Citrix Systems, Inc.
Q2 2006 Earnings Call Transcript

Published: 20 Jul 2006

[Operator:]

Good afternoon. My name is Katina and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Citrix Systems second quarter earnings conference call. (Operator Instructions) I would now like to introduce Mr. Jeff Lilly, Senior Manager of Investor Relations. Mr. Lilly, you may begin your conference.

[Jeff Lilly:]

Thank you, Katina. Good afternoon everyone and thank you for joining us. In this call today we will be discussing Citrix’ second quarter of 2006 financial results. Participating in the call with Mark Templeton, President and Chief Executive Officer, and David Henshall, Senior Vice President and Chief Financial Officer. This call is being webcast with a slide presentation on the Citrix Investor Relations web site and the slide presentation associated with the webcast will be posted immediately following call. Before we get started, I want to emphasize that some of the information discussed in this call may be characterized as forward-looking statements made pursuant to the safe harbor provision of Section 21E of the Securities Exchange Act of 1934. Those statements involve a number of factors that could cause actual results to differ materially, including risks associated with the company’s businesses involving the company’s revenue growth, products, their development and distribution, product demand in the pipeline, economic and competitive factors, the company’s key strategic relationships, the effect of new accounting pronouncements on revenue and expense recognition, including the effect of FAS 123R on certain of the company’s GAAP financial measures, and acquisition and related integration risks. Additionally, additional information concerning these factors is highlighted in the earnings press release and in the company’s filings with the SEC, including the safe harbor disclosure contained in our most recent 10K filing available from the SEC or the company’s Investor Relations web site. Additionally, during this call we will discuss various non GAAP financial measures as defined by SEC Regulation G of certain adjusted figures which include operating expenses, operating income, gross and operating margin, net income and earnings per share. The most directly comparable GAAP financial measures and a reconciliation of the differences discussed on today’s call can be found at the end of our press release dated today and on the Investor Relations page of the Citrix corporate web site. Now, I’d like to introduce David Henshall, Senior Vice President and Chief Financial Officer of Citrix Systems.

[David J. Henshall:]

Thank you Jeff, and good afternoon. Today, I’m pleased to report strong second quarter results for the company, demonstrating good execution across all aspects of the business and growing customer demand for application delivery products. In addition to providing you with some commentary on the second quarter results I will discuss the current trends in our business and our outlook for the third quarter and full year 2006. Beginning with our financial results, I should note that certain numbers discussed are adjusted figures. Please refer to the press release and our Investor Relations web site for a full reconciliation of adjusted figures to U.S. GAAP figures. So, let’s take a look at the Q2 highlights

[Mark B. Templeton:]

