American Virtual Cloud Technologies, Inc.
Q3 2007 Earnings Call Transcript

Published: 18 Oct 2007

Operator:

Good day everyone and welcome to this Avocent CorporationConference Call. Today's call is being recorded. At this time for opening remarks and introductions, Iwould like to turn the call over to the Executive Vice President of Legal andCorporate Affairs, Mr. Sam Saracino. Please go ahead sir.
Sam Saracino:

Thank you. Good morning everyone, welcome to AvocentCorporation's Quarterly Conference Call. I want to remind all participants thatthis call will contain forward-looking statements. These include, statements regarding future businessprospects, capital spending and economic conditions in general, statementsrelating to Avocent's revenue, sales, expenses, gross margins, customers,inventory, tax rates, cash flow, and operational earnings per share, includingour expectations for the remainder of 2007. Statements relating to the integration of the operations,products and technologies of the companies we have acquired, and future revenueattributable to them, and statements about the development and introduction ofnew products and technologies, the size, growth, and leadership of thepotential markets for these products and technologies, and the timing of futurerevenue related to them. These forward-looking statements are based on currentexpectations that involve a number of risks and uncertainties, which couldcause our actual results to differ materially. These risk factors are describedin our periodic SEC filings, including our Annual Report on Form 10-K. The information discussed today will include certainnon-GAAP operational measures. These operational measures are reconciled to themost directly related GAAP financial measures in our Earnings press release,which was distributed yesterday. That press release is also available on ourwebsite; www.avocent.com, and was furnished to the SEC on a Form 8-K yesterday. As we have previously stated, Avocent Corporation intendsto comply fully with Regulation FD, and we have adapted our Investor Relationspractices and procedures to do so. Any and all guidance given to analysts andinvestors will be done only during this conference call; either in our preparedstatements or during the question-and-answer session that follows. Accordingly, we encourage you to ask any questions youhave concerning Avocent or our business or prospects during this conferencecall, since we will not be providing additional material, commentary orguidance during one-on-one conversations with analysts or investors. I would now like to introduce John Cooper, AvocentCorporation's Chairman and Chief Executive Officer. John?
John Cooper:

Thanks Sam, and let me add my good morning to all of you.We are pleased with the results of our third quarter. As is customary on thesecalls, I will take a little time to provide you some of the financialhighlights from the quarter. However, as in previous quarters, we found our commentaryin our press release for the quarter on an 8-K yesterday, so a morecomprehensive version of all of these numbers and many others is availablethere. Before I go any further, let me take care of a couple ofhousekeeping items. Ordinarily, Teddy Blankenship shares the stand with me, andprovides some additional color surrounding the financial results for thequarter. However, as some of you already know, Teddy currently is participatingin the Advanced Management Program at Harvard University, and so is not available for thecall today. Two other Avocent executives have been through this program, andgive it very high marks. So, while I miss Teddy's good counsel, I am pleased thathe is taking advantage of this opportunity. We look forward to welcome him backto the office in just over a week's time. In his absence, Robert Curly, our Corporate Controller,has filled in, in great fashion, and I am pleased that we were able to sustainthe quality of our financial and accounting operations during this period. Next, in a housekeeping vein, as I am sure everyonenoticed, we have changed the format of our financial statements in the pressrelease. For those of you that have followed us since the merger of Apex andCybex in 2000, you will recall that we initially developed the FinancialReporting Model we used after the merger in response to many requests that weexclude the impact of purchase accounting, and similar, primarily non-cashadjustments in our Earnings release. Eventually, we created the columnar format that presentedan operational income statement, which excluded these items, as well asstock-based compensation, and reconciled those statements to our GAAP results. However, as time passed, reporting standards clarified,and our format was outside what our auditors and the SEC preferred. We resistedchanging the format for some time, because it was familiar to our investors andanalysts and we believed it provided information they found useful. However,the time has finally come that we cannot sustain our position. So, the primary financial statements in the press releasefor this quarter were prepared on the basis of General Accepted AccountingPrinciples, commonly referred to as GAAP, the basis that has previously beenused only in our formal filings on Form 10-Q and 10-K. In the Supplemental Tables in the release, we haveprovided the information you need to analyze our results, in a mannerconsistent with previous financial statements. Now, with those housekeeping items out of the way, let memove on to our financial highlights for the third quarter. Total revenue for the quarter was $162.7 million, anincrease of 14% over Avocent revenues for the third quarter of 2006, and 8%over revenues for the second quarter of 2007. Our earnings per share were $0.56for the quarter, compared to $0.41 for the second quarter of this year. I may also mention with a great deal of pride that ourcash flows from operations were $41 million for the third quarter, and over $99million for the first nine months of the year. We told you last year that oncewe finish the integration of the acquisitions, we would get back to the kind ofbalance sheet management you have a right to expect. I am proud to say we havedone that. My thanks go especially to Gene Mulligan, our Senior VP ofGlobal Operations, and his operations team for getting our inventory returnsback to the level we looked for, while continuing to satisfy the needs of ourcustomers. Teddy, Robert, Dave Breck at LANDesk, and the finance team,also deserve a lot of credit for working so productively to bring ourreceivables back to the level we consider appropriate. I know that several of you follow LANDesk very closely,and are acutely interested in how things are going there. Overall, I am verypleased with what they have accomplished. I am also very optimistic about theirprospects and their current markets, and the broader opportunities we see touse their expertise in the infrastructure management area. LANDesk revenue grew to $28.6 million in the third quarterof 2007, from $24.5 million on a pro forma basis in the third quarter of 2006.This represents a 16% increase in LANDesk revenues. For reasons that I am going to explain in a minute, thisincrease represents strong performance by the LANDesk sales force, even thoughin total it is a little below what we had anticipated. I believe Pogo is credited with the expression, “We havemet the enemy and he is us!” Unfortunately that quote originally intended to behumorous, maybe applicable as I explain why I believe the LANDesk revenuenumber represents strong performance by the sales force, because I have to tellyou, I think I may have limited their revenue producing capability withoutplanning to. As you will recall, we had some particular challengesrelating to revenue and the LANDesk business in the first quarter of 2007.Challenges that in hindsight affected us in ways I did not intend. Salesorganization at LANDesk is very good, it has produced strong growth over anextended period of time. When we experienced the dislocations in the first quarterand the resulting sluggishness in revenue growth, I decided to hold off on thepreviously planned expansion of the LANDesk sales team. In a somewhat uncertainenvironment, I opted for the safety of controlling cost. Steve Daly and Mike Hall, LANDesk's new VP of Sales haveconvinced me that Avocent would have been better served had I allowed LANDeskto fill these sales positions. Simply put, while the opportunity to grow theLANDesk business remains as exciting as it ever was, we temporarily constrainedthat growth earlier this year by not putting more feet on the street. Thisadditional headcount would have been producing meaningful revenue by this time,and could have made a difference in the third quarter. Fortunately, I think the dynamics of the situation aresuch that we will be able to stretch the existing sales force in channels toachieve good growth in the fourth quarter. To deal with the challenge over the longer term, Mike Hallhas started the process of adding to our sales team in selected areas, and willbe redirecting some of our efforts to better utilize our existing sales force.I do not expect a significant increase in cost from this action during thefourth quarter, and I believe we will be able to more than offset these costswith revenue growth in 2008. My confidence in this statement is increased by theimpressive way Mike Hall has taken leadership of LANDesk sales efforts. Thirdquarter results were solidified because of his contribution, and I expect hisimpact to be even greater as we move forward. During our second quarter conference call, we addressedcertain questions surrounding our business and how the trends toward servervirtualization would affect it, and I promised you some announcements on thatfront during the third quarter. At VMworld in early September, we announced the latestrelease of our DSView software, Version 3.5, which includes the ability tomanage virtual servers in the same way physical servers are managed. Combiningthe access and control of both virtual and physical servers in the same pane ofglass, as we refer to it, reduces both cost and complexity of managing datacenters. In addition, this DSView release also supports VMware, byallowing a unified view of an enterprise with multiple virtual centers; afeature that is unique to our product. I have been told by our productmarketing group that upgrades to this newest DSView release have been brisk. While we are in the very early stages of this deployment,I can confirm that we already have small amounts of revenue from the product.We have also received favorable press in IT publications regarding this releaseof our DSView software, and I am very pleased with the reception it hasreceived. I want to add my thanks to Steve Blackwell, our VP of Engineering,and his group for the development of this well received product. As I mentioned earlier in my comments, all of the detailsunderlying these highlights are available in our commentary. We provided thiscommentary in written form for I believe six quarters now, and I trust thateach of you has grown accustomed to the commentary and have had the time toreview it in satisfactory detail. I think at this point I need to add one point ofclarification to the information provided in the commentary. While we providedsome updated information with regard to revenue expectations for the secondhalf, we failed to do that with respect to earnings per share. Our currentexpectation is that operational EPS for the second half will come in around themidpoint of our initial guidance. Now, Dustin, we will respond to any questions from theparticipants.
Operator:

(Operator Instructions) We will go first to Mark Kelleherwith Canaccord Adams.
Mark Kelleher -Canaccord Adams:

Thanks. Hi guys! I wanted to start where you kind of leftoff there on the guidance. Your revenue commentary indicated that you might beat the midrange or below that midpoint. Can you just give us some of thefactors from the things you are seeing that would put it below that midpointgoing into the fourth quarter?
John Cooper:

Well, Mark, I think if you go back to the guidance that wegave for the second half, and if you read that guidance in its full context, wetold you a bunch of things, if I recall correctly in that guidance. Among those things that we told you at that time were thatwe expected certain trends that had held forth in prior years in fourthquarters to probably be muted a little bit as we attempted to more effectivelymanage channel inventories, and contain the growth of those inventories duringthe fourth quarter. So, all of that guidance remains in effect, and all ofthose details remain in effect. Having said that, I think that the guidance that we havegiven, combined with the update this morning, provides I think some degree ofinsight into what we expect in terms of revenue for the fourth quarter. So, therange that we have given for that revenue in the fourth quarter, taking thethird quarter out of the guidance we gave at second quarter, I think creates arange of what we expect for that. I would say that I think those trends are what we wouldregard as reasonably normal trends going from third to fourth quarter,particularly when you bear in mind that the information that we gave you at thebeginning about the second half, in ways that we intended to try to normalizeactivity a little bit in the fourth quarter.
Mark Kelleher -Canaccord Adams:

So, you are not seeing any necessary change in thebusiness environment as you had from the third quarter to the fourth quarter?
John Cooper:

No, we are really not. The environment remains I thinkoverall reasonably positive. It is not a, how do I say this, it is not a bubblekind of environment, it is very real. We are seeing transactions I think closeon a reasonably normal basis. The timing of transactions appears to have remainfairly consistent once we got through the first quarter. The delays that weexperienced then have not really repeated themselves in any meaningful waythrough the rest of the year, and we don't see that happening in the fourthquarter. We think our customer base is reasonably optimistic. We have said before that we think the virtualization trendis a short-term headwind to our business, while people are still exploring exactlyhow they are going to do that. We think virtualization remains in its early deploymentphases. I mentioned that we have had some initial sales of our 3.5 upgradeproduct for controlling virtual servers. Those tend to confirm that, in that,what sales we have had to this point tend to be for relatively small numbers ofservers by each user. So, I don't think the environment has changed a great dealfrom the time we gave the guidance for the second half, and I don't reallyexpect it to through the end of the year. I think it will be a good, but notfiery kind of fourth quarter.
Mark Kelleher -Canaccord Adams:

Okay, great, thanks.
Operator:

We will go next to Rob Stone with Cowen and Company.
Rob Stone:

So, a couple of strategic questions, John, if I may. Thebase business is growing in the latest quarter, a little over 1%, 1% to 2%year-on-year, and you have passed the anniversary for LANDesk. So, what factorsmight lead to a resurgence, to more significant year-on-year growth in theoverall business in 2008?
John Cooper:

Rob, I think there are several factors that we feel goodabout going into 2008. First, to kind of try to take them in an order that Ihave talked about in my comments, I will take LANDesk first. That business appears to us to be in fundamentally verygood shape, and the opportunity that we saw there a year ago, we are even moreconvinced of today. As I said in my comments, I think inadvertently Iconstrained that organization by maybe being a little too conservative in theface of some less than stellar numbers in the first quarter, and kind of takena state of Missouri stance of, "Show Me," with some of the salesadditions that they had wanted to do. As I have said, I think that was my error. They haveconvinced me of that. So, I believe with the people we have in place, and thethings that we can see adding to that, I believe we can return that business toa growth rate of 20% or better in 2008. In the, what some people refer to as the core business, orwhat you might say is Avocent prior to LANDesk, what we now call the ManagementSystems Division, we have obviously encountered headwinds in that businessduring the current year, and I believe once we get through the first quarter ofnext year, the timing will be about right for that headwind to turn into alittle bit of a tailwind, because I believe we will start to see moreaggressive build-outs of data centers. Once we get through the first quarter and the remnants of thebudgeting that will go on in that quarter; this quarter and that quarter, Ithink we will start to see actual build-outs that will involve more rationalcombinations of physical and virtual servers, and will involve a high componentof new servers, that will lead to build-out, the addition of additional servers,and additional data centers, and that is good for our business. So, to get growth going in our core business, we need amore aggressive deployment schedule for virtual servers, tied to the physicalservers that go with them, and we need data center build-outs. I see that beinga function of capital budgets for 2008, I believe it to be realistic, it willbe the second quarter of 2008 before we start to see any real movement on thosebudgets.
Rob Stone:

So, what do you think should drive more aggressive capitalbudgets next year?
John Cooper:

I think, and a lot of other people think, that there’s abulge coming in data center build-outs, because I think the build-outs that wehave experienced, really going all the way back to the time that we kind ofwrapped up the Y2K build-out, have been less than what is needed. I think that a lot of people are making do. A lot ofpeople are stretching their existing capacity. A lot of people are trying to dowith their data centers what I tried to do with the LANDesk sales force, whichis take it beyond a place that it can go. So, I think once the technologytrends are clarified in CIOs minds of where they want to go, I believe we willsee a significant build-out of new data centers in the last half of 2008, the 2009and 2010 era. I think that is necessary. We have got significant inadequacies in a lot of datacenters, in terms of power and cooling capability. We have got a greatdivergence of technologies trying to be deployed in data centers that were notoriginally built for that purpose. So, I believe that we will have thatbuild-out. I am not alone in that, there are a lot of folks who believe that. Ithink the question is the timing. As I say, I am not optimistic that it will start earlynext year, but I believe it will get started in a concrete planning way in thesecond quarter, and I believe the second half of next year will start to showthat.
Robert Stone:

My second question has to do with strategic decisionsregarding cash, as the business is not at the moment growing all that fast, andas you pointed out, you have done a good job of bringing balance sheet measuresback into line, you are throwing off of cash flow. What do you plan to do withthat other than paying down debt?
John Cooper:

Well, you co-opted my answer by saying other than payingdown debt. I certainly intend to continue paying down debt. We paid down $20million during the quarter, I think we paid down another $5 million or sosubsequent to the quarter. The cash balance floated up a little bit during thequarter, and that’s not a bad thing, the investments that we were able to make.It’s not a significant cost to a little float up in cash. We bought back over $8 million worth of stock in thequarter. If you noticed, we kept our pledge to kind of keep the averageoutstanding shares, equivalent outstanding shares, pretty level. We would beopportunistic in additional stock buybacks if the occasion arose, but my firstpriority is to pay down the debt. As I said at the last call, I want to keep some powderdry, I want to be able to participate in the free agent draft, to use myanalogy from that quarter, when it comes, and so I am keeping some space undermy salary cap. I am not in the acquisition market right now. The pricesare unrealistic, but I think that will change in the early part of next year. Ibelieve we will go back to more normal times, and evaluations that all theentrepreneurs have in their mind today I believe will become more reasonable. So, we still consider ourselves an acquirer, and there aresome areas that we have an interest in adding capability if we get theopportunity at the right prices. That's not today, but six months is not a longtime in that world, so we will wait for that change. But fundamentally, our priority will remain paying downdebt, keeping our stock no more than even, no less than even, and buying backstock if the opportunity arises and if the cash were to continue to float up.
Robert Stone:

Okay, thanks very much.
Operator:

We will go next to Aaron Schwartz with JPMorgan.
Aaron Schwartz -JPMorgan:

Good morning. I had a follow-up question on the LANDesk unit,and just wanted to get your views on the margin expansion, potential there overthe next several years. I know you had initially talked about getting themargin up to the company average in the low to mid-20s. Is that dependent onyou generating the 20% growth, or how should we think about the margin expansionthere if its changed at all?
John Cooper:

Aaron, the margin expansion capability there remains Ithink very much intact, and it is dependent on revenue growth. We believe thatLANDesk software business is a very fixed cost kind of business. We believethat the core fixed cost at LANDesk is adequate to support a significantexpansion of the business. Now, the variable costs, there will be some as I mentionedearlier, we're going to incur some cost to make some additions to the salesforce and to strengthen it. We have incurred some relatively small costs as we have strengthenedmarketing efforts in certain areas during this year. We even incurred somecosts during the second and third quarters to strengthen the sales force in acouple of key strategic accounts that we have. We will continue to spend that kind of money, but salesgrowth far more than covers that. So, as we move forward, we believe that salesgrowth combined with a relatively stable fixed cost base in that business willallow us to expand that margin. The numbers, I wish I had Teddy here, because that's thekind of question he normally would deal with, but the numbers on that movearound a little bit depending on the assumptions that you can make, but I thinkwe are still optimistic that in the next couple years we can move that marginvery close to our corporate average, if not up to.
Aaron Schwartz -JPMorgan:

Okay, that's helpful. Then shifting gears, I did have aquestion on the OEM business. It looks like it declined in the quarter for thefirst time in several years, and I am just wondering if that’s justquarter-to-quarter volatility, or if there is a more systematic approach maybeto shift some of that, to brand it, to better monetize the few assets?
John Cooper:

Aaron, there are multiple parts to the answer to thatquestion. The third quarter last year benefited, I think we disclosed at thetime, from a couple million dollar catch-up in some of the royalties that getunder that OEM category. A second factor that is mentioned in that, for those ofyou who have followed us will remember that we acquired some business fromAgilent, that was kind of a runoff business, and that runoff continues. So,there was -- I don’t know, a million or two more revenue from that business lastyear than this year. Then the third thing that factors into that is that wenever know from quarter-to-quarter what the inventory management profile is ofour customers. So, we do not know what an individual OEM is doing with theirown inventories. Sometimes we learn that information after a few months, andsometimes we never learn why some of the fluctuations occur. That is a goodpart of the answer. To answer the implied second part of your questioninvolving DSView, I think one of the things that we deal with as we go forwardis that more of the business is moving to an enterprise kind of business, evenin a lot of middle market companies, where they want the capability of a DSViewkind of product. One of the opportunities I think we have with our OEMcustomers is to work toward an arrangement where there is a common managementplatform between the branded and OEM product that would enable the channels tooperate relatively equally out in the marketplace. That is something we worktoward.
Aaron Schwartz -JPMorgan:

Okay, so is it fair to say maybe over the next severalyears or just longer term that some of the development work you're doing onDSView could be better monetized through the OEM channel?
John Cooper:

I believe that's a possibility, I can’t promise anything,but it’s certainly an aspiration of ours.
Aaron Schwartz -JPMorgan:

Okay. I just have one follow-up question on the guidance.I know last quarter you talked a little bit about the inventory managementthrough Q4 into Q1. It seems like that came up again today, or with your moremuted comments toward guidance. But is it fair to say that the fundamentalshaven't really changed at all and it's just a more updated view on how you'regoing to manage the inventory there that’s led to the comment in the revenueguidance?
John Cooper:

Well, I thought I kind of had said that in the guidancewhen we gave it on last quarter's conference call, and I thought I said that inresponse to the first question today, let me say it again in response to yourquestion. I think the market is in pretty good shape. We are trying to be open and realistic with you and saythat we believe one of the factors that in the past couple of years hasexacerbated the significant downtrend from fourth to first quarter, has beenthat some of our channel partners have purchased in such a way that fourthquarter volume drove the inventory levels in the channel up beyond what firstquarter volume would support. So, you had a pendulum effect of kind of swinging too farone way and swinging then too far back the other way when first quarter volumessupported a lower level of inventory. We believe that has exacerbated thosetrends, and we are trying to remove that particular factor from that change,and we are trying to do that by better convincing our channel partners tomanage their fourth quarter inventories differently than we have jointly donein the past. It's not their fault, it's not our fault, it's the way wehave done business. We're trying to say that we think those levels should bedown a little bit. So, what would ordinarily be a sale for us in the fourthquarter, we are hopeful, we move that to a sale in the first quarter, andnormalize the activity. In the room with me today is Gene Mulligan, our OperationsVP, make his laugh a little simpler by eliminating surges up and down in someof our activity, and just kind of generally better manage our business, and itis the fact that the financial result of that is to move a number from thisquarter to the next quarter. Other than that, we didn't mean to be making anystatements about -- in our guidance or the update to our guidance or anything,about any adverse trends in the market, we don't see those, we think the marketis in pretty good shape.
Aaron Schwartz -JPMorgan:

Okay, that's helpful. Thanks for taking my questions.
Operator:

We will go next to Manny Recarey with Kaufman Brothers.
Manny Recarey -Kaufman Brothers:

Good morning.
John Cooper:

Hi Manny.
Manny Recarey -Kaufman Brothers:

Hi. Most of my questions have been answered. As we look atthe margins for the fourth quarter and then in 2008, you're going to make someinvestments in the LANDesk sales force, but you expect that to increase. Isthat going to be the only sort of margin driver, or do you expect the coreAvocent to improve there?
John Cooper:

Manny, with regard to margins, we did mention the LANDesksales force broadening. We will do some of that always, we always do some ofthat at Avocent. I think it is fair to say that some of the technologies thatwe want to supplement our infrastructure management capability with, that wemight otherwise purchase, we're probably going to spend some R&D money ondeveloping some of that in-house over the next two or three quarters, assuming thatwe don't make a purchase. So, it might be that the R&D numbers would creep up alittle bit in 2008 as we do that. We're not fully sure exactly how that's goingto play out, so I am not prepared to give any guidance on it right now. But, Ithink it is a possibility that we will come back and say that in the absence ofacquiring some of this technology outside, we build it ourselves and so thatwill show itself in an R&D number that probably creeps up a little bit onthe core Avocent side. I think that will affect margins. I think that theeffectiveness of the organization is pretty good and in place and pretty solid.So, I don't expect fundamental movement in margins other than around the edgesfor some cost like R&D that we might incur.
Manny Recarey -Kaufman Brothers:

Okay, I am sorry. The other question I have is on, whenyou bought LANDesk you had said that about 24 months or so is when you would hopeto have a common platform for both products. I am just curious, if you can giveany update on how that's progressing?
John Cooper:

Manny, that's going to role out in phases, and I think thefirst phase of that is schedule for either late this month or very early nextmonth, and is on target. I expect that to be done pretty much by the middle ofnext year. That common platform will be I think a robust basis for usto combine our own products, also enable us to interface with and combine otherproducts that we need to as we move deeper into infrastructure managementwithin that platform, to provide the user with that common pane of glass wetalk about so much, that single console. So, it is on schedule, it’s being run by Tom Davis, whowas the VP of Engineering at LANDesk prior to the acquisition, and we moved himinto the role of our Chief Platform Architect. It's an engineering project, soit has a code name. I don't know if I am empowered to give that out on thiscall or not, but it’s on schedule.
Manny Recarey -Kaufman Brothers:

Okay, thanks.
Operator:

We will go next to David Duley with Merriman.
David Duley -Merriman:

Good morning. Congratulations on a nice cash flow quarter,that's two quarters in a row, right around $40 million, and certainly you willannualize more than the $90 million in the last nine months number that you’retalking about. I got a little bit of a softball question for you. Inoticed LANDesk threw operating profit this quarter of around $900,000. So, Iguess I’m saying that, roughly that’s break even of this business, in this $28million range, and every incremental dollar of revenue now, since you have 88%growth margin, is most likely going to drop, what, 75% to the operating incomeline? Is that a good percentage to think about incremental LANDesk revenuecontributing to profitability?
John Cooper:

You know, my first response is to say that softballquestion and David Dooley is an oxymoron. So, having put that caveat out there,Dave, thank you for the softball question. It could lead me into all sorts ofdire straits, depending on how I answer it, but I will try my best to answerit. I think that directionally the question that you asked,which might have become a statement like, have I stopped beating my wife, but,the question you asked, I think directionally places things in a properperspective. Certainly, we believe that we can improve the bottom lineof LANDesk disproportionately to what we improve at top line. I hesitate tocommit to exactly what those ratios are, at least with the degree ofspecificity you put in the question that you want me to answer, butdirectionally, I agree with the tone of your question.
David Duley -Merriman:

Okay. Could you talk a little about your virtualizationproducts? I have seen your recent presentation, you kind of talk about I thinkin 2007 there being roughly $10 million or $12 million of installed basevirtual servers. You have put out a new product recently to address this. Thisis a trend that you have had no exposure to, and probably slowed the growthrate of your core business. What kind of market opportunity do you see in those10 million units of installed base, which is obviously going to grow morerapidly than physical servers?
John Cooper:

Well, first off, to answer that question, I think we needto preface it by saying that everyone needs to remember that all virtualservers reside on a physical server. There has been for a number of years astrong trend to manage physical servers, and we have participated in that trendreasonably successfully. So, I think the first answer to that question is to saythat we certainly expect to continue to be involved at our current share orgreater of managing physical servers that are in that universe. So, that's abig part of our business. If you take everybody's projections of the makeup ofthe server base, install base, between now and 2010, physical servers areexpected to remain far and away the more significant part of that, and areexpected to grow. So, I would expect that we could grow our business,probably not at rates that it would excite you today if I cited them, but wecould grow our business, and will grow our business through physical servers. Then to the extent that we can add virtual servers tothat, and get paid for managing additional servers, which we believe we can,and this product starts to indicate that we can, I think it will take itseveral months to kind of achieve a momentum. But, people have already boughtit, which indicates to us that there is a market for it. When we can do that,then that revenue comes on top of the growth that we might otherwise experience,that revenue will be less per server, but it will be totally marginal. The cost of providing that revenue has already beenexpensed. It's a software upgrade. It's not another box, it's not anotherappliance that has to be produced. So, as we add those virtual servers to theuniverse of servers that are managed using Avocent technology, that addsrevenue to what would otherwise be there. When you also take into considerationthe complexity that virtual servers add to a data center, I think that makesmore compelling the prospect for people to buy Avocent products. So, we believe that the growth in virtual servers, whichwe want to hurry up and come about, we believe that growth will stimulate ourgrowth in two ways - One, by adding marginal revenue, or by virtual server. Secondly,by increasing the penetration rate of our core products as management ofphysical servers becomes even more important with virtual servers residing onthem.
David Duley -Merriman:

So, kind of to summarize, you have both the virtual serversoftware products growing rapidly and the LANDesk software products growing rapidly,those are all going to have a 88%, 90% gross margins. So, those pieces of your businessare the ones that are growing the most rapid.
John Cooper:

Well, I think clearly the LANDesk business is the fastestgrowing part of our business at the current time. I actually think that couldchange for periods of time as we see the build out of new data centers, that Iexpect to come about, but I don't know when that will be, and I don't knowexactly how it will play itself out by quarters. But clearly, both sets ofproducts that you mentioned add to our margin, because they have very littledirect cost once they are designed and built and prepared for the market.
David Duley -Merriman:

Final thing from me on the competitor front, futurecompetitor front, it seems like you had some cooperation with VMware to designthese virtual management control products. Do you think controlling all thephysical servers that you do will give you an advantage in controlling thevirtual servers in the future?
John Cooper:

Well, I hope it will, but I certainly can't speak for anyother company. I think someway there is some degree of misconception that maybepeople think we regard VMware as in someway competitive to us, and that's just deadwrong, we don't. We are working very hard to be complimentary to them andtheir technology, just like we have worked over the years to be complimentaryto server vendor technology, to serial technologies that come up in the datacenter, and so we see VMware as a kind of killer app that stimulates growth indata centers over coming years, and we really want to do everything we can tohelp that trend move forward. So, we see ourselves as complimentary to them. We willmake every effort to work and support their rollout, as well as the rollouts ofall the other virtualization vendors that are out there, and try to becomplimentary to all of them and support them. We see that trend as beingsomething that will be very good for our business once it really gains its fullmomentum.
David Duley -Merriman:

Thank you.
Operator:

We will take our next question from Tom Curlin with theRoyal Bank of Canada.
Tom Curlin:

Hey, good morning. The serial management revenue downagain year-over-year, I think there was some commentary about a producttransition, but can you just elaborate on what's happening in that business,and does it specifically relate in part to your commentary on data center build-outs?
John Cooper:

Tom, I think it does relate in part to the generalheadwind that we have talked about relating to virtualization. I think itrelates in part to a pause or waiting on some parts to build-out. But, the mostpointed part of that is the fact that as we mentioned last quarter, we had oneproduct line that we could not make RoHS compliant, that’s the Europeanenvironmental standards commonly referred to as RoHS, which more or less turnedinto a world standard because of the significance of that market, we justsimply in our engineering priorities couldn't get that done. We attempted to up sell away from that product with otherproducts, and we were not successful in doing that. So, we had to go back andrebuild that product to make it RoHS compliant. As we mentioned at the lastquarter conference call, that's cost us sales through the first half of thisyear in the serial product area. We did introduce the replacement product I believe inAugust, and we said during the second quarter call, that we really didn'texpect to be able to rebuild that revenue for several months after that, becausewe have got to get the product into the market, we have got to back into our customerbase with the product, and get our position reestablished in the purchasingline for that product. So, what happened this quarter in serial was not really asurprise to us given the transit we talked about, and knowing that we still havethat product omission that we have not yet gotten covered in our customer’s eyes.
Tom Curlin:

Okay, that makes sense, kind of looking at the KVM side ofthe business as well. I look at the various numbers your OEM on a revenuemetric year-over-year versus your KVM revenue metric year-over-year, what we haveseen over the last couple of quarters, it seems to me that the OEM base KVMrevenue is growing substantially less than branded. If that's true, what do youascribe that to? Is that embedded adoption of the OEMs? Is it share shift? Isit a change in your go-to-market approach, assuming of course that I aminterpreting it correctly?
John Cooper:

I think that the answer to that lies pretty much in theremarks I gave in answering the prior question. Part of it is just the general headwindin the market, but a significant part of it is the technologies that the OEMstend to sell. It's not any loss in share if the OEMs are sellingexternal KVM, they are selling ours, the people who sell it at the OEMs aredifferent people than people who would be selling an embedded solution by andlarge, so it's not that. I think that what we have going on here is the fact thatas you shift product technologies, the shifts tend to occur more quickly in thebranded world, because typically with the branded product you go through theuncertainty of exposing that product to the market and going out and provingit. Historically in our OEM business, it has been that way, and I think thatwill continue. As the significance of the management part of the productbase has increased over the last couple of years, as I mentioned earlier, oneof our aspirations is to work with our OEM customers to bring the appliancesthey sell under a common management framework, which would kind of level thefield I think in terms of which channel has the advantage of selling theproducts in a managed environment. Their products tend to be more rack-centric, they tend notto be controlled as well or as high level as the DSView provides, and so we areworking with them to try to move to a more level playing field where theirproduct would come under the DSView purview. We think that would allow bothsides of that equation, us and them, to have a more effective presentation forthe customer. So, I think you are seeing some of that to be fair to theanswer. Part of it is answered, as I have said earlier, by some of thecomparisons where particular things occurred during the quarter last year, thatdidn't reoccur this year, and part of it probably is just due to their ownparticular buying patterns. But, there is an underlying need for us to bringthose products in conjunction with the OEM customers, more into the mainstreamof the DSView type product, so that they can be managed by a common framework.
Tom Curlin:

Related to that, I realize the embedded revenue wasimpacted year-over-year by the Agilent piece. Do you feel like the embedded,it's KVM, but it's also IPMI and so forth, I mean is that progressing,excluding Agilent, the way you have expected, or are there any other factorsthat are impacting that up or down versus your expectations over the lastquarter or so?
John Cooper:

Let me be precise, the embedded revenue was effected notonly by the Agilent change, it also was where the effect showed up of thecatch-up adjustment that was built last year, which was a positive adjustment.
Tom Curlin:

Okay.
John Cooper:

So, that exacerbates that trend. The general answer toyour question is that we hold share there. We continue to do well with thosecustomers. The revenue is almost directly tied to server volume with thosecustomers. Server volume with those customers, as we have talked and talkingabout the general trends in our business, has been relatively flat. So, outsideof some fluctuations in shipment or some of the special items that filter inand out of quarters, that revenue is flat from quarter-to-quarter.
Tom Curlin:

Okay, thank you very much.
John Cooper:

You are welcome.
Operator:

We will go next to Reik Read with Robert W. Baird.
Reik Read:

Hey, good morning. I wanted to just go back and touch onvirtualization, and ask maybe the same question in a little bit of a differentway. Let me ask it this way, to what extent will your virtualization software,for the various products that you have there, and the trend towards higherservers, offset the underlying virtualization trend that there will be fewerservers out there, and maybe a little bit John, you could talk a little aboutmagnitude and timing of how that would work.
John Cooper:

Well, first off Reik, one of the suppositions of yourquestion is that there would be fewer servers in the install base. Thatactually is not what is being forecast by the Gartners and IDCs of the world,everyone in that does that is continuing to forecast and increase, although amuted increase in the number of physical servers in the install base.
Reik Read:

Yeah, and that's what I'm getting at John, I don't mean tomisstate that.
John Cooper:

Okay, and so as I have said earlier, what will happen istwo things that work to our advantage, we believe. First off, if you look attheir charts, it makes itself very nice for our business in this way, it justsimply shows the virtual servers adding on top of the physical servers. All of those servers have to be managed. We believe thatthere is a significant opportunity to manage those servers on a common consolesuch as ours; an agnostic party facilitating the utilization of not onlydifferent kinds of physical servers, but also different types of virtualservers within the same data center. So, we believe that’s good for ourbusiness, and we think that will be additive to the business. So, as to how the impacts are going, clearly the impact tothis point in time has been a slowing in the growth of the install base ofphysical servers, and clearly that's been a headwind to our business. When the full rollout to virtual servers and when thepurchase of replacement servers to facilitate those virtual servers, and whenthe build-out of data centers that will adequately facilitate all the disparatetechnologies that are going to have to be in there and deal with all of it froma power consumption standpoint and a cooling standpoint, and other environmentalfactors, when all that's going to happen is very much up in the air. My own prediction, as I stated earlier, is that we willsee that trend start to emerge in the second half of next year. It always takeslonger than what any of us would like. I think that we are still in theheadwind phase of it today. I think we will start to see purchasing activityand RFP kind of activity in the second quarter of next year that's related toit. We see some of it today. There's never an absolute in ourbusiness. But, in magnitude, I think we will start to see that emerge in thespring of next year after we come out of the year-end close, the typical lullin the first quarter, and we have got budgets for that sort of thing, and peoplestart planning to get it done in the second half of next year. That's my own belief. You can read all kind of expertopinion on this trend. There are people predicting a huge bulge in constructionin 2009 and 2010. Some people are saying, like me, that it will start in 2008, othersare not. I recognize that it's just my own guess, but just -- that is my guess.
Reik Read:

Okay. No, that's great. If I can go back to the LANDesksales issue that you talked about in not putting those folks in place. In whatareas would you have seen improvement, and given that you're planning to hireinto these positions, are those still areas where you have a good opportunityto attack?
John Cooper:

Reik, The truth is that an individual salesperson in theLANDesk business, with the requirements of serving the customer, there is afinite limit as to what that person can sell. You can stretch those limits overshort periods of time. You can get lucky in some quarters and have generallybigger transactions than you do in other quarters, but overtime, a salespersoncan deal with so many resellers and so many accounts. The mistake I made was not recognizing that we had reacheda step function in that sales force, and that we were at the upper end of the capacityof the existing sales force instead of kind of in the middle. The lull in thefirst quarter and the ability to bounce back from that lull in the secondquarter, kind of convinced me that well, there is more capacity in that salesforce. I think in a short period of time, where the market is there and readilyavailable, there is, but you need to keep the sales force in reasonable balancebetween hunters and farmers. If you let a sales force reach the top levels ofits capacity, you tend to develop a disproportionate number of farmers. What we need to do is add some hunters back to the mix, sothat we can expand that to create a bigger group of farmers down the road, andhopefully, not have the lull between the creation of hunters and farmers that Ihave allowed to happen this time. Does that clear it up in any way?
Reik Read:

Yeah, but it does sound like what you're saying is thatthat is not necessarily a lost opportunity out there, you can add those huntersand go find plenty of opportunity out there.
John Cooper:

There is still plenty of opportunity out there. What weneed to do is add the hunters to go find the new opportunities as opposed tohaving a disproportionate number of farmers who have to take care of theexisting base, and add on products into the existing base, and renewals in theexisting base, and service of the existing base, and I let that get out ofproportion.
Reik Read:

Okay. I apologize if I missed this before, but can yougive us a sense for -- on a proportion basis, how many hunters you need to add,and what the timing would be?
John Cooper:

I think we will probably increase the LANDesk sales force,something on the order of 10% headcount wise, and we will probably reorientanother 10% of the sales force into some higher end markets than they'reworking in today. Concurrent with that, we will try to move to broaden ourreseller base, and we will move to transfer some of our existing resellers morecontrol over some of the accounts that we have been exercising internally, justto kind of summarize what we're looking at doing.
Reik Read:

Has this stuff started to take place, and when will it befinished?
John Cooper:

It has started to take place. I think the phase that I amenvisioning now will complete itself during this quarter and next quarter, andhopefully, we create the kind of momentum that we are doing the same thingagain by the middle of next year.
Reik Read:

Okay.
John Cooper:

I have to confess, I simply wanted to be shown that we hadthe capability, and with the uncertainty that I faced, I opted to control thecost in retrospect, I kind of strained at a gnat and swallowed a camel.
Reik Read:

Great, thank you for your help in understanding that.
Operator:

We will go next to Eric Kainer with ThinkEquity.
Eric Kainer -ThinkEquity Partners:

Thank you very much for taking the call, andcongratulations on very strong profitability numbers, which obviously the marketseems to be ignoring right now. The question that I would really like to ask first isabout some of the additional information you provided in the disclosure lastnight. Specifically, you mentioned that last year, in the third month of thequarter, LANDesk got 54% of their revenues, and you booked that at a 94% grossmargin. Couple of things then, first, is that the normal type ofprofile of how we should expect LANDesk revenues to play out, maybe not in thefourth quarter, but in other quarters, that is half or so of the revenue comingin, in the last month? Then, building on that, the 94% gross margin, is that alittle bit more typical of what we should see out of LANDesk, or is it reallythat 88% you just posted more along the lines of what we should be expecting?
John Cooper:

God, I am impressed with the gentle and subtle way youhave asked me that dynamite question. I am not going to be talking aboutLANDesk’s monthly revenue going forward, I was kind of forced to do it to kindof illustrate what happened last year. I think, Eric, I would answer the question this way.LANDesk is in the software business. It clearly has a back-ended quarter. As towhether the 54% is typical or not, I think that obviously could vary fromquarter-to-quarter, but clearly, it's always back-ended, and it's veryback-ended. It's back-ended toward the end of the third month, not even just tothe third month, but very much toward the end of the third month. I think thatwill remain in place. I would say this, the 94% gross margin does illustratesome of the potential that you get when you keep LANDesk books for finiteperiods of time and increase the revenue during that period of time. I wouldn'tgo so far as to say that you can maintain revenue at a pace during the quarterthat you can switch from 85%, 88% to 94% gross margin, but it is a neat littleillustration of the upside of increased revenue in that business. So, I thinkit does kind of bear out that point. I don't know if I can really answer your question inanymore -- I don't know if I am willing to answer your question in anymoredetail than to say, that clearly we would conceive that LANDesk is a softwarebusiness, has very back-ended quarters, the third month is always mostcritical, the second half of the third month is always most critical. We wouldcertainly concur that there is upside potential in the profit percentage to theextent that you can increase revenue in any finite measurement period withinthat business.
Eric Kainer -ThinkEquity Partners:

Okay. Well, let me just kind of jump on to some of thenon-LANDesk products. We saw very, very strong margin performance in the thirdquarter. Can we assume that that kind of performance is sustainable? I meansequentially, just tremendous, tremendous improvements there, should we expect thatthose are normally achievable, maybe X the first quarter, which tends to be alittle bit lighter even with some of the smoothing that you are going to bedoing this time?
John Cooper:

Eric, I have to admit, I had a diversion. Would youquickly summarize the question?
Eric Kainer -ThinkEquity Partners:

Sure. I mean the margins that you posted here in the thirdquarter were truly outstanding, especially on a sequential business. Maybeexcept for the way first quarters normally lay out, can we assume that thosemargins are sustainable as we go forward, at least on the non-LANDesk side, becauseobviously LANDesk will be improving in those as the revenue picks up there?
John Cooper:

Eric, we haven't given any guidance beyond the end of thisyear, so I hesitate to go too deeply into that question. I will answer it thisway. I think this was a reasonably normal third quarter. We probably had alittle more favorable than normal excess in obsolete trends, because Gene andhis group did such a good job of managing the inventories. So, it probably wasa little bit on the upside of what our normal range would be in terms of theability to manage inventory, and be totally efficient with it as opposed tohaving some get aged on you or get model obsolescence, or whatever it may be.So, I think in that sense it probably was at the top end of what we can expect,to be honest, but overall, that's not a huge factor within the numbers. I think this was a reasonably ordinary third quarter. Wedid benefit from not being hit by any significant large adverse development inour business. I would have to say that I have lived with numbers for almost 40years now, and that in itself is somewhat rare, to not be hit with anymeaningful adverse number in any part of your business during the quarter. So, I guess I would answer your question by saying, thethird quarter went about as well on an operational standpoint as a quarter couldgo. It's within a range that we can achieve. I would have to be fair and saythat I would have no one to criticize if we had a quarter where we didn't doquite that well.
Eric Kainer -ThinkEquity Partners:

Okay. Well, thank you very much, and good luck thisquarter.
John Cooper:

Thank you, Eric.
Operator:

We will go next to John Emerich with Iron Works Capital.
John Emerich:

Thanks. Can you walk me through what the amortization dollaramount was, the cost of goods sold, what depreciation was in cost of goods soldas well, and then the total DNA?
John Cooper:

Hold on, just a minute John, I am going to ask RobertCurly, our Corporate Controller, to do that for you, we would be happy to. John Emerich - IronWorks Capital Thank you.
Robert Curly:

The amortization that we recognized in cost of salesactually for this quarter was $2.7 million, a little over $2.7 million, thatwent through cost of sales.
John Emerich:

Okay.
Robert Curly:

The amount that went through basically the other operatingexpenses was almost 7.6.
John Emerich:

Is that on a schedule that we can point to, Robert?
Robert Curly:

Yeah, I think if you…
Sam Saracino:

You restate sales and gross margins and the difference incogs between there and the one on the front of the page I am guessing is theamortization and the options expense, and you break that with the option’sexpense, it’s all kind of netted out.
Robert Curly:

You are right. If you look at that that table, thatsupplemental table that we gave, the reconciliation from the non-GAAP numbersto the GAAP numbers, you will see that we list out the net sale issue, whichwas the haircut impact for LANDesk. Then the very next line, the second line,you see the operational gross profit in that purchase accounting column, thatincludes both the haircut impact, as well as what I just mentioned for theamortization, to net out to the $3.3 million difference there.
John Emerich:

Okay. You used the term haircut, it might be well toclarify what a haircut is in this context.
Robert Curly:

Okay. We did back several quarters ago, and probably mostpeople would have forgotten by now, but when we acquired LANDesk, GAAPbasically requires us to attribute a certain amount of the revenue that was inthe deferred revenue account to effort free acquisition. So, we have done that,and that's why the GAAP numbers are a little different. So, we amortize thatimpact, that deferred revenue item, as if it was included in the numbers forthe operational purposes, so we can actually measure our business more.
John Cooper:

Maybe we could summarize, the operational revenue is theLANDesk revenue they would have had, had there been no purchase.
John Emerich:

Got you.
John Cooper:

And the GAAP revenue takes into effect the haircut, whereyou have to book the deferred revenue with the acquisition.
John Emerich:

Got it, that's all I had, thanks very much.
John Cooper:

You are welcome.
John Emerich:

Thanks.
Operator:

There appear to be no further questions at this time, Iwould like to turn things back to our speakers for any additional or closingcomments.
John Cooper:

Justin, thank you very much, and for all of you still withus on the call, I want to thank you for your attention this morning and foryour interest. And we look forward to meeting with you again next quarter.Thank you very much.
Operator:

Again, that does conclude today's conference call. Thankyou for your participation. You may now disconnect at this time.

American Virtual Cloud Technologies, Inc. Q3 2007 Earnings Call Transcript

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American Virtual Cloud Technologies, Inc.
Q3 2007 Earnings Call Transcript