VMware Inc (VMW) 2008 Q1 法說會逐字稿

Good afternoon, everyone, and welcome to the VMware's first quarter earnings conference call. (Operator Instructions).

At this time, I would like to turn the conference over to Mr. Mike Hasse, Vice President of Investor Relations. Mr. Hasse, you may begin your conference.

Good afternoon and welcome to VMware's first quarter 2008 earnings call. With us today are Diane Greene, President and CEO, Mark Peek, Chief Financial Officer. Both Mark and Diane will present prepared remarks, and afterwards we will open up the lines to take your questions.

Please note that this call is being web cast from our Investor Relations web site. Our press release issued after the close of market is also posted on the web site, along with slides that accompany today's prepared remarks.

I'd like to remind you statements made in today's discussion that are not statements of historical fact are forward-looking statements subject to the Safe Harbor provisions under federal securities laws. This includes but is not limited to statements regarding our financial outlook, future product offerings, and projected demand. These statements are based on current expectations as of the date of this call and are subject to uncertainties and changes in condition, significance, value, and effect, as well as other risks detailed in documents filed with the SEC, including our quarterly report on Form 10-Q for the period ended March 31, 2008, that may cause actual results to differ materially from those set forth in our statements.

In addition, during today's call we will discuss certain non-GAAP financial measures. These non-GAAP financial measures, which are used as measures of VMware's performance, should be considered in addition to, not as a substitute for or in isolation from measures of VMware's financial performance prepared in accordance with GAAP.

You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP measures in our earnings releases for the period ended March 31, 2008 and in the web cast slides available on the Investor Relations page of our web site. The slides and telephone replay will be available for the next 30 days. To listen to the replay please call 719-457-0820, and provide the following pass code -- 4557344.

For your planning purposes, our second quarter quiet period begins at the close of business June 16.

Finally, unless otherwise stated, all financial comparisons in this call will be in reference to our results for the comparable period of 2007.

With that, let me hand it over to Diane Greene.

Good afternoon and thank you for joining our call. I've been looking forward to this call.

Revenues this quarter was $438 million and growth was 69% year over year. According to our research, only two other enterprise software companies have grown at or more than 50% year over year after they had $1 billion in revenues. We're pleased to be heading this way.

To the leadership we have in the industry and the strategy and execution across all aspects of the business, we plan to continue at approximately this growth rate through 2008.

For ten years now, VMware's demonstrated the ability to deliver superb quality and market-expanding solutions well ahead of the competition. We now have the benefit of a well developed, multi-tier distribution model. And with our new solution areas gaining traction can see our way to continuing this sort of growth well beyond 2008.

We're leading in virtual desktops and virtual data centers. We're leading in applying that virtualization to business continuity, automation and management, security, and software application delivery via virtual appliances.

Moreover, customers are in the early stages of transforming their data centers ultimately into compute clouds that leverage both on-premise and off-premise resources. VMware virtualization is enabling this vision of cloud computing and we're making it a reality.

Many size today's virtualization market by just the consolidation opportunity. And that is a very large market. This is good for VMware because as servers become consolidated through virtualization, customers progressively adopt more of our products. We see customers moving through five distinct stages of deployment. There's an even larger opportunity for VMware's higher value products and I'll discuss this later in the call.

While there could be short-term fluctuations, we're reaffirming our 50% guidance for the year. And in the interest of providing more transparency are guiding for approximately 55% growth in Q2.

I'll now turn the call over to Mark. He'll provide more details on our results for Q1 and our outlook going forward. And then I'll close with a discussion of the business.

Thanks, Diane. Good afternoon, everyone, and thank you for joining us today.

This was another strong quarter for VMware. We're very pleased with our Q1 results. Our balance sheet remains strong. We ended the first quarter with $1.3 billion in cash, up $75 million from the prior quarter. Deferred revenue, representing revenue for future periods that we have not yet recognized, increased 88% from a year ago to $641 million and is up 16% from the end of Q4 2007.

We clearly have the resources to continue investing in the long-term growth plans we have to further secure our leadership in this exciting and expanding new industry.

Let me emphasize once again that investing in our long-term leadership is exactly what we intend to do.

As we begin Q2, we have over 5,700 people around the world. Despite turbulence in the US economy and increased competitive noise, our operating results reflect strong customer demand across all geographies, including the US. They reflect both an increased adoption of enterprise agreements by our large customers and an increase in the number of smaller transactions delivered through our strong channel partner network.