Thanks David, and thanks for joining us today. I’m really pleased with our second quarter results, capping a record first half performance and demonstrating continued momentum in the business. We saw across-the-board strength in products, sales geographies, and revenue streams along with a really solid operating margin. We’re well-positioned to deliver a strong second half performance, to further invest in our growth engines, and to stay aggressive with our access infrastructure strategy. Now, I’d like to discuss a few Q2 business highlights. First, our application virtualization business. Customers are seeing the power in many form of virtualization, now more than ever. With client server applications, the evidence is overwhelming. Installing software clients just once in the data center then virtualizing the delivery of those applications to every end user and any device provides the best possible performance, security and TCO. This is the value proposition of our flagship Presentation Server product. Second quarter revenue momentum for overall Presentation Server business continued right off the first quarter’s success, with licensing up about 6% over Q205. Migration to PS4 was strong across both existing and new customers, driven by instant ROI economics, manageability, better compatibility and scalability of PS4. The aging and consolidation of server farms, many of them running MetaFrame XT on Windows 2000, is further justification for customers to migrate. At the same time, a growing number of customers are evaluating a direct move to 64 bit. The fact is, it’s a smart move. Early implementations of the x64 edition of Presentation Server are powerful. In fact, two weeks ago a large UK customer told me they’d reduced their server count from 130 32 bit blades to just 35 64 bit blades supporting 3,000 concurrent users, giving them a savings of over $750,000 over the course of three years to justify moving to Presentation Server X64. So all of this is driving license growth, strong subscription renewals and continued success of our getCurrent program. Citrix Access Essentials, a part of our Presentation Server business, was launched a year ago and is our first app virtualization solution built for small businesses. Sales continue to ramp in Q2, up almost 25% over Q1, helped by the release of Version 1.5 and the availability of shrink wrap packaging. We now have more than 3,000 partners authorized on Citrix Access Essentials. Transaction counts were up about 10% sequentially in both unique customers and in new licenses. EMEA is a particularly good market for Access Essentials, accounting for over 60% of sales. So we’re making good, steady progress in our first SMB foray. Going forward, we feel really good about the potential of our app virtualization business as the performance, security and cost of application delivery becomes increasingly critical for customers. We’re making substantial investments in our Project Constellation technologies, preparing for the Longhorn platform and building new purpose-built products, for both application and desktop virtualization, that move the bar and change the game in this market. Next, let’s discuss our web application delivery business. When it comes to web applications, the best way to ensure great performance, security and TCO is to optimize their delivery as they travel the network. In Q2, our Citrix NetScaler product line continued to gain market traction and the process of scaling this new business within Citrix is on course. Q2 was the first full quarter where a NetScaler products sales specialist and Citrix ERMs were both compensated on NetScaler sales. It was also the first full quarter where NetScaler products were a complete part of Citrix’ channel incentive programs, like Advisor Rewards. In Q2, we certified about 40 additional resellers on NetScaler and now have over 265 NetScaler authorized channel partners worldwide, great progress toward our goal of 400 to 500 by the end of this year. A lot of energy is now going toward working hand-in-hand with these partners, building pipeline, moving them up the productivity curve and making them more self-sufficient. In Q2, we expanded the NetScaler product line with the introduction of the NetScaler 12000 system. The 12000 raises the bar for web app delivery, processing application transactions as much as 400% faster than high-end products available from competitors. We also released our web apps firewall on standard NetScaler hardware, improving supply chain logistics, and we’re on track with seamless integration of the firewall technology into NetScaler’s application intelligent policy engine, AppExpert, to offer our customers an integrated, multi-function web app delivery system. According to Gartner, NetScaler was the fastest growing product in its category last quarter, posting the highest overall growth rate among all web app delivery market share leaders. I’m really pleased with our NetScaler momentum. It’s shaping up to be one of our next big growth engines. Trends in web application development, data center consolidation and branch office simplification are driving explosive growth of the application networking market, expected to grow to $3 billion in 2009. We’re going to continue to invest here, leveraging our early success into market leadership. We have excellent solutions for delivering client server and web apps. Our next step is to be the first one stop shop for delivering any type of application, including desktop apps. For delivering desktop applications, especially to the notebook-carrying knowledge worker, we believe application streaming provides a compelling solution for disconnected use of personal productivity applications. Our Project Tarpon, previewed last year, is our exciting new technology for on demand streaming of desktop apps to these users. Since April, we’ve had a technology preview release of Tarpon in the hands of 40 partners and customers and just this past Monday we launched a broader data program in North America and EMEA. We’re getting some great input and we’re seeing standing room only crowds whenever we demo this technology at our events. As we prepare to bring our Tarpon project to market, we’re encouraged by the possibility of working more closely with Microsoft on this front. Their acquisition of Softricity represents another collaboration opportunity for us to embrace and extend their solutions, their technologies, with Citrix’ unique value add. Now that they’ve completed the acquisition, we’re discussing the best approach to partnering. Delivering any application with the best access experience also requires the best possible access security. Citrix Access Gateway, which solves this problem, continued to show strong market acceptance in Q2, growing over 25% sequentially. In Q2, we began shipping the new Enterprise Addition, moving Access Gateway from a product to a complete product line. In fact, the Enterprise Addition grabbed eight of our top ten SSL VPN deals in the quarter. According to Infonetics, Access Gateway was the fastest growing SSL VPN over the past 12 months, with an average quarterly growth rate nearly 10 times that of its nearest competitor. In the 18 months since acquisition, Access Gateway has raced past all other competitors and is now second only to long-time market leader Juniper. Clearly, Citrix channel partners are doing a great job of upselling and cross-selling our customers to our innovative SSL-based gateway. Delivering applications reliably and with optimal performance requires real time visibility into exactly what the actual end user experiences. That was the strategic rationale behind our Q2 acquisition of Reflectant Software, a privately held firm that provides an integrated real time view of application performance from the end user’s perspective. We closed the transaction in May. The team of about 30, led by Lou Shipley, formerly head of Reflectant and now our newest group VP and GM, continues to operate in the Boston area as our new management systems group. Reflectant pioneered core technologies in this space with its award-winning EdgeSight product line. EdgeSight for Presentation Server and EdgeSight for Endpoint will provide immediate benefits to our install base of Presentation Server customers, to NetScaler-delivered we applications and eventually to desktop applications streamed via Project Tarpon. Through August, we’re in Phase 1 of the integration. As with our other successful acquisitions, this phase is about getting the basics right

