VMware Inc (VMW) 2009 Q1 法說會逐字稿

Good afternoon. Welcome to VMware's first quarter 2009 conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. At this time I would like to turn the call over to Mr. Mike Haase, Vice President of Investor Relations. Please go ahead, sir.

Thank you. Good afternoon, everyone, and welcome to VMware's first quarter 2009 earnings call. We will have prepared remarks from Paul Maritz, our President and CEO; and Mark Peek, our CFO. Following the prepared remarks, Paul, Mark and Tod Nielsen, our COO, will be available for Q&A.

Please note that this call is being simultaneously webcast on our Investor Relations website. Our press release was issued today after the close of market and is also posted on the website.

I would like to remind you that 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 Securities and Exchange Commission, including our quarterly report on Form 10-K for the period ending December 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 an isolation from, measures of VMware's financial performance prepared in accordance with GAAP. Our non-GAAP financial measures differ from GAAP in that they exclude stock-based compensation, amortization of intangible assets, the write-off of in-process research and development, employer payroll tax on employee stock transactions and the net effect of the amortization and capitalization of software under Statement of Financial Accounting Standards No. 86.

You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP measures, in our earnings release for the period ended March 31, 2009 and on the Investor Relations page of our website. The webcast replay of this call will be available for the next 30 days on our Company website under the Investor Relations link.

For your planning purposes, our first quarter quiet period begins at the close of business, June 16, 2009. Also, unless otherwise stated, all financial comparisons in this call will be in reference to our results for the comparable period of 2008. With that, let me hand it off to Mark.

Thanks Mike and good afternoon everyone. Welcome to our first quarter earnings call. Despite the challenging economic environment, VMware had a good quarter in the context of the difficult macro environment and reduced IT spending. We are very pleased with our execution in the field, operationally and in our R&D organization. Customers continued to adopt the VMware platform as a strategic investment that delivers substantial cost savings, improved efficiency and flexibility for their business. But with the economic uncertainty, we are seeing customers reduce their IT purchases in order to preserve cash.

Despite the quick ROI from virtualization, customers have generally put the brakes on all new investment. With the uncertain macro environment, people are doing what you would expect them to do; conserve cash and focus on operations. Any investment is done with extreme caution and done with just enough and just in time. As a result, despite a couple of large deals, our ELA volumes fell to less than 20% of bookings during the quarter and our total license volumes lagged, consistent with new server shipments.

In January I told you that for planning purposes we were estimating first quarter revenue of approximately $475 million. Total revenue for the quarter was $470 million, about 1% off of our planning assumptions and candidly, given the market conditions, we feel pretty good about this planning accuracy. However, we saw continued weakness throughout the quarter in all geographies, particularly Europe.

Total license revenue declined 12.6% from the very strong first quarter of a year ago, compared to our estimate of roughly 10%. On the other hand, services revenue increased to a very strong 48%, as we benefit from our model of selling multiple years of maintenance and saw very strong growth in renewals.

We adapted very well to economic conditions by reducing our non-GAAP operating costs sequentially by 8%, resulting in non-GAAP operating margin of 25.7% and non-GAAP diluted EPS of $0.25 a share. We executed well on the austerity measures we instituted at the end of last year and we will continue to have a laser focus on cost management, but at the same time -- and this is a point I want to emphasize, we were able to sustain our investments in the strategic areas of our business and we will continue to invest through this recession.

Our strong balance sheet became even stronger, as we now have over $2 billion in cash and $917 million in deferred revenue. Our non-GAAP operating cash flows, led by strong receivables management, bookings and cost control, were $230 million, growth of 51% from last year.

Now let me take you through some of the details of the quarter. First quarter total revenues were $470 million; growth of 7% compared to last year. Services revenues were $213 million; a 48% increase compared to last year and up 7% sequentially.

As you would expect, given the economic conditions, our business mix continues to shift with services revenues continuing to become a larger proportion of total revenues. In the first quarter, services revenues were 45% of total revenues as compared to 33% a year ago. Total services revenues included software maintenance of $176 million; a 57% increase from last year. And professional services revenue of $37 million; up 17% compared to last year.

The professional services delivered around VMware products throughout the ecosystem are growing much faster. Our strategy has been to help our partners build consulting businesses around VMware to leverage the total capacity available to customers and as a result we expect to see only modest growth in our professional services revenue.

The customer renewal rate for maintenance agreements continues to be strong, as demonstrated by growth in renewals of 42% compared to Q1 of 2008. License revenues were $257 million; down 12.6% from last year, primarily reflecting a decline in ELAs during the quarter and declining server shipments.

Geographically, U.S. revenues increased 8% from a year ago, to $244 million, representing 52% of total revenue. International revenue grew 6%, to $226 million.