As you know, we measure our operating results both on a GAAP basis and on a non-GAAP basis. The non-GAAP results are what we use to measure our specific business operations.

We've reviewed the differences in these measures together on prior calls and are pleased with our results by either measure. But I will speak here in non-GAAP terms.

In our first quarter, revenue was $438 million. Operating profit was $106 million and diluted EPS was $0.22. These numbers represent increases of 69%, 62%, and 38% respectively over Q1 of 2007.

And considering these percentages, let me remind you that EPS comparisons with quarters during which we were wholly owned by EMC do not take into account the dilution from the IPO, sale of shares to Intel, or dilution associated with our important employee equity programs, which now involve use of our own stock.

Geographically, US revenues for the first quarter were $225 million, representing 51% of total revenues, an increase of 65% over Q1 of 2007. International revenues increased 74% to $213 million. Our international markets were particularly strong for us this quarter with triple-digit growth in bookings in Australia, Brazil, Russia, India, China, and others.

License revenue, revenue which is primarily recognized when we ship our products, was $294 million, an increase of 73% compared to the first quarter of 2007. Service revenue, revenue that we recognize over time and consisting of support, maintenance, and professional services, was $144 million, an increase of 62% compared to Q1 2007.

Our reported revenue was affected by changes in deferred revenues from quarter to quarter. At quarter end, deferred revenues of $641 million consisted of $32 million of license and $609 million of services revenue. We're pleased with the increase in deferred revenues this quarter as it is consistent with our enterprise agreement strategy.

Our most comprehensive volume license offering, the enterprise agreement, serves the purpose of establishing and building long-term relationships with our customers as they commit to our infrastructure for their data center architecture.

We're pleased by the increased demand that we are experiencing for enterprise agreements. Over the course of the past year, we have changed how we structure these agreements to put more revenue into services to [create] a recurring annuity.

A typical agreement includes a right to use a specified set of our products under a perpetual license, three years of support and maintenance, professional service credits and training.

We generally limit the number of licenses which may be deployed and we expect the renewal of the agreements to result in further license and service revenue as customers extend virtualization in their data centers and onto their desktops.

Under an enterprise agreement, a portion of the revenue is attributed to the license and recognized immediately, but the majority is deferred and recognized over time, which we classify as deferred services revenue.

As this program gains momentum, you will likely expect to see some mix shift in our revenues from license to deferred service revenue. These agreements drive our recurring revenue, which provides us with greater visibility and predictability into our future revenue.

We also have future growth opportunity in renewals of service revenue, additional license revenue, and upsell of additional VMware value-added products.

During Q1, enterprise agreements were approximately 20% of total bookings, more than triple a year ago.

Another area in which we see increasing momentum is our expanded channel network, which consists of distributors, resellers, and OEMs, and is now one of the largest in the industry.

In February, we entered these new programs for these channel partners to help them quickly establish and expand their virtualization practices and drive new customer acquisitions.

The programs provide channel loyalty, allow us to reach additional market segments and acquire new customers. We are seeing these programs gain traction and we are encouraged by the long-term opportunity.

Turning now to non-GAAP expenses, cost of revenues for the quarter were $56 million or 12.9% of revenues, up from 11.9% in the sequential prior quarter. This reflects a slight mix shift towards professional services as part of our enterprise agreement program.

Research and development was $102 million or 23.2% of revenues from 22.6% of revenue in the sequential prior quarter and reflect our continued determination to advance and improve our products.

Sales and marketing expenses were $137 million or 31.2% of revenues compared with 31.4% in the prior quarter and reflects the cost of our channel execution, with which we are particularly pleased this quarter.

And general and administrative expenses were $37 million or 8.5% of revenues compared with 8% in the prior quarter as we continue to build our global infrastructure.

Taken all together, we earned non-GAAP operating income of $106 million. This represents a 62% increase over the same quarter of the prior year, a result with which we are very pleased.

Report on operating results would not be complete without a word or two on our cash flow this quarter.

As a reminder, our non-GAAP operating cash flows, which exclude adjustments for capitalization under FAS 86 and excess tax benefits from stock-based compensation, were $152 million for the quarter compared to $98 million for Q1 2007, growth of 54%.