[Operator:]

(Operator Instructions) Your first question comes from Phil Winslow, with Credit Suisse.

[Phil Winslow:]

Very quickly, just a housekeeping item. I think you said what, you know, the gateways and ANG division grew sequentially. I was wondering if you could just give us a hard number for what those were? I think you said next quarter would be 25 to 26.

[David J. Henshall:]

Sure. I mean, going forward as we started talking about last quarter, I mean, we are going to be spending, talking about the business more on a combined basis because we’ve integrated the products and that’s really how we’re looking at it. But if you wanted to break it out, the NetScaler standalone products were roughly $16 million of license and the SSL VPN products were approximately [inaudible].

[Phil Winslow:]

Great and then also, would you just, going forward here, as far as your spending goes, just wanted to think about where you’re going to focus that as far as, you know, R&D and sales and marketing. From the sales and marketing perspective, is it really focused on, you know, on NetScaler or are we still talking about the core access suite and from R&D, you know, once again, sort of along those same lines?

[David J. Henshall:]

Sure. If you look at – or actually, what I talked about in my prepared comments really showed a balanced investment across a lot of parts of the business and I think that, consistent with the message that we’ve said for the last several quarters, we’re very focused on investing for the long-term and that is really about growth across all segments of the business, whether it’s, you know, R&D or some of the new products coming out of the VSG Group, Project Constellation and other new great technologies we’ve highlighted there, or it’s about just expanding our leadership in some of the other areas. So I think you should expect, you know, balanced growth across all of the product segments from an R&D standpoint. Go to market is really focused on the individual geos and what makes sense to, either to develop new markets or continue to penetrate existing markets and then, of course, you know, working on our infrastructure. So we added as I mentioned about 200 people last quarter which represents about 6% growth. If you remember back in Q1, I also stated that we were significantly behind our hiring plan in the first quarter so a little bit about catch-up, I think, in this period. Going forward, I would expect somewhere in the 3% range on a quarterly basis would be the headcount growth you should look for.

[Phil Winslow:]

Great. Thanks, guys.

[Mark B. Templeton:]

Thanks, Phil.

[David J. Henshall:]

Thanks, Phil.

[Operator:]

Your next question comes from Ed Maguire with Ed Maguire.

[Ed Maguire:]

Actually, with Merrill Lynch. I don’t own the firm. Hey, question on Europe. It looks like the U.S. was pretty strong sequentially but could you comment on the business conditions you saw there and any regional differences across the different countries in Europe?

[Mark B. Templeton:]

Ed, I’ll tell you. I actually spent two weeks in Europe during the quarter and honestly, traveling with our teams through sort of all aspects of Europe, southern Europe, central Europe. I spent a few days in Nordic and even the UK. We saw very much a standard type of notion for Q2. No anomalies at all. Obviously there were some distractions, you know, within certain parts of Europe around the World Cup but, you know, nothing that affected the business. I mean, it grew 20% year over year so I’d say, you know, a tremendous quarter and if you look at some other measures there, we held a number of partner and customer conferences across all of Europe during the quarter and the attendance rates were records and so, you know, we just saw a really good environment there.

[Ed Maguire:]

How about large deal metrics during the quarter? Were you – I mean, did you see closure rates, you know, within your expectations during the quarter kind of broadly across the globe?

