at the lower level, better communication between product management and sales doing more demand generation from a marketing point of view and in the sectors point of view. Those are some of the execution issues we were talking about. We are not planning to make any changes to the sales leadership.

Alright, thanks, guys.

Thanks, Alex.

Your next question comes from the line of Scott Zeller from Needham and Company. Your line is open.

Hi, good morning. I wanted to ask us a question around, we have all ready hit AT&T a couple of times, but just in general. The commentary from Michael about the Tier two activity being significant. Are you rebalancing the pipeline so that the Tier one opportunity that we have talked about for quite some time has perhaps scoped down and Tier two is a larger part of the pipeline? Could you give us a sense beyond AT&T, when you look at Verizon and such, what are your expectations around the Tier one contribution versus the emerging crowd?

Despite ongoing success in Tier two, Tier one remains the critical component of our service provider growth plan. Over the course of the year, we expect that Tier two will increase its contribution, but still will be the minority by far, vis-a-vis the Tier one contributions. Tier one meaning the top three US and the two big Germans I guess is probably the best characterization of Tier one versus the rest of the market. I think it is going to be balanced, but not significantly over this year, maybe the following year it is going to get into more balance. The goal is to create a more balanced revenue stream, of course, over time, but it is not going to happen in the short-term.

Okay, then another follow-up question on federal. There have been several, but I am just wondering on the pre-announcement call I think someone asked if it was a sudden change in behavior that you saw. Could you just give us some sense as to whether or not you felt the pipeline management may have, if it could have been better, or if you could tell us if this was a sudden change in actual buying behavior?

Well, it appeared to us as a sudden change. We had expected that many of those deals would be coming, and so it was the last couple weeks, two weeks, even the last few days even of the quarter even, when we recognized the budget process. Our federal business, we have been in the federal space for six, eight years now, and we have learned that it is a hard thing to predict, the actual closure of deals because the process is complex. Some would say byzantine, and there are a lot of players and a lot of layers, and we are recognized that we can be better at understanding the process and the likelihood of close. That hasn't been a big problem for us up until now, and we have to recognize that this change was, that this circumstance was extraordinary. It is not usual that the federal government goes through this tightrope act with the debt ceiling and the budget process, but having said that, we would have preferred to see things a little sooner.

Thank you.

Your next question comes from the line of Gary Spivak from Noble Financial Group. Your line is now open.

Hi, thank you for taking my question. I want to change it up just a little bit and get your comments on Europe. I know it wasn't a big thing, certainly not calling it out as a reason for the quarter's performance, but I am very interested in your thoughts in what you are seeing this in that theater?

I think in Europe we see continued interest especially in the service provider space, and that we are bidding for several large LTE projects, as well as some Tier two opportunities. This quarter was actually, we had a higher percentage of international than we typically have. While the US Tier one is going to be a big portion of our total service provider business, Europe and Asia PAC will also be big for us.

So your performance to your expectations or better than in the June quarter?

Could have been a little better, not to the expectation, but it was not as big a shortfall as in other areas.

Right.

And the pipeline there looks healthy.

Okay. And my final question is about ASI. I guess we started to speak about that a few quarters ago. I am interested in customer receptivity to that, and the products and specifically how they are using it?

I think there is a lot of interest. We have released two products providing part the functionality of ASI, so I think one product which Michael talked about is enterprise intelligence, and then we have a new portable announced in the last call, and both of them compared the ASI technology, and we think that will be a big differentiator, but the effect of that remains to be seen, and we think there will be a lot of interest, especially from existing customers for this next generation technology in the second half when we fully deliver it, and make it part of our entire product line.

Okay, thank you.

Thanks, Gary.

Your next question comes from the line of Kevin Liu from B. Riley & Company. Your line is open.

Good morning. So I wanted to throw in one on the federal side as well. So just to clarify, the deals that you have seen put on hold or slip out were those deals that you had anticipated or would close within the confines of the fiscal year? In other words were they already funded and maybe that funding got pulled, or were these deals that maybe would have maybe pushed out to the upcoming year and that is where the uncertainty lies?

You are talking about the government's fiscal year. We had assumed that these deals, believed these deals would close in this government fiscal year, I think that is what is clear now. Some will. We are expecting, hoping that the government budget crisis will be resolved in time, and that some of the deals will therefore participate in the normal government fiscal year-end closing rush. Some may not, and nonetheless as we said earlier, those projects, those deals remain on the boards, not just in our pipeline, but with the government sponsors that we work with, and we expect that if they don't get funded in priority for this fiscal year that they will be back for next, albeit perhaps at a smaller size.

Were these constrained concentrated in programs or agencies, or was it pretty broad based across your government customers?

We saw it across the agencies.

Civilian and DoD.

Right, both civilian and defense as Michael said. It was not as if somebody that we were concentrated was singled out for budget pressures. It was everybody as far as we can see.

Projects that were funded were called back for additional budget cuts, and these projects have to go through the whole cycle one more time, and that was the underlying mechanism for most of the slips or missed deals this quarter.

Got it. On the telco side, you certainly saw a strong growth there. Curious if you can flesh out how many of that growth was domestic versus international? Also, are you anticipating that this growth will be relatively consistent through the year, or should we expect a fair amount of lumpiness based on when the large deals come through?

You should continue to expect lumpiness, that is the nature of these deals. As we go down to Tier two the lumps will get smaller, but the nature of the business, that business is inherently lumpy. Regarding International, I don't have the data parsed that way right here, but the Tier two focus that Michael talked about, the success that Michael talked about is in two places, is in two traunches. One, Tier two in the US where we are having a significant success, and most of our international business outside of Europe, as Michael pointed out in his remarks, is what we classify as Tier two.

You may recall that we had invested as we were growing the sales force over the last 18 months in service provider territories around the globe where we didn't have presence previously, and that investment is starting to pay off in some of the things that Michael talked about. So I can't give you exactly international versus US, but most of our Tier one business remains in the US, and most of the Tier two business is split between US and international much more evenly, and that is where a lot of the strength was coming from as it so happens in Q1, the Tier two.

And I think you mentioned earlier that M&A remains the top priority for cash here. Curious as to how large a size some of these opportunities actually are, and whether you guys have reconsidered maybe share repurchases given where the share prices have gone since the pre-announcement?

So you are right, our M&A remains the top priority use of cash. You saw our cash came down in Q1 and that is the Psytechnics effect. You should expect to see opportunities of that size, obviously plus or minus but of that size in our sights going forward, and this is as we have said before, an ongoing process that we will continue. Regarding our second priority, which is potential for a buyback, you probably recall that we have had a buyback authorized for some time, it has been inactive. Obviously, as our cash generation continues strong with our strong margins and revenue flow, each though it is lower than we anticipated 90 days ago, it is still very strong. We will potentially have other cash available to do more than just M&A opportunities, and we look at that continually. It is a topic at Board meetings every quarter. So without talking about exact intentions on either front, which we can't disclose, you should take away from this that we are focused on both.

Thank you.

Your next question comes from the line of Rohit Chopra from Wedbush. Your line is open.

Thank you. I just want to go back to what you are doing to manage expenses given the new revenue levels?Can you be more specific about what you are doing on the expense control side, and also if you can be a little bit more specific about what you are doing on improving execution with the sales force?

I will take the expense control question. As we have said, we are looking at non-critical programs, projects, and deferring them. We are also looking at hiring and slowing hiring down. That slowing of hiring gives us the opportunity to do some rebalancing of resources which we are also doing, putting new resources that we are continuing to hire, but putting the new resources in the more critical productive areas of our business as we see them today, and letting attrition happen in the less productive areas, so that is a rebalancing that will be a natural consequence of this.

In terms of the projects, we have things that we consider important to our business on a long-term basis, but less important to happen in any particular quarter that we are deferring, and while we are not here going to get specific about what those programs are, they are explicitly not programs that we expect will damage our strategic growth prospects. There are, of course, in addition to those major categories other expense areas in which we can just tighten down, tighten down on travel, just as one example, by changing the criteria and asking people to be more prudent and use Telepresence or teleconferencing more and airplanes less, those are the normal kinds of things that you would expect. So that is the expense picture. I will ask Michael.

Thank you, David. In terms of execution, one of the key areas is of course driving demand and making sure that the funnel growth is there, and it is strengthening over time. One of the major vehicles here is the voice video product, and it appears that we are meeting, we are seeing open doors across our installed base, as well as a number of new accounts and new opportunities that are brought in on the strength of the unified communications value proposition, so that will be our key focus in driving new demand.

Number two, we are reallocating resources, primary technical resources to free up sales cycles, and so move some technical personnel from other areas, services areas to back up the post-sales support function, so that our SEs that normally perform functions, support in the post and pre-sales areas, can now concentrate on the pre-sales area. And thirdly, we are reorganizing, we have reorganized to consolidate all of our demand generation functions, including the business development reps and internal sales reps, and end market, order defend marketing elements under my direct control, and we will be instituting very close programs and initiatives to continue to drive demand through that.

Thanks, I had two other quick questions. Anil mentioned that yield was down even though the number of deals was the same, and I wanted to get some specific comments about why the yield was down?Are people trading down as far as what they want to buy? Are they buying lower priced equipment? Is there more discounting? Is there more competition in the channel? What is actually happening there? Then, David, if you can quantify new versus existing customers, that would be great.

First of all, I think the lower, smaller deal sizes have nothing to do with competition or importance of our product, or channel, or anything like that. I think that is just the reflection on the budget pressures. Despite the budget pressures, some people still have to invest a minimal amount of stuff on our products. That is an indication that they continue to be having interest in our products and there is no competitive pressure. But at the same time deals smaller and deals completely going away, just like we are doing some budget adjustments or expense adjustment, some the vendors are doing the same, some of the customers are doing the same, so that's why the deal sizes are smaller this quarter versus last year.

Yes, can you repeat your second question?

I want to get a sense of new versus existing customers?

Our new customers, when we mentioned I think we had 15 new customer customers, that is a little lighter than a normal quarter, we expect to do better than that. Most of our revenue, however, always comes from, 90% sometimes higher comes from existing customers because of our business model that we have explained before, and I won't bore you with it again. So new customer flow was a little light in Q1.

Thank you.

Your next question comes from the line of Ben Abramovitz from Kaufman Brothers. Your line is now open.

Thank you, good morning. I just wanted to circle back a bit on financial services. I know you have roughly, I believe it is about 25 employees that are embedded at your customers. One, I guess if we could get a better idea of how many of those are embedded at financial customers, and then maybe if you peel back a layer to help us understand a little bit more of what is going on in that segment?When you look at projects in the pipeline that are coming down, are these expansion projects or replacement projects, in terms of helping us gauge where the confidence comes from? Is it coming from with those embedded at those customers, or is it your expectation of expansion that is to occur within that customer segment later this year? Thank you.

Okay, thanks, Ben. So on the first question as you call them embedded, sounds like press in a war zone. We do have part of our business model is to have our sales and support teams very close to the customers. We have a consultative, high-touch business model. As you call them embedded people, can be of several kinds. Obviously, the salesman who man who tries to live as close to the customer as they can, the systems engineers that Michael talked about, who do both pre-sales selling work as well as post-sales support, then there is another category, which we call support people, support engineers who live with the customer and help maintain the product as an extension of our service contracts. We don't talk about exactly where these people are deployed and which customers have them, but that number has been growing, because customers finds it very useful to have a skilled person dedicated to making sure that they can get value out of the product, and a lot of them because of our customer base, a lot of them are in financials, but by no means the majority.

Now in terms of expansion versus new projects, there is a strong mix of both. What we see as the economy and the buying patterns cycle, is that when customers are feeling aggressive and expanding their use of infrastructure, that is when new major projects typically occur, and when they start to spend money on new reasons for deployment of our products. When things are tighter and right now they are tighter in financial services, then customers spend money on extending what they have, and upgrading what they have, and Michael talked earlier in another context about one of the reasons. If they are consolidating data centers, then that gives us an opportunity and will cause them to upgrade our products, the hardware elements of our products. So right now we are, without having exact data because we don't really classify things deal by deal in that category, but the sense is we are in expansion of existing mode today, than we are in major new projects mode, but that will come back.

Okay. Thank you, that was helpful.

Your next question comes from the line of Gabe Lowy from Mizuho Securities, your line is open.

Good morning. I have two questions for Michael, and then one for you, David. For Michael, are the 4G LTE projects or builds, some of which are pilots that you have been waiting on, are those delayed because carriers are considering new competitive offerings, or is there some other reason for that?

I guess I am not sure that they are that much delayed. I don't remember expecting the pilots to be more expedited. Maybe there is a little bit of delay in the Tier ones, and that could be for the reason that you are mentioning. Internationally I don't see a fundamental delay, the pilots are going according to my expectations.

Just one thing to add is making a decision on LTE it doesn't mean that they will start spending money this year. A lot of LTE deployment is going to be much bigger next year, so even if we were to be certain of these pilots, we will not necessarily see it reflected right away on the order side.

And let me add one thing, other thought to that. With the Tier one carriers that we are dealing with, there are a known set of qualified vendors of which we are one. We are unaware of any new entrants into the competitive landscape, and so to support what Michael said, it is not that we perceive these projects as delayed. The revenue flow as Anil said may not come right away, but it is not that we see them delayed, nor do we think that there are any new competitors. It is the same competitors we knew we would face going in. They have had a full hearing along with us, and we are still in there.

Great. I didn't mean new competitors, I meant new products from your existing competitors?

I don't think we have seen that either. Those products were all on the boards at the beginning of the year when the AT&T cycles started, so no.

Okay. Second question, does the ASI technology have the capability of honor user experience for enterprise internet apps that are being webified if you will, as well as apps that are specifically developed and deployed on the web, and also SaaS-based applications?

Yes, all of the above, and it is not just the enterprise space. ASI is going to be a big differentiator in the service provider space also. So all kinds of applications, Web-based, cloud-based, which is SaaS model, our internally developed non-web applications and back end database applications of email applications, all of them will benefit from the ASI technology.

Okay. And that roll-out is still on tract for the entire product line?

Yes.

Okay. And then last question probably more for David. What is the geographic mix roughly of the financial services customers, and is that customer base mostly the large money center operations?

I don't have at my fingertips the international versus domestic breakout of our financial services customer base. Most of it is in the US. Most of it is in the large money center banks, although we do have some smaller regional banks that we also serve. We do have some very large and significant internationally-based financial services customers, won't name them here, but you can see them on our logo slide on our investor presentation, but they are not the lion's share of our financial services business.

Thanks. Helpful, thank you.

There are no further questions in the queue at this time.

Okay. Well, thank you very much for attending our second Q1 earnings conference. We appreciate your questions, they have been very thorough and far-ranging, and we look forward to talking to you again at the end of our second quarter. Have a good day.

This concludes today's conference call, you may now disconnect.