I'll now provide some details on operating expenses. Unless otherwise noted, all references to our expenses and operating results on a non-GAAP basis, which are reconciled in the press release table and on our website. Total non-GAAP operating expenses, including cost of goods sold, declined 8% sequentially to $349 million, driven largely by strong cost management and improved operating efficiencies. Our total headcount increased by approximately 50 people.

Our international expenses were $3 million lower sequentially, as a result of the benefit from the strengthening of the U.S. dollar. The Q1 operating margin was approximately 120 basis points less, due to operating cost associated with acquisitions we closed over the last 12 months. As a percentage of first quarter revenue, cost of revenues increased sequentially to 12.3% from 10.5%. The increase is due to cost of services revenues, driven primarily by some onetime support expenses and the professional services mix that was more weighted towards consulting versus training, but carry a higher cost of sales.

First quarter R&D expenses totaled $111 million or 23.7% of revenues as compared with 23.1% in the fourth quarter of 2008. On a GAAP basis, we capitalized $36 million pursuant to FAS 86, including $6 million of stock-based comp and $30 million in cash salaries. Our accounting policy under GAAP requires us to capitalize cost once we are in beta versions of our products. Driven by the GA of vSphere, we expect the amount of capitalized software to decline significantly over the next several quarters, while the amortization which is recorded in cost of license revenues will increase. This will have no effect on our non-GAAP results.

Sales and marketing expenses were $140 million or 29.7% of revenues compared with 31.9% in the fourth quarter. The improvement was largely due to lower variable costs in the form of commissions, as maintenance made up a larger percentage of total revenue. G&A expenses declined $2 million, to $40 million or 8.6% of revenue compared to 8.3% of revenue in Q4.

Our operating profit, measured on a non-GAAP basis, increased 14% from a year ago, to $121 million or 25.7% of revenue. Although our current focus is on continued investment and expansion of our market opportunity, we believe we have a strong business model for the long-term margin expansion.

Our non-GAAP tax rate in the quarter was 17% and the non-GAAP diluted EPS was $0.25 a share on 391 million diluted shares. The Q1 non-GAAP tax rate was lower than the GAAP tax rate for the quarter, due to significant FAS 86 capitalization related to our vSphere launch. After we GA vSphere, this difference will reverse and we expect our non-GAAP tax rate to increase in subsequent quarters. As a reminder, the guidance we provided last quarter projected our GAAP tax rate for the full year to be in the 16 to 18% range and the non-GAAP rate approximately 4 to 5 points higher than the GAAP rate.

Now onto our balance sheet and cash flow statement. Our balance sheet once again strengthened with cash at quarter end of $2 billion, a sequential increase of $191 million. We remain invested in short-term cash and cash equivalents and have not experienced any declines in valuation of our holdings. Total deferred revenues increased 5% sequentially to $917 million. Our net accounts receivable declined $74 million from last quarter and our DSO, including the change in deferred revenue, is approximately 46 days, primarily driven by the sequential decline in bookings from Q4.

Capital expenditures were $36 million compared to $58 million in Q4. During the quarter we completed the final building on our Palo Alto campus and completed our Data Center in Washington State. The interest rate on our $450 million note with EMC adjusts each quarter at LIBOR plus 55 basis points. For Q2 2009, the rate is 1.76%, 23 basis points lower than in Q1. Similarly, we anticipate our investment rate to be sequentially lower.

Non-GAAP operating cash flows, which exclude adjustments for capitalization under FAS 86 and excess tax benefits from stock compensation, were $230 million for the first quarter, an increase of 51% from Q1 2008. On a trailing 12-month basis, non-GAAP operating cash flows were $873 million, up 56% compared to the 12 months ended March 2008.

Our fulltime headcount at the end of the first quarter was approximately 6,700 people and grew about 50 people from year-end.

Before I hand it off to Paul, I want to share with you how we are looking at the business, to give you some assistance in developing your estimates. It's quite clear that IT spending in the first half of 2009 is slower than most third parties were predicting at the beginning of the year, as demonstrated by both IDC and Gartner revising their 2009 IT spending projections downwards to reflect the worsening environment in Q1.

There are a number of factors that impact VMware's reported revenues over the near-term. First, customers have little appetite for any CapEx outlays for new projects, although virtualization has a high ROI, it is frequently accompanied with hardware purchases and professional service engagements.

Second, we recognize OEM royalty revenue in arrears; accordingly, shipments made by the X86 system vendors in November through January were in our Q1 results and shipments made in February through April will be in our Q2 results. We believe we benefited from the moderate Q4 budget flush in our reported Q1. From what we have seen thus far, Q2 will be sequentially weaker.

And finally, yesterday we introduced VMware vSphere to the world. Q2 will be the quarter when we and our extensive set of ecosystem partners begin to go to market transition of vSphere. The product introduces significant changes in our pricing and our packaging. We will also be billing in foreign currencies for the first time, after the GA of vSphere. We believe that in the short-term there will be a disruption in the sales process and the close rates, thereby potentially impacting our near-term license revenue.