[Mark B. Templeton:]

Yeah, I’d say so and I’d say, you know, as usual, our top ten deals, you know, tend to be skewed toward, you know, sort of six figure, $500,000 to $1 million. We’ll have a, you know, couple a little over a $1 million, but very traditional mix. We’re looking more and more as you could tell by some of the comments at sort of deal sizes more by product line now because, you know, we are participating in a number of market segments that are product markets that have direct competitors and we’re trying to measure, you know, our effectiveness in product market as well as sort of over all of the company looking at cross deals.

[Ed Maguire:]

Okay, I’ve got actually a question for Dave. In looking at gross margins, seeing those trending down, I mean, is that really the result of a higher proportion of hardware in the product mix?

[David J. Henshall:]

Yeah, exactly. I mean, we forecasted those to decline into the lower 90s by the end of the year just driven by the continued success of really the ANG and the gateways products. I will say that on a sequential basis, we’ve actually, you know, up ticked by about 100 basis points the gross margin in the application networking group as the pricing environment was very stable and we continued to just work on efficiencies.

[Ed Maguire:]

Okay, and one final question. Just on cash. I mean, the levels are getting pretty healthy here, you know. What’s your preferred stance on buybacks, you know, use of cash for acquisitions? Your preference for using cash for stock, for acquisitions, you know, as much as you can. And I’ll let someone else ask questions. Thanks.

[David J. Henshall:]

Okay. Overall, like you said, we’ve got about $900 million in total cash and investments right now. Our primary usage of cash over the last full year, two years, has been for share repurchase. This past quarter we bought back about 500,000 shares at an average cost of around $35 a share, bringing the first six months of the year to about 2 million shares for total repurchase. I think going forward I’d expect us to be more aggressive in the third period than we were in the second period and at this point it continues to be our primary use of cash. We’ll always occasionally use cash for acquisitions or for licensing but, you know, we’re generating a very solid amount of cash at the same time. No real specific plans beyond that.

[Ed Maguire:]

Thanks.

[Operator:]

Your next question comes from Israel Hernandez with Lehman Brothers.

[Israel Hernandez:]

Hey good afternoon, everyone. With respect to NetScaler, as it starts to ramp and find its way into broader channel distribution, are you seeing any differences in how competitors are acting relative to NetScaler? It seems like it’s gaining some momentum here. I’m just wondering if there’s been any changes with respect to F5, Cisco and some of the others in the space.

[Mark B. Templeton:]

Israel I’d say, you know, first of all, F5 continues to be, you know, the player we see out there most frequently and they do have broader channel coverage than we have and we’ve been, you know, approaching the channel coverage process very much in a systematic way on one end and then obviously, where there’s an opportunistic situation and a partner brings a deal to us that’s a great opportunity to get them into our partner program. So we are seeing F5, for the most part, and competing head to head with them oftentimes. We, you know, replace them in key accounts every quarter. We saw that in Q2. It was no exception to prior quarters and I’d say that our posture there is pretty much where it’s been in the product and competitor’s perspective. We did begin to see in Q2 and it’s what we like about kind of our strategy, honestly, is that a new trend in Q2 was that we’re starting to see an increasing number of deals where we’re not seeing, you know, any competition at all and these are deals that are really driven by Citrix ERMs who have strong relationships with customers. It is - the web app delivery market is an early stage market, especially in the enterprise. And so we’re identifying opportunities because we have a different kind of relationship with customers than, let’s say, an F5 does. Look for that to continue and, you know, through systematic training, incentivising, etc., of our channel partners we’ll be able to see, you know, the fruits of that part of the trend.

[Israel Hernandez:]

Great, and one follow up with respect to the profitability of the Citrix Online division. What can you say about that? I think the last quarter you guys talked about it approaching kind of the corporate average. Are we still on that trend line?

[David J. Henshall:]

That team continues to execute really well and once again even increased their profitability on a sequential and year over year basis last period.

[Israel Hernandez:]

Great. Thank you.

[Operator:]

Your next question comes from Sarah Friar with Goldman Sachs.

[Sarah Friar:]

Good afternoon, guys. Just first of all, a quick question on the cash flow. Cash flow is a little light. It looks like you had some sort of shift up in prepaids. Could you just let us know what that was, please?