On a trailing 12-month basis, these operating cash flows were $559 million compared to $258 million for the 12 months ended March 2007 or growth of 116%.

Diane has provided our top-line guidance and I'd like to say a few more words about next quarter and the balance of the year.

In the first quarter, our operating margin of 24% was down from 25% for the same quarter of the prior year. Because our sales occur in US dollars, but we have operating expenses in local currencies, the weakening US currency, which has declined 5% against the euro since our last quarterly update, was a significant factor here.

The effect of currency reduced our operating margins by approximately $10 million or 225 basis points compared to a year ago.

While we are exploring strategies to mitigate this, these involve complex international implementations that will take time. You should not expect to see our operating margin exposure to the weakness of the US dollar change very much in the next several quarters.

What we call net interest income and other this quarter was $2.6 million, a decrease from $6.8 million in the prior quarter. This decrease is due to $2 million less interest income on certain inter-company balances with EMC, as well as a declining interest rate on our investment portfolio.

I expect the lower amount in the first quarter to be representative of what you might expect in the second quarter after taking the impact of what interest rates may do into account.

First quarter average diluted weighted shares were 398 million and we are expecting a similar number in the second quarter, somewhere around 400 million shares.

A number of factors affect our results, including an uncertain domestic economy, seasonality, particularly between the third and the fourth quarters, customer demand for enterprise agreements, and the rate at which we invest in our business, particularly products and channels.

We fundamentally believe -- and are supported in this belief by a variety of independent surveys -- that our products remain first choice as companies make their IT investment decisions. This we believe will continue to represent an advantage over our competitors. This does not necessarily mean, however, that our customers will not slow their spending as economic conditions continue to deteriorate, particularly in the US.

Considering these factors, we continue to expect that our revenues should grow approximately 50% in 2008.

Right now, we do anticipate a solid second quarter based on our early view of global demand with revenues growing approximately 55% compared to Q2 '07.

Once again, we are very pleased with Q1. We delivered great results, have a strong balance sheet, and are really looking forward to executing on the opportunity in front of us.

With that, let me turn it back over to Diane.

Thanks, Mark.

VMware's strategy from day one has been product and innovation-driven. We focus on quality and partner-based delivery of the ultimate customer experience. The strategy is working very well.

Our customers use phrases like, "It's just amazing the kind of benefits," and "constantly finding new uses for it all the time." At VMware, we find these kinds of customer responses to be highly motivating. We like delivering this kind of value and it is a strategic and competitive imperative for us.

Our partners like VMware's strategy as well. I was recently on the East Coast meeting with partners. They were talking about why they value their VMware partnership. First, the brand value of VMware is significant. Customers know that VMware is the technology leader and far ahead of the competition. It makes it easier for them to sell complementary products and services and this drives their average deal size up.

Second, our partners see us continuing to distance our selves from the competition. And third, they have a long-term view of how the partnership with VMware will help them continue to grow their own customer relationships and offerings, particularly in the services area.

We've been expanding our hardware vendor partnerships, including the hundreds of certifications and also the co-development projects that deliver joint value and differentiated products to our mutual customers.

An example of this is in the announcement we made with IBM at VMworld Europe, our first European virtualization conference held in February.

VMware and IBM announced a world record for exchange scaling. We were able to announce hosting 16,000 mailboxes on a single server, 50% higher we believe than any previous record.

This is why customers like the University of Plymouth in the UK used VMware to virtualize their 50,000 Exchange mailboxes. This is the largest virtualization of Exchange resources that we're aware of.

In order to transform their data center and move to a VMware architecture, customers are increasingly standardizing on VMware across all of their applications. This strong trend keeps us well positioned competitively.

Once a customer standardizes on VMware, our field and partners have the opportunity to grow with them. On an ongoing basis, they can help them get even more value from virtualization by integrating our steady stream of expanding data center products in business continuity, desktop virtualization, app delivery, security, and automation and management.

Let me now take you through how these opportunities generally develop. The adoption path generally maps to five stages that we call separate, consolidate, aggregate, automate, and liberate.

These five stages correspond to VMware innovations and also VMware offerings. Our field is working quite successfully with our partners to deliver on these stages as appropriate for the customer.

The first stage is separate. VMware Workstation lets one computer do the job of multiple computers by separating the logical function of a device from the physical device itself. One computer can act as many different computers and run multiple OSs.

Workstation is sold principally through the channel and the web. And it opens up data center opportunities by giving people the VMware experience.

The next stage, stage two, is consolidate. Clearly server consolidation has been our initial killer app. It began with another VMware innovation, GSX Server, which was the first virtualization software that enabled businesses to logically partition their Windows-based servers into multiple virtual servers.

Seven years later, VMware ESX hypervisor is the runaway market leader and is the core VMware virtualization technology in use by more than 100,000 customers, including 92% of the Fortune 1000.

We're taking aggressive measures to proliferate the high quality ESX hypervisor through a new, ultra-small and secure footprint in our ESXi hypervisor. ESXi is expected to ship with all of the major x86 vendors this quarter, eventually enabling every new server to arrive supporting server consolidation and giving VMware and our partners the opportunity to upsell to VMware infrastructure and much more customer value along with, again, a higher deal size.

If you really want to optimize your data center, then you need stage three, which is to aggregate your servers and pool the resources and deliver capacity on demand.

Many of our customers at this stage also discover that with a virtualized data center, they have the best insurance policy for business continuity and disaster recovery.

Some customers work towards it in stages, but others are moving right to it. We see mid-market customers move immediately to this phase. They're smaller and more agile, so they can just deploy a virtualized architecture from day one. In fact, this last quarter, we further segmented our field to address this opportunity.

The same is true in emerging countries. I was recently in India and also China where companies are definitely in a hurry. What this translates into for VMware is that they are skipping the early stages and just moving directly to deploying of VMware architecture as fast as they can roll it out. This includes both desktop and server.

Security, manageability, reliability, and minimal power usage for desktop deployments have very high value to our customers in the emerging countries. Moreover, the legacy physical and social structure are just not an issue. So we see this as a large growth opportunity. In fact, in Q1, we had triple-digit growth in 15 countries that would fall into the emerging category.

Increasingly customers across the geographies are extending virtualization and adding desktop resources to the pool. Workers using VMware virtual desktops get a full PC experience, both online and offline. This allows them to work from anywhere and on multiple devices. They also get the highly manageable, scalable, and reliable VMware infrastructure backing the productivity of the PC users.

The desktop is an area that VMware is investing in heavily and we are innovating at a rapid pace. We plan continued leadership in this area.

Stage four is the automation phase. This is an exciting and fast-moving opportunity. Automation's the next transformation area in the virtual data center. This quarter, we're shipping an automation bundle that includes products for managing virtual machines across their entire lifecycle, automating the lab environment for test and dev, automating the application lifecycle, and automating disaster recovery processes, bringing disaster recovery to applications that before just weren't candidates.

These products work on top of VI and work with all of our major storage partners. The interest in them has been very high. Our partners are excited about the opportunity that the automation products provide to them to deliver more services offerings to their customers.

We're excited about how together with our partners these new products and services will increase VMware's momentum.

The fifth and final stage is liberate. This means as virtualization becomes pervasive, it will be available across corporate boundaries with virtual machines distributed both on- an off-premise, well secured and well managed.

It is the age of the cloud. And this presents another opportunity for VMware. The proof points can be seen in our increasing traction in hosting and with service providers.

We're continuing to execute on other fronts as well. SMBs are an area where we already do a significant amount of business. The Foundation and Standard editions of our VMware Infrastructure 3 Suite provide the best TCO for small and medium businesses embarking on virtualization.

Our newly-introduced SMB targeted virtual infrastructure acceleration bundle gained great traction in Q1. And finally, we complement our innovative product strategy with our also innovative multi-tier distribution strategy with partners.

VMware has a unique win-win approach to partnering. And we're in the fortunate position of having products that complement and interoperate with hundreds of offerings from our partners.

Q1 was another solid quarter of strong execution with our technology, consulting, and channel partners.

So to wrap up, let me reiterate the key strengths driving VMware's strong position in the marketplace.

VMware is doing what few companies have achieved in terms of revenue growth. And we're clearly maintaining our excellent product and go-to-market execution as we grow on all of these fronts.

Demand for VMware's solutions across all geographies is very strong, as is our customer and partner following. Our partners don't hit customer objections when selling VMware. And they appreciate the growing suite of services resulting from our broadening VMware portfolio, particularly in management and automation.

VMware has more than 6,000 employees passionate about making our customers and partners successful. And VMware has more virtualization expertise than any other company on the planet.

VMware has the lead in virtual desktop, business continuity, automation and management, virtual security, and software applications as virtual appliances.

Thank you for listening. And now Mark and I would like to take your questions.

Okay, before we go to Q&A, I would like to ask everyone to try to limit yourself to one question. Thanks a lot for your cooperation.

Operator, let's open up the lines, please.

Thank you, sir. (Operator Instructions.) And we'll take our first question from Brent Bracelin with Pacific Crest Securities.

Thank you. Diane, the first question I have for you really is tied to kind of the trends and what your customers' feedback was in the quarter. Obviously there was a lot of concerns on the economy, obviously increasing concerns on competition. As you think about kind of the feedback from customers, your longtime customers and new customers, what was the general kind of commentary on why they were buying or why they decided to pause the deployment of virtualization in Q1?

Well, Brent, as you know, the - our product suite has a very high ROI. And so that puts us in a really good position for getting wallet share as the economy gets a little more uncertain. And I would say that we see that in our customers where they're going ahead. We increased the number of big deals we did. We were able to close deals in the financial - big deals in the financial sector. People are definitely talking about the economy, but we don't see hesitation with our customers. They're pretty eager to deploy the VMware infrastructure as an architecture.

And on the desktop side, was there any kind of acceleration there or a pause on the desktop side?

No. And the desktop as we've thought for some time is a major infrastructure change. And so we don't see that happening immediately, but we were pleasantly surprised to see a big uptick in the number of pilots. So 2008 seems to be the year of the pilot. And we've got hundreds of thousands of deployments in pilots that we're starting to see. But we believe 2009's going to be the year they roll these things out.

Thank you.

And we'll take our next question from Brent Thill with Citi.

Thanks. Mark, on the operating margin decline this quarter, can you just give us a sense, is that something we should expect as a trough level and how to think about the rest of the year with the 24% base you set up in Q1?

Well, Brent, as I mentioned on the call, we were hit pretty hard with currency. We have consciously gone to invest globally as a business and we're selling only in local dollars. And so we were hit hard this quarter. And we see that continuing on for the next couple of quarters.

I think an important point as we've always said is that we're really looking to invest in this business and we're not trying to optimize for quarter-to-quarter operating margins. You know, that said, we still think the mid 20s is the right intermediate place to think about our operating margins. But regardless of troughs that we might see, be it from revenues or increases in costs for whatever the reasons, we're not going to optimize for operating margins. We're going to continue to invest in the business, in our products, in our channels, and in the infrastructure to support it.

Thanks.

We'll take our next question from Kirk Materne with Banc of America Securities.

Yes, thanks very much. Mark, last quarter you noted that the November and December OEM revenues obviously flow into the first quarter. And I think last quarter, the deferred license number was something in the area of $54 million. I think you noted it as $32 million this quarter.

Could you just give me some I guess just background? Is that what we should expect sort of normally from a seasonal point of view? Is - did you see any sort of deceleration? I mean, it didn't seem that way, but did you see any deceleration in February, March, because that obviously doesn't show up till the second quarter? Could you just try to frame that for me just so I understand some of the volatility in that number?

Sure, Kirk. And I - you need to disconnect deferred revenue from the recognition on the OEMs because the OEM revenue that recognize in arrears isn't on the balance sheet. And so we see some seasonality from the x86 system vendors. We are recognizing their shipments towards the end of the fourth quarter and our first quarter. And then the seasonality that they have in the first quarter will be recognized in our second quarter.

With respect to deferred revenue overall, we look at the number in total. And we're really pleased with the growth that we had, 88% year over year in total deferred revenue.

The deferred license revenue is - it's really based on product shipments. And so it's going to have a certain amount of volatility to it. But the deferred service revenue is part of our strategy with entering into long-term enterprise agreements. And it's much more predictable and gives us a lot of visibility into the quarter and the year ahead.

Thanks for the clarification.

Yes, I can just reinforce that. We made a conscious decision about a year ago on these big deals to where now we're getting to where it's sort of 50/50, 60/40 on the services and the license, creating a nice and good annuity for us.

Thank you. We'll take our next question from Brent Williams with The Benchmark Company.

Hi guys. I noticed that R&D significantly jumped as a percentage of revenue. It's the highest going back the last couple of years. Within the engineering organization, where are most of these bodies going? In other words, is a lot of this porting and certifying on new hardware units from new partners? Is it new releases of the core hypervisor engine? Is it enhancing existing management products? Or is it net new sort of greenfield development?

Well, as you know, R&D is sort of a key strength of VMware's differentiation. And we've got quite a great track record of continual innovation, pretty amazing innovation coming out, which has got us to five phases of virtualization deployment. So we do continually invest in our R&D. And they are doing all of the above. We are certifying for more platforms. Our - we're significantly broadening our product portfolio. And we did come out with a new, small footprint, highly secure hypervisor, so all of the above, great investment because of the superb competition lead that VMware's got.

Yes, if I could add to that, we've also over the last year really worked on diversifying where our engineers - we have a development center in Bangalore, a development center in China, a development center in Bulgaria. And so we've had a certain effect from currency in the R&D line as well. But we're really pleased.

Great. And relatedly, what percentage of the new hires or what's the absolute number of new hires that were in R&D added in the quarter?

We don't break our headcount out by function. We do have of the 5,700 people we have at the end of March, almost 2,000 of them now are international. And so we're - it just shows the diversity that we've been growing in the business.

Great. Thank you for taking my questions.

And we'll take our next question from Toni Sacconaghi with Sanford Bernstein.

Yes, thank you.

I was wondering if you could comment on your revenue outlook for next quarter. Your guidance implies about 5% sequential revenue growth. That's actually a deceleration in the sequential revenue growth that you experienced this quarter and it's dramatically lower than the 20%-plus sequential growth you've experienced in Q2 over the last two years. So the question is ultimately what are you seeing or what might be changing that appears to be calling for a relatively dramatic deceleration in your revenue run rate?

Well, Toni, there's a number of factors. One is that we're providing several new data points, first 50% revenue guidance for the year, which we gave back in January. So now we have the Q1 results and then providing to approximately 55% growth in the second quarter.

As I've already mentioned, there is some seasonality from the OEM business and that we're recognizing revenue in our Q1 from the OEM late Q4 shipments. And then we have their seasonality affecting our Q2.

Some of it's related to product cycle and the shipments that we had in Q1 from Q4 deferred license revenue. And - but importantly is really the shift that we're seeing in enterprise agreements and the ability for us to develop long-term relationships with our customers. That growth year over year was quite significant. It tripled during the first quarter from Q1 of last year. And we expect that trend to continue and we're really excited about it.

As Diane mentioned, it was a conscious strategy on our part to create the annuity of more service revenue. And it gives us the opportunity to sell more into those organizations, both with value-added products, with renewals, and with additional service offerings.

Mark, if I could just follow up on that last point, I appreciate the change in the model from - moving from license revenue to deferred services revenue. At least on the - for this quarter, we actually didn't really see much impact on license revenue. They were pretty close to normal sequential patterns. So the question is why would we start to see that dramatically in the second quarter?

Well, part of that is from the effects on this quarter of the other items I mentioned, the OEM revenue, license revenue coming in on seasonal shipments and just as this program is continuing to build and to ramp up.

So we should be thinking about the OEM revenue recognized in Q1 as being lower than the OEM revenue recognized in Q2 despite the fact that total licenses went up sequentially and despite the fact that you've been pushing OEM partners more and more? So the - effectively what you're saying is the revenue recognized by OEM partners in Q1 or in the back half of Q1 was lower than it was in Q4? Is that what we should be taking away?

Yes, we're seeing some of the same - the seasonality from our OEM --

Toni - yes, if I could just - Toni, I think you want to look at the total revenue and the total deferred revenue. And if you look at those numbers and then look at your changes in deferred revenue, you'll see that it's not quite as strong an effect as you're saying. But we feel very good about Q2. So when we look at it, we're looking at how's the market growing, we're looking at the economy, and then we are as Mark points out seeing an increase in the large deals, which we see as a very good thing. But we did see an increase in transactions. And that - and the increase in transactions is also very - continuing.

We'll take our next question from Heather Bellini with UBS.

Hi. Thank you. I actually had a follow-up to Toni's question. And I was wondering, I guess two questions.

To follow up on Toni's, I was wondering if you could talk a little bit about you mentioned, Mark, seasonality. You called out in particular 2Q to 3Q expectations.

And I guess I'm just wondering if you could share with us given your sequential growth expectations for the second quarter, your seasonality does appear to be changing versus what you've seen over the past few quarters. Can you give us any qualitative commentary that might help setting expectations in Q3 give that that's a - normally a seasonally weak period for sales in Europe and the US for most software companies.

And the follow-up question would be just on headcount plans for 2008 if you could share with us where you expect headcount to go. Thank you.

Sure, Heather.

Again, as we've provided guidance for the second quarter that was really to help you frame and think about the entire year in relation to the 50% guidance for the year. And you need to think about the seasonality between the third quarter and the fourth quarter as you look out to the second half of the year.

And if you look at last year, the overall change in bookings -- license plus the change in deferred revenue, you see that the second quarter and the third quarter were quite similar a year ago. And so just as you look ahead to the second half and try to break revenue into quarters, that was just designed to give you a little bit of help there.

Well, I guess the question is is that - that if you're looking at about 5% total revenue growth or sequential revenue growth in 2Q, I believe - I don't have consensus open, but the Street's double that, more than double that for Q3, which is usually a seasonally weaker period, again, having you want us to focus more on total revenue than license revenue.

Yes, we're - as we gave guidance at the end of the - at the end of January, at the end of the fourth quarter, we didn't break it out by quarters. And so we feel really good about the first quarter and also really confident about the - about how the year is shaping up. And so we wanted to put just a little bit of a bridge just to what we thought the first half was looking like. And I think some of the estimates may've come in a little lower in the first quarter and a little higher in the second quarter. And overall, it's like we're just like really pleased with the demand that we've seen.

And in terms of the seasonality in Q3, we have a big comp we're working off of from last year.

We'll take our next question from Kash Rangan with Merrill Lynch.

Just so I understand the Q2 license revenue guidance correctly -- and correct me if I'm wrong -- you did have the benefit of OEM bookings from the December quarter that helped your March quarter. And also when I look at your deferred revenue license component, it looks like it went down from $54 million in Q4 to $32 million in Q1. So it's easy to see how you guide - how you kind of had that strong license revenue quarter that you did in the March quarter.

So just I'm sure about this, in light of that, do you want to be a little bit more conservative about your Q2 license revenue assumption? Because as people seem to be coming to the conclusion that growth rate sequentially seems to be a little bit anemic. But is the reason for that primarily what we just talked about, the OEM bleed-through and you're still catching up on the seasonality of that and also the deferred revenue license component that went down from $54 million to $32 million? So you need sort of time to rebuild the pipeline? And then it sounds like you're optimistic about the year, but a bit of a pause and rebuild in Q2? Is that the way to characterize it or not?

Well, there's a combination of factors. And what we're really driving towards is to look at the overall bookings and the overall deferred revenue that we are driving as our relationships change as customers become more mature and go towards enterprise agreements.

There is some seasonality from the OEM business that is a little bit different than you'd expect from the hardware manufacturers because we're recognizing in arrears. But as we enter Q2, we're really happy with the pipeline and just really happy with the overall growth in deferred...

Yes, I mean, if you exclude the ELAs, we had great license growth regardless. And if you factor out the ELAs, it was even better. And then with the ELAs, you have to remember that we are consciously changing our model and that those ELAs are becoming 50%, 60% services, the enterprise - well, it's not just the ELA. Volume agreements, enterprise agreements, we have three kinds of high volume agreements that we do do.

Yes, and that - what you seem to be hitting on seems to be very important, though, an important aspect of your business model that I think we should pay closer attention to. So what you're saying is that the - in a typical deal, the license to making the split is changing, that it's becoming really a maintenance license and a emerging what you call subscription revenue it sounds like because when you say services, most people seem to think of services as time and materials, using consultants. But when you say services, you're...

We're saying...

...subscriptions.

...support and maintenance.

Okay. So that is higher margin stuff.

Along with professional services, but yes, support - three-year support and maintenance.

Okay. Does that...

Our professional services business is still less than 10% of overall revenues and overall deferred revenues.

Got it. So then going forward your margins should actually be helped because a bigger percentage of your revenues are going to be higher margin?

No, no, because more of our revenues are going to be deferred.

Oh, understandably, yes, but as you recognize...

So once you - I mean, as that reaches maturity, but when you're just building that change to a model, more of your revenues are getting deferred.

Yes, understandably. Understandably. But once they get - satisfy criteria for revenue recognition, then what you're going to be recognizing is high margin subscription revenues?

Yes, yes.

Okay.

We are headed towards the high leverage model, that is correct.

When, Mark, then, are you going to be breaking out subscription revenues as a percentage of your total revenues?

Well, at this point we're not doing it. But we'll give it some consideration.

Got it. Finally, any thoughts on hypervisor pricing relative to the core management...

I think we're going to keep one question.

All right, I'll pass. I'll go on then.

Thank you very much.

Thanks. Bye. Good job, good quarter.

Thank you.

Thank you.

And we'll take our next question from Israel Hernandez with Lehman Brothers.

Hi, good afternoon, everyone.

Regarding pricing, can you talk about your pricing assumptions for the remainder of the year as some of the competitors come out to market with new pricing models? Clearly as some of these competitive offerings mature, we're probably going to start to see customers start to look at some of these other vendors. So just kind of walk us through some of your pricing assumptions, please?

Yes, hi [Izzy].

We have now segmented our offerings somewhat to correspond with those different stages of virtualization where you have the foundation SKU on up to the enterprise SKU. And as you know, our strategy for years now has been to increase the value in that enterprise SKU. We keep - that's a bundle and we keep adding value. And that strategy is working extremely well, so we don't - we haven't had pricing pressure there. And that just continues. So we're adding bundles for the SMBs and we're continuing to raise awareness around the different offerings that we have.

(Inaudible) that pricing at the high end should hold despite some of this increased chatter and competition?

When someone moves to virtualization as an architecture, they want all that VMware infrastructure offers and then some. And so they buy the whole VI 3 suite. And those prices, our strategy is just increase the value. That strategy is working very well.

Thank you.

And we'll take our next question from John DiFucci with Bear Stearns.

Thank you.

Sorry, I'm going to go back to the topic Kash was talking about. Diane, we understand that now you're going to be recognizing services or maintenance like revenue over time, but you're also - the way I understand it anyway is you'll recognize the cost of those services as they're also incurred and as you recognize the revenue.

However, your cost of services has gone up as a percentage of services revenue. It's actually higher than we thought it would be and it's higher than it's been. It's actually gradually gone up I think every quarter over the last five.

Just curious, you would think that that would sort of level off at some point or go down. I'm just curious where - how we should be modeling this going forward and actually (inaudible) and why?

John, what you're seeing right now in the services gross margins is the fact that although our professional service offerings are small as a relative part of our business, they have been growing. We also are - once we enter into an enterprise agreement with a customer want to spend a lot of time with them to make sure that their deployments and that their strategies are - that they're able to achieve what they want to achieve out of it. And so there's a certain element of us having [hands] in those accounts and working with those accounts.

So we're seeing an uptick there, as well as partially a currency effect from the PSO organization in international countries.

So, Mark, you have been signing more enterprise agreements, but the - I guess just some - can you give us any kind of guidance as far as how we're modeling it out? We - I would expect at some point anyway that would sort of level off.

Well, at this point, we're still at the very early stages. It was about 20% of overall bookings this quarter, which is certainly an acceleration. And we're seeing a lot of interest of customers begin to do - to get more and more comfortable and decide to virtualize their data centers. And so at least for the foreseeable future, we believe that'll increase.

Well, the other point also to take into account is this is great when customers move to a VMware-based architecture because of our rich pipeline for new products, which actually really increased the value of their virtualized architecture. And we're rolling out pretty steadily this quarter a whole slough of management and automation products in a bundle and you'll see more and more of that. So if we get more footprint out there that's pure goodness.

Okay, thanks. And just a quick follow-up, just because - just to try to avoid the guessing game, what does guidance imply in regards to deferred license? I realize there's a lot of moving parts there. It's just - and it looks like you put up some good numbers, good results this quarter. But as you guys know, it's just one of those things that everybody kind of looks at, realizing it's not a big number.

Well, it - deferred license is becoming less a part of what you should see in the volatility from the company because we're really focused on $1 of deferred revenue is $1 of cash in the door or in a short-term receivable. And as I mentioned earlier, deferred license revenue is really product shipped-specific. And so you could see some spikiness depending on product cycles. But it is really hard to factor in.

That does conclude our question and answer session. At this time, I would like to turn the conference back over to management for any additional or closing remarks.

I just want to thank everybody for participating in the call and we look forward to reporting our second quarter results in July.

Thanks again.

That does conclude today's conference. Thank you for your participation. You may disconnect at this time.