Based on these factors, we expect our second quarter revenues will at best be flat compared to Q2 of last year and very likely could decline. Our operating costs will increase sequentially from Q1, primarily from activities with the vSphere launch and as a result, non-GAAP operating margin could dip to 20% or even slightly below, depending on revenue. This is after taking into account our adjustment to GAAP operating income that Mike Haase listed at the start of the call. Due to the decline in cost capitalized under FAS 86, we expect our Q2 GAAP operating margin to be approximately 15 points lower than the non-GAAP margin.

To summarize, we are in this business for the long-term and believe we have tremendous opportunities ahead of us. We are managing the business prudently, mindful of providing a reasonable return, while continuing to fund the important investments in our strategic initiatives. We have great confidence in our ability to execute on the unique opportunity in front of us. We want to thank our people, our partners and our customers for the strong start to the year and look forward to delivering vSphere during this quarter. Paul?

Thanks Mark. Good afternoon. As Mark outlined, we managed to return a solid quarter in tough times. To amplify on what Mark said, I'll give you some additional color in both the challenges and the opportunities we face. As we outlined to you in our last quarterly call, we expected that this quarter, after the year-end budget flush that we saw in December, would be tough and indeed it was. Basically customers battened down the hatches and were reluctant to spend on anything that was not operational. One can see this in the overall x80 server shipments which based on our feedback from OEM partners, contracted sharply in the last part of 2008. The official IDC numbers for service shipments in the first quarter are not out yet, but when they come out, I don't expect that they're going to make pretty reading.

We also continue to see larger customers be reluctant to enter into enterprise license agreements, preferring instead to buy just enough, just in time. And as Mark noted, this has affected our abilities to close large ELAs with some noticeable exceptions that I'll mention later on. On the other hand, we continue to not see significant competitive pressure or pricing pressure. The primary factor seems to be just a broad decline in IT spend, particularly on new investment, with customers buying, but buying in smaller increments.

Against this backdrop of tightening conditions, I'm happy to say, as Mark outlined, that we've executed well in terms of the austerity measures that we instituted late last year. And this is reflected in our strong margin performance for the quarter and gives us the financial strength to continue to invest and launch a new generation of products.

Our customers continue to report that virtualization and VMware in particular are important to them. We staged three major events so far this year; VM World Europe in February, where we had over 4,700 attendees; one of the few industry events to show an increase from last year in terms of attendance. And most recently we had Partner Exchange down in Florida, where 1,500 of our channel and technology partners attended, again, a very strong attendance. And then yesterday, as we'll cover, we obviously had the launch of vSphere.

These customers and partners report that virtualization and VMware remain at the top of their priorities. This is confirmed by the various industry surveys. Companies continue to show confidence in VMware and our products, particularly in those sectors where spending is still strong. During the first quarter we booked two of the largest enterprise license agreement deals in our history, both for $20 million and over; one with a leading outsourcing and service vendor. They will use those licenses to provision their outsource customers. And another one in the defense sector, where the licenses will be used to increase the mobility and flexibility of forward troop deployments.

In addition, we now track the deployments and other detailed attributes of over 300 of our major customers and of the 350 major customers that we have surveyed recently, over 70% of them have standardized on VMware for their virtualization needs. The more aggressive of these companies have now actually parsed the 5,000 mark in terms of the number of virtual machines that they are now managing using VMware software and many of them are heading to 10,000 and beyond.

Another heartening factor is that our customer support contracts, as they come up for renewal, are being renewed in increasing rates. In fact, our overall services revenue, as Mark outlined, for the quarter grew close to 50% year-on-year and all of this contributes further to our financial stamina.

Our acquisition of new customers continues to be strong. We added over 11,000 new customers, purchasing virtual infrastructure products for the first time in the first quarter of 2009 and this excludes customers for our workstation and products for our free ESXi server product.

But most important of all is new product, the lifeblood of any software company. Yesterday we formally introduced vSphere, the first of a generation of new products and we were lucky enough to have executives from our key partners come in person to attend the launch; John Chambers of Cisco; Michael Dell of Dell; Pat Gelsinger from Intel; and James Luton from Hewlett Packard. vSphere forms the foundation of our family of new products that are in development. In keeping with our revenue recognition policy, we don't formally announce products until the quarter in which they're available, but you should expect us to continue to introduce major products, built on this vSphere foundation through the remainder of 2009 and into 2010.

vSphere is the product that really transforms virtualization from being a narrow CapEx play into a full fledged system software platform, targeting both CapEx and OpEx. It speaks to a new way of organizing x86 based servers, storage and networking equipment, aggregating them into a cloud, hiding the underlying plumbing and allowing a fundamentally higher level of management. vSphere provides really unprecedented levels of scale and efficiency. We've worked very hard to make sure that there is no compute load that now cannot be virtualized, enabling the efficiency and simplicity of turning all of your x86 servers into an internal cloud which can support all of your applications. We can honestly now say that there is no reasonable technical reason for a customer not to reach for 100% virtualization.

vSphere also carries groundbreaking new features; fault tolerance; new ways of doing security; storage for thin provisioning; storage in motion, distributed power management. We believe that these efficiency benefits alone in vSphere, the ability to achieve greater levels of consolidation and significant gains in storage utilization and power utilization, that these gains alone will save customers significant amounts of money and justify them moving to vSphere, whether they be moving up from our current generation of products or be new customers.

We also worked very closely with our ecosystem partners, as this vision of an x86 based internal cloud requires that what are today physical appliances, in fact become virtualized and cooperate with the virtualization layer in the management of the cloud. The conical example of this is the Cisco Nexus 1000V. Cisco has taken one of their leading mainstream physical switches and converted this into a software module that now plugs into vSphere. This switch can now be associated with application loads, be scheduled with them and travel with it, wherever the application goes, enabling greater levels of efficiency and security. The result is that vSphere is in a very real sense the world's first operating system for the cloud, be it an internal cloud or an external cloud.

When I first spoke to you back in July, I said that one of the things that had attracted me to VMware was the opportunity to build an important new platform, but realize all the benefits that come from that. And we're now actually achieving that goal. We believe that vSphere extends our current lead over our competitors and really changes the nature of the game. In keeping with this, we have refined our packaging and pricing, moving some of our older key marquis features down the price curve and replacing them with new features at the top end.

While the features of vSphere speak to the ability to create internal and external clouds, we also believe that these new features are highly relevant to the small and medium sized business market, so in addition, we are introducing new packages that are specifically targeted at this end of the market, packages that will provide what we call Always On IT in a box, as well as packages that will capitalize on our free ESXi server offering. Downloads of ESXi continue to be very strong, running at nearly 10,000 a week.

vSphere thus significantly broadens and deepens virtualization, giving us a foundation to reach for deeper penetration in existing accounts and allowing our customers to set the goal of 100% virtualization. It also opens up new customers for us. So we will build on this foundation by releasing a series of complimentary products that will target three main areas.

The first main area is the series of management suites or products that target important scenarios such as creating the self-service data center, doing custom development, disaster recovery or business continuity, and application management. These management suites are important, as they will constitute the new user interface to the vSphere platform and allow customers to get out of the business of managing plumbing and basically focus on the things that are truly business critical to them.

Second major area is our client or desktop space, where our VMware View product roadmap continues to be very well received. We have leading edge customers doing large scale deployments of VDI now and we have many more pilots underway. We expect that the client or desktop space will contribute significantly to our growth when mainstream deployments kick in, probably in 2010.

The third main area is the external cloud, which continues to be a very active space for us. Our service providers and enterprise customers alike are attracted to the idea of achieving federation between the internal and the external cloud and that is what the vCloud initiative is really about. We have over 400 service providers signed up for that initiative and we will be releasing product in the coming quarters, specifically targeted at that segment.

On the operational side of the business, we continue to focus on strengthening the management team here at VMware. This quarter we welcomed Richard McAniff, a 20-year veteran of Microsoft, to become our Chief Development Officer and oversee our product units. We also welcomed Andrew Dutton to be General Manager for our Asia Pacific operations. In fact, without explicitly intending to, each of our geographic regions is now headed by a gentleman who previously fulfilled that role for IBM Software.

Equally importantly, we welcomed Scott Bajtos to be head of Worldwide Support and Renewals. He held similar positions before at SAP and before that at Cadence. I am now very confident that we have the people management foundation in place that we need.

Looking forward, I'm afraid we cannot promise a near-term change from the current tough conditions that we're in. While there are some people promising signs of renewed life in the United States, customers are keeping a very tight reign on any new spend. If there is a bright spot anywhere, it's likely to be confined in the very near term to the federal sector. Europe in particular remains depressed. Asia is more promising, but we're still investing there and while growth will be good on a relative basis, it will be small on an absolute basis, given from where we are coming.

As Mark noted, the second quarter is also likely to be challenging, as it will be the quarter in which we make the major shift from one generation of product to another. We're changing the pricing and packaging with vSphere and that includes a move, as Mark said, to billing at local currencies. In addition, our ecosystem partners basically have to recertify their solutions and while we've made an early and deliberate start on this, this takes time. While these changes are absolutely essential for our future, they are going to have a short-term or near-term impact as people get educated and make the necessary assessments and changes.

What this all means, as Mark noted, is we think it is prudent to basically expect a flat quarter compared to Q2 '08 and even allow for the distinct possibility of downside. As Mark noted, we will continue to be disciplined and manage towards healthy margins, but given the transition, we probably won't see a repeat of this quarter's margins in the second quarter of the year.

So in summary, I'm now very confident that we now have the right foundations, vision, products and people to benefit significantly when the economy turns around.

At this point we'll open up for questions. I'm here. Mark's here obviously and Tod Nielsen, our hero, is also here.

Operator, let's begin the Q&A session, please.

(OPERATOR INSTRUCTIONS) The first question is from Heather Bellini with UBS.

I was wondering, Mark, this might be a better question for you. How much of your guidance for the second quarter could be attributed to the macro environment versus the disruption you mentioned from the vSphere launch? Because I guess what I'm trying to get a sense of is that normally we should expect your services revenue to grow sequentially, so I'm just trying to get a better sense for the license distribution and then how we should expect things to bounce back in Q3? Thank you.

Well Heather, as I mentioned in my prepared remarks, there's really three factors. One is the macro environment. What we do have visibility in is our services revenue, particularly the maintenance revenue that will amortize during the quarter and so we would expect maintenance revenue to be up sequentially in the second quarter, relative to the first quarter. But we're also fighting the revenue recognition that we have on OEMs and that we'll expect to be down sequentially on license revenue from our OEM royalty business and also we don't expect to see large enterprise agreements in volume during the second quarter. Add on top of that, the introduction of vSphere and you get the aggregate guidance that we provide.

Okay, so is the macro a bigger factor? Is the macro three-quarters of your flat guide for the year and vSphere -- I'm just trying to get a sense of the magnitude of each of those.

It's hard to disaggregate the component parts, but what happens is in an uncertain environment in which our visibility is challenging, we are adding more uncertainty with the new product introduction.

And should that bounce back then in the third quarter from a license perspective?

Well, in the third quarter, we'll provide fuller guidance on the third quarter in July. All we can tell you is that from a historical trend perspective, Q3 and Q2 have looked very similar, but we'll have more information and more knowledge as to how the launch goes and better market information at that time.

The next question is from Adam Holt with Morgan Stanley.

A couple of questions about how we should be thinking about the potential impact of vSphere on revenue. You noted that it will take a little while for your partners to get recertified and obviously to get loaded into the channel. If we're assuming a late May release, when should we start to see sort of general availability in the channel, number one? And number two, how should we be thinking about the potential revenue impact; would you expect average selling prices to be going up? Do you expect to see an acceleration in units, possibly as early as the third quarter? How should we be thinking about the elements there?

This is Paul; I'll jump in there. I think you should think of vSphere as having a strategic impact rather than a tactical impact. Our software is foundational software; it sits at the bottom of the stack and has lots of other layers and solutions sitting on top of it, which means that while the changes are fundamental, they happen slower than other forms of software. So, we think that vSphere is very important, because it strengthens us strategically. It allows our customers to do new things. It keeps us ahead of our competition. But you can't think of it in terms of giving a near-term hit. This is something that's going to have to work its way through the system. So I wouldn't be looking for a near-term pop from vSphere.

And what kind of impact would you expect it to have on your ELA business? Are people that are buying ELAs right now entitled to upgrades or how should we expect to see that unfold?

One of the things that vSphere will do is quickly show the great value of our maintenance. We're going to provide some increased functionality on the like product with the maintenance release that people are eligible under, under their current contracts. So we think that what we need to do for new ELAs is take our customers through the new features in the products, along with our channel. They'll be looking at certifications of their existing hardware and their future hardware purchases and going through the buying decision. But that said, it will be in the headwind of the current macroeconomic environment.

And just one quick question on the margins. Obviously you're looking for margins to be down significantly in the second quarter. Are there any onetime expenses in Q2, either related to launch, marketing or anything that may be unusual in second quarter or is that kind of the right expense run-rate going forward?

There's a couple of factors. We did add $35 million or so of capital during Q1 and so we'll have the depreciation addition in the second quarter. But we have expenses around not only the launch and the marketing around the launch, but also contractors in readiness for the ultimate shipment of the product.

The next question is from Sarah Friar with Goldman Sachs.

Paul, I think you laid out quite a lot of points to kind of deflect the competition question, but if folks look at your revenues they always get concerned that it's not just the macro, that you are starting to see more of an impact of competitors like Microsoft get their products out into the market or maybe even them kind of coming in at a lower price point. What else can you tell us in terms of how you measure win rates, how those have changed over the past three to six months? I think your installed base is clearly quite sticky, given the renewal rates, but what about new deals as they come up, how has that been changing?

Well, we try and get the very best intelligence that we get on that. Clearly our competitors don't tell us directly, so we have to rely on our field sales force and our channel partners to tell us that and believe you me, this is a question that we constantly ask them. We were just down in -- as I said, we just had our channel partner event in Florida last week, where they had 1,500 of them there and the best intelligence that we can get is that at this point in time, competition is not a factor, that the macroeconomic conditions are the major factor and that's what our direct sales force tells us as well.

Now, we know that Microsoft is preparing the launch of Windows Server 2008 and we expect increased competition from that and we hope that vSphere will have further moved the bar for us, but the best knowledge that we have that at this point in time, competition is not the major factor.

Got it. And if I could, just one more on the other side, Mark. You talked at the very beginning of the call about being pleased with the accuracy of your prediction on the quarter, I think plus or minus 1%. As you looked out to the guidance for the second quarter, were there any changes in your assumptions about things like coverage rates and the pipeline visibility continuance of decline, how did you think about that as you thought about second quarter guidance?

Well Sarah, the biggest impact on looking at coverage ratios and the actual conversion of coverage ratios in the second quarter is what impact would the vSphere launch have. And so we've done some work around that, but it's really too early to tell how that will convert into revenue during the second quarter. The other factor that we've baked in is the fact that we will begin to bill in local currencies, in most of the major currencies in the world during the quarter and that will add another level of complexity, really from a change management perspective with our channel in EMEA, Australia and Japan.

But it sounds like your overarching assumption is things are not getting any better here, that Q2 is just another kind of symptomatic of Q1, in terms of the environment.

We're not calling the bottom, if you want.

That's okay; I wouldn't expect you to. Thanks so much.

The next question is from Kash Rangan with Merrill Lynch.

Mark or Paul, I was wondering if you could give us some commentary on ELAs? You clearly indicated that it was a little bit less than 20% of bookings. How should we expect that metric to trend over the next couple of quarters? And also, Mark, I know you've disclosed the license backlog number; I was wondering if we could get an update on that?

Sure, I'll take it. On ELAs, we were below 20% this quarter and that was also with a couple of fairly significant enterprise agreements that made up about a third of the dollar value of the total ELAs. And so as we're looking ahead, again, the environment we're seeing is that people are being very cautious about large investments and so I think it will be really up more to the macro before we see large enterprise agreements come to fruition again.

On deferred license revenue, as we've been saying over the last few quarters, it's been relatively flat and once again this quarter. The deferred license revenue out of the total deferred revenue is a very small percentage and it was up a few million dollars, but not appreciably different from where we ended the year.

Also on the webcast yesterday for the vSphere launch, we've been getting actually a ton of good feedback from customers on fault tolerance and some of the other functionality, but yet I couldn't help but notice that the pricing per core went down quite a bit from the previous version. I was wondering why that might be the case or what is the strategy here? Are you looking to offset that pricing per core decline with the higher volumes when the economy starts to pick up? Just more to get the thinking behind the contradiction showing that the functionality is getting stronger and stronger, but the pricing, it looks like it could have been a little bit even better than what you put out there.

This is Paul; I'll jump in there. We obviously spent many quarters studying that question in detail and the pricing and packaging is always -- you're trying to balance many factors. We did an extensive customer survey to try and find the right price points and functionality points that would appeal to the breadth of customers that we address. And we really have at least three customer segments that we need to be thinking about.

We've got the small and medium size customers at the one end and we have done specific pricing and packaging for them. We have our good enterprise customers at the other end, where by and large -- I don't want to say things are pricing elastic, but where people are willing to pay for value up there and we try to create packages for them. It's the area in the middle where one has to tread carefully and clearly that's where we know that our competition in the future will focus. So we're trying to on the one hand make sure that we harvest value from our customers who appreciate it, but not inadvertently open up beachheads for our competition. We are in a competitive market. We do have to think about that and we try to strike the right balance.

Your next question is from Israel Hernandez from Barclays Capital.

Can you guys talk about what conditions you saw through the quarter in terms of linearity; did it get off to a tough start and just remain tough or did you see some improvement, particularly during the month of March, when the capital market seemed to have settled down a bit? Can you just talk about the type of flow in kind of that core mid-market segment as you exited the quarter?

I think certainly the year started very tough. January was -- well you know, as you said, after December basically everyone battened down the hatches in January. While there were increasingly some signs of improving sentiment towards the end of the quarter, it hasn't yet translated into people wanting to open their wallets. You know, we got a lot of positive feedback in April from our channel partners, saying that they're feeling better about the rest of the year, but we haven't seen that actually translate -- the feet aren't doing what the mouths yet and we have to base our projections on where we see people's feet going, as opposed to where we see people's mouths going.

And clearly you guys are having a tough time with large enterprises with the ELAs. Can you characterize the demand that you're seeing among your mid-market customers? Is it the same trends there as well?

Well, they have always been much more cautious buyers. They have always tended to buy -- not do forward buying and buy on an as-needed basis. And in that area, we're just seeing the same circular decline or easing that we've seen in the market as a whole.

This is Tod. One thing to add to that too is to be clear, we're not seeing the demand for virtualization drop off from a customer perspective; it's just the scope and size of the projects, they're trying to contain it more. So they absolutely still have virtualization on the top of their priority list, it's just instead of doing a larger ELA and buy forward, they're buying in smaller increments.

Your next question is from Brent Thill with Citigroup.

Paul, I have a question for you and a question for Mark. Paul more on the distribution side, historically you've been 75% indirect; 40% of your accounts receivable in the last quarter came from two distributors. So as you go towards vSphere, it seems like it's a shift towards a more direct sale, it's a more solution sale, it's going to require heavier lifting from your sales force. Can you just talk about where you think the channel partners are in terms of their training around vSphere and is this tied back into your comments why you don't think there's an immediate pop on vSphere, because it is a more complex sale?

This is Tod. I'll take a first crack at that. We actually -- I'd disagree with your theory there. We think that the partner is going to play an even more important part in the selling of vSphere. At our partner event we had last week in Orlando, we spent a week with our partners, working with them on training and really further helping them segment and focus on their core competencies and whether they're adding, you know, solution selling or they're bundling this with other solutions that they resell or if they're a technical partner that's integrated with us. We really tried to focus on expanding our reach and breadth through our channel. We've been rolling out a series of training programs over the last few weeks and we'll continue to roll these out through May and June to make sure our channel is ready to expand.

Our direct model is certainly an important part of selling our value proposition, but in many ways we view that as a compliment or a spearhead to help the channel drive and make our revenue happen.

The only color I'll give on that is while vSphere can seem somewhat intimidating in terms of the number of new features and functionality it provides, we've also worked very hard to try and improve the usability and user interface of the product, taking a lot of feedback from our customers, going through intensive workshops with them and if you were watching the launch yesterday, you would have noticed that even a feature like fault tolerance, that in previous solutions would have required quite a bit of technology and expertise to set up, literally is just turning on a property now.

So, while the product can seem like an intimidating product, we try to work hard to mitigate that. And we actually think that some of the more advanced features in the product like fault tolerance, will actually receive a very strong reception at the lower end of the market, the SMB market, where they can use it to actually dramatically simplify things.

Okay. And just real quick for Mark. The international business has lagged for two quarters in a row, the growth rate of the U.S. Is that more a function of the macro or is it just you don't have the right resources in place to reenergize that growth rate?

I think it's more a function of the macro. As we mentioned last quarter, we saw particularly late November-December, that things in Europe started to soften and that carried through during the entire first quarter.

I think once you call, you'd have to look at the IMF report that came out today, with the German economy contracting 5.6% this year; the U.K. economy contracting 4-point-something percent. It's pretty dire over there.

Your next question is from John DiFucci with JPMorgan.

I'd like to follow-up to the first question from Heather. Mark, you gave guidance that total revenue is going to be flat to down year-over-year and that implies license revenue is going to be down about 20% year-over-year and I'm just trying to get a better feel for that, after being down 13% year-over-year this quarter, so that sounds like it's getting worse. Now, you do have vSphere coming out and Paul said not to expect a pop from vSphere, but it sounds like we should be expecting this to really -- I don't know, stall purchases and you do see that ahead of a big release like this.

Maybe to help understand this, if you're paying maintenance, if you own the VI3, if you own your platform and you're paying maintenance, now vSphere has a lot more functionality to add too. Do you get everything in vSphere if you're paying maintenance on everything in your current platform? And if you're not, then are you putting yourself in a position where everybody is going to delay purchases and maybe this 20% down year-over-year is an optimistic outlook.

This is Tod. I'll take a first crack at that. So, regarding the packaging, if you're a current customer and your maintenance contract is current, you are entitled to an equivalent set of functionality or package in the vSphere packaging. However, some of the new higher end features, like host profiles and things like that, we actually have a package we call Enterprise Plus and that is something that we expect our enterprise customers will upgrade to once they understand more about the technology. So we think we've done a good job of migrating some of the functionality further down in the stack to remain competitive and extend our lead and make technology more acceptable to more folks, by putting more value at the higher end and encouraging our existing customers to upgrade as well as new customers to purchase that.

And we want to make sure that the value proposition of our maintenance continues to be strong, as it has been in the past and has been our history, but we will have a concerted effort on upgrades to Enterprise Plus or whatever the equivalent package is. Not all of our customers have bought Enterprise in the past.

Okay, so going from -13% in license revenue year-over-year to -20%, is that delta, the -7%, is that due to people just sort of delaying, just waiting to come out with vSphere before they actually purchase, is that what you're anticipating or again to Heather's first question, is it because the macro economy you think, looking out at your pipeline, is actually getting worse in the second quarter?

This is Paul. I think back to Heather's question and the way Mark answered it, it is the three factors that Mark mentioned and at this point we're providing you our kind of best view of how those three factors will interact. As you've seen in the last two quarters, once we get into the quarter we've been pretty accurate in where it actually ends up, which is both good and bad news, but that is our best judgment at this point.

Okay, just one last one. (Technical difficulty)

One moment please. You're open, Mr. DiFucci.

I'm sorry, on the maintenance stream, you know, the macro's tough, some of your customers are having tough times certainly; are you getting more pushback on maintenance, are people asking for some maintenance relief today and are you actually giving them any of that?

No, in fact, quite the contrary. Our renewals rate on maintenance was very strong during the quarter and we think yesterday was really a proof point as to the value of that maintenance with the vSphere release.

Your next question is from Phil Winslow with Credit Suisse.

I just wanted to get into expenses a little bit. You mentioned it would be up quarter to quarter. I'm just wondering how you see that playing out across sales and marketing, R&D? And also on R&D, obviously you've seen pretty high levels of capitalization the past three quarters. With the launch of vSphere, how should we think about that trending and also just the impact on OpEx?

We lost the first part of your question. Could you just summarize it for us again, please?

Sorry, on the spending side with operating expenses, you mentioned they'd be up quarter to quarter. Just wondering how you see it between sales and marketing and R&D and G&A?

Most of the sequentially increase that we expect to see during the quarter is related to the launch and that is a combination of marketing and engineering.

And then also, does the effect going forward of the vSphere launch, you mentioned the capitalization of R&D would come down. I wondered if you could just give us a little more direction on that?

What we called out on operating margins is that we expect a total of about a 15 point gap in the second quarter between the non-GAAP operating margins and the GAAP operating margins, so when you look at what historically has been primarily driven by the stock-based compensation, you'll see that gap widen a bit because of capitalization.

Your next question is from Bill Fearnley with FTN Equity Capital.

This is Matt Whitaker on for Bill this evening. My question was on -- there's been a lot of commentary on seeing customers buy more just in time, just enough. On the just in time part, is that also to say that decision cycles themselves are getting shorter, customers just need less time to do the evaluation and they're just ready to pull the trigger, you know, with much less hesitation?

Unfortunately not. It means that they're basically husbanding cash and trying to distribute that in as small amounts as possible, as late as possible.

Okay. And I guess on the just enough side, are you seeing customers forego substantial long-term discounts just in order to meet short-term needs?

Without any question.

Any chance you could quantify that at all?

You know, it's hard to quantify it, but it is a very distinct trend that we've seen. We've seen it in many cases where we've even been fairly far into the cycle of getting an ELA structured, approved through the CIO organization and have it get to the CFO's desk and then be converted into a lesser purchase.

Operator, we're going to take two more questions, please.

Your next question is from Jason Nolan with Robert W. Baird.

Just a couple of short questions. First, on the large deals, $20 million-plus I believe for each, certainly those are going to be hard to come by in this environment, but do you have more visibility in a deal of that size and then just broadly as the opportunity for deals like that in more normal days real?

Well, those deals, one of them came out of the outsourcing sector and the other came out of the federal sector. If there is any silver lining in the current situation that we're in, it's that the federal government has money and is spending it. And we think that while we can't guarantee that we'll get another deal like that in this quarter, there are certainly the opportunities for more deals like that in the federal sector.

Fair enough. And then just a short question from me on the launch yesterday there was a couple of storage features highlighted, storage VMotion and then thin provisioning, I guess. Are these complimentary to what a storage hardware vendor would do or would they be viewed as substitute solutions?

No, they are complimentary. They both work with existing storage solutions. The one, thin provisioning, if you can sort of think of as virtual memory for storage, so it allows basically much more efficient use of storage and the storage VMotion allows you to migrate information from one storage array to another without stopping or starting your virtual machines. So customers love that in terms of numbers in our estimate.

Our final question is from Robert Breza with RBC Capital Markets.

I was wondering if you could just comment in talking with customers and the launch around the new products, do you see that extending the sale cycle? Obviously more complexity tends to introduce a longer sales cycle. And then maybe can you comment on how ready do you think the sales force channel is ready to sell the new products? I mean, or is there quite a bit more training we need to go through? Thanks.

Well, as Tod said, we've been working very hard on preparing our channel and doing training and there's a number of programs we've instituted there. We've increased the number of authorized partners who can conduct training, so our capacity to do training on a worldwide basis, in local languages is dramatically higher than it was for the previous launch that we had. So we've been doing a lot in that department. But, we think actually the genius of virtualization is it's a non-disruptive technology and a lot of these features that we provide are designed to kind of just slot right in without disturbing anything. So if you want to do fault tolerance, as I said, it's literally basically you fire up the management console and you pick the loads that you want protected and you check a box next to them. If you want to migrate storage in real time from one array to the other, again, you'd fire up the console and basically initiate it as though it happens auto magically

So while conceptually these are new concepts for the industry and they've historically been associated with fairly complex solutions, our value proposition is we take the complexity out of it. Our whole essence is to hide the plumbing and make it happen. So, while we think that there's going to be certainly some near-term lag while people just wrap their minds around these issues, we're hopeful that the combination of the investment in training we've made and the investment in product that we've made, that this will not create an undue burden, in fact, it may very well in fact have the opposite effect.

Okay, great. Thank you, everyone for participating.

This does conclude today's conference call. We appreciate your participation. You may disconnect at this time.