[David J. Henshall:]

I think the cash flow being about $60 million, there’s two things that were going on there. Really, the first one is just some of the geographic changes that you see related to FAS 123. You’ve got a little bit of shifting in some of the numbers now showing up in financing. The other thing was related to, you know, FX contracts maturing in some of the prepaids. You also have accounts receivable balance changing materially from Q1 to Q2. Those are the big swings but, you know, certainly within our range and expectation this period.

[Sarah Friar:]

Sure. But you would expect, cash flow should be growing on a year over year basis going forward, correct? It’s probably more of a timing issue this quarter?

[David J. Henshall:]

Yeah, it usually is. I mean, if you look at it on a trailing 12 month basis, the trend is certainly up and to the right.

[Sarah Friar:]

Got it. Great. Then, just, more broadly on the geographic expansion of the newer products, the ANG products and specific online products, where do you stand on that? Do you feel that you’re starting to get them out into EMEA and Asia Pac?

[Mark B. Templeton:]

The answer Sarah is yes, but slowly. This is one of the many investment opportunities and growth engine investment opportunities that we have facing us and really why David indicated that, on a prior question, that the kind of expense growth and that’s what we’re making in the business; really expand sort of R&D and go to market. Especially when you consider a number of the acquisitions that have come on board, exciting products but very, very little presence outside the U.S. at the time of acquisition and all of that is sort of build from scratch kind of work.

[Sarah Friar:]

And do you think, Mark, that you’ll do that more through channels when you get outside the U.S., or will you also put feet on the street with direct sales people?

[Mark B. Templeton:]

The answer is both, Sarah, and it really does get down to which products we’re talking about because generally speaking, obviously the online business has its own sort of dimensions there related to geographic expansion that aren’t, you know, sort of part of this. But when you look at the application networking product, especially the NetScaler products, it’s a pretty technical sale and, you know, very much feet on the street, even with partners, you know, holding their hands early in the cycle. At the other end, on the access gateway, especially the entry-level products, very much a mass channel kind of thing and we look for leverage everywhere we can so we’re doing, you know, that kind of expansion through channels everywhere in EMEA and in the Pacific. If you look at Reflectant and EdgeSight, you’re going to see, you know, kind of a balance there. First, in the beginning, more of the higher-end partners, higher-end customers, ERM approach, followed by, when we get to Summit, you know, the packaging, etc., and pricing will be such that we’ll be able to reach out to much more of a mass channel. So we’ve got kind of both kind of go to markets going on across all geographies and I’d like to be able to do more outside the U.S. in terms of go to market investment than we are doing.

[Sarah Friar:]

Okay. Fair enough. And then David, just a final one for you. On the license updates line, that actually came in a little stronger than we expected. It actually accelerated in the quarter, up 24% year over year. What’s driving that, because I would think you were getting to a point where maybe you were getting more saturated there and yet you’re actually accelerating the growth rate?

[David J. Henshall:]

Yeah, Sarah, actually there’s a great story there. What you’re seeing is, it’s a combination of a couple of major effects. One of them is the 4.0 cycle and since we have most of our customers on a subscription-type model when it comes to upgrades and new product platforms, they are participating in that by being on our Subscription Advantage program. So that’s one of the big factors that’s driving the increase in that number. You see it in the renewal rate as well, at it’s highest point that it’s ever been.

[Sarah Friar:]

Okay, and can I just check the logic of that because I would think if they are already on a maintenance program, they’re getting 4.0 not for free but as part of that maintenance. So why are they paying more and why are you actually seeing increased year over year growth?

[David J. Henshall:]

Let me give you the second part of the answer and that was related to the fact that our getCurrent programs, which are really targeted towards those folks who’ve lapsed or were never on a program in the first place, showed outstanding performance in the second period, in fact, almost double what it was for the last couple of quarters That’s really just, you know, getting people back on the program that have lapsed so that they can participate in future versions, or that were never on and the portion of that which is really the lapsed piece recognized in the current period and the rest is essentially deferred over the term of the agreement. So that’s what you’re seeing as the primary strength that caused the acceleration there.

[Sarah Friar:]

Can you give us that amount, the last piece or you don’t want to get that level of granularity?

[David J. Henshall:]

Well, I’ve talked in previous quarters about being, you know, getCurrent representing, you know, $4 or $5 million per period. It was more than double that in Q2.

[Sarah Friar:]

Okay, great. That’s very helpful. Thank you. Good quarter.

[David J. Henshall:]

Thank you.

[Operator:]

Your next question comes from Kirk Materne with Banc of America securities.

[Kirk Materne:]

Yes, thanks very much. David, could you just talk, I know you guys have been talking about certain mid to upper 20% margins for a long time so, you know, everything is consistent with what you’ve been saying but you would have thought some of the upside in terms of revenue would have flowed down. I guess going forward I understand there’s some catch up this quarter. I guess going forward, would we expect, I guess, maybe just give us an idea how you guys are spending sort of intra-quarter based on how your top lines going. Obviously you don’t want to shut off, you know, the long return revenue driver but I would have expected perhaps a little bit more of the top line to flow through, back down to bottom line given the, you know, the great performance from the top line perspective.

[David J. Henshall:]

Okay, Kirk. If you take it in pieces, I mean, we talked a lot about last quarter being, with operating margins running a little, you know, a little ahead of plan and investments being below plan from a tiny perspective and what not. So you’ve got obviously the catch up in headcount driving the largest single increase, which is compensation. You also have the impact of our annual, we call them our annual raises which go into effect on April 1. You’ve got the addition of the Reflectant team, which was, you know, let’s call it dilutive to the bottom line by about $0.01, and a lot of other opportunistic and just timing-related investments. So I think going forward the biggest shift will continue to be in headcount growth and while we won’t be adding 200 people per quarter, I wouldn’t be surprised to see us add upwards of 100 per quarter going forward. So certainly the rate of increase will moderate into the balance of the year.

[Kirk Materne:]

Okay. Sounds sort of from a sequential standpoint the rate of increase should be sort of in line with your revenue growth sequentially to a certain degree?

[David J. Henshall:]

I think if you look at where the guidance is it will point you to, you know, op margins essentially consistent with what we posted in the second period.

[Kirk Materne:]

Okay. That’s helpful, and then just secondly on the NetScaler business you had a strong quarter from a revenue perspective, too. I was just curious, as NetScaler gets farther and gets taken up by the channel more and more in the next couple quarters, what’s the margin contribution from that business start to look like once you get it into the channel? Does it sort of dramatically shift or is it sort of a slow evolution in terms of starting to contribute more to the bottom line?

[David J. Henshall:]

Well Kirk, I think it’s more of a slow evolution. As Mark described, we’re working really hard to get partners fully trained, to roll out the right geography, to do the things that we need to do to be able to lead this market into the future. As I mentioned, I think we’ll see some steady improvement on the gross margin line and we’ve really integrated the go to market teams, the field teams, into the broader site engines so it’ll be, you know, continuing improvement but it won’t be a stair step approach.

[Kirk Materne:]

Okay, and just a last question. Could you give us an update? What’s your buyback authorization stand at and then, do you guys have a committed amount this quarter?

[David J. Henshall:]

We never had a committed amount. However we have historically spent somewhere in the $40 to $50 million per quarter range. We were behind that if you look at it on a year to date basis so I would expect us to be more aggressive in the third quarter.

[Mark B. Templeton:]

Overall, in total, we have about $230 million outstanding under the current buyback authorization.

[Kirk Materne:]

Great. Thanks very much.

[David J. Henshall:]

You bet. Thanks, Kirk.

[Operator:]

Your next question comes from Steven Freitas with BMO Capital Markets.

[Steve Freitas:]

Hi, good afternoon. Mark, I was wondering if you could talk a little bit about Citrix WAN optimization strategy? I mean it would seem that some of the technologies in that space are very complementary to what you’re doing in the Application Networking Group and I just want to know what your posture is there. I know you’ve addressed some of it in the past by way of alliances but just, you know, wondering how you’re going to address it in the future.

[Mark B. Templeton:]

Sure, Steve. Happy to. First, I think we’ve made no secret going back to when we actually acquired NetScaler that we believe that WAN optimization was one of the key components of the overall application networking marketplace. And we’re seeing, you know, both from a competitor perspective and from a customer demand perspective, that there’s an expectation to have a complete offering, especially at the enterprise level when it comes to delivering applications and every protocol that every application employs to sort of every part of especially a complex enterprise, that you’ve got to have a WAN optimization strategy and product offering. So that’s our sort of top-level view. Now, we are also very interested in this space because at the same time Presentation Server has been connected up to WAN from the time that God created Presentation Server. So actually our partners, our field teams, know where the WANs are and they know how they’re being used, especially in branch infrastructure kinds of systems, in outsourcing and off-shoring systems, in specific verticals that really, you know, have lots of smaller and diverse remote sites like in especially in finance banking and health care. So we like the WAN marketplace and the opportunity there for us because we think it serves sort of both ends of our go to market engine, the relationships we have and we’re building with partners and enterprise customers with the existing motion around NetScaler as well as the kinds of things that we’ve been doing all along with client server base, app virtualization and delivering those apps over wide-area networks because we think that there’s great value add there as well. So that’s kind of our perspective on it and, you know, we’ll continue to look intensely at this space.

[Steve Freitas:]

Secondly, are you finding that with the upgrade to 4.0 the ratio of concurrent licenses to users is changing?

[Mark B. Templeton:]

No, not in any material sense. You know, generally speaking, concurrency ratios over time, they actually come down from sort of a first deployment that can often be sort of a 10-user to one license, to over time can be, get to even, to be 1 to 1. Anywhere there’s sort of a thin client device the ratio is going to be 1 to 1 by definition. But then, you know, we see over time that the more committed customers get to Presentation Server which employs the concurrent licensing model, the concurrency ratio declines because they are, you know, users are just more active. They’re receiving, you know, more applications via Presentation Server. So, you know, PS4 doesn’t particularly change any of that other than to the degree that customers feel like they can build larger scale environments due all of the improvements we’ve made around application and device compatibility, around management and scalability, and around sort of the whole X64 economics message, then obviously we would benefit from that in terms of reduced concurrency ratios.

[Steve Freitas:]

Fine. That’s what I was getting at, so I was assuming that may be the case.

[Mark B. Templeton:]

Pardon me?

[Steve Freitas:]

That was the point I was getting at, that they may, you know, generate more applications on PS4 and therefore, you know, that ratio improves to your benefit.

[Mark B. Templeton:]

Well, that’s our goal and we think that we have such a compelling, you know, case for customers to take every client server application and with respect to the type of user, where they work, etc., etc., that they’re going to get the best performance, the best security and the best TCO model, you know, around delivering those applications, with Presentation Server and obviously this is something that customers learn, you know, over time as they do early deployments, measure the results, and come back for more.

[Steve Freitas:]

Okay. Understood. Thank you, Mark.

[Mark B. Templeton:]

Thanks, Steve.

[Operator:]

Your next question comes from Walter Pritchard with Cowen.

[Walter Pritchard:]

Mark, maybe you could just update us on, given you’ve got Tarpon rolling into a broader beta program, what you see as the revenue or deployment model for that product, for that technology? Does it end up being an add-on module as we move into PS5 or is it rolled into the base product?

[Mark B. Templeton:]

Walter, thanks for the question. At this point we haven’t made the kind of packaging, pricing, and even positioning question decisions that you’re referring to. I think we have lots of options, not only around all of those dimensions but have lots of options in terms of which form to package, price and position Tarpon. You know, as software, as an appliance, or some combination of those things. You know, considering the discussions we’re having with Microsoft right now to look at what really is the best sort of strategy to take to have a value added, embrace and extend kind of relationship with Microsoft which will give us sort of more efficacy in the marketplace in working with their field teams, and at the same time help us differentiate our application delivery focus around app streaming versus what’s Microsoft’s trying to do to enterprise-enable the Windows environment across, you know, their SMS platform, Windows server and moving customers, you know, to Vista and to Office 12. But that’s kind of how we’re looking at it right now and it’s early, since they just closed the deal with Softricity on Monday, and we are actively engaged in those discussions and optimistic.

[Walter Pritchard:]

Okay and then, David, just for you on the field marketing specifically, I think I picked up a comment there around paying both the NetScaler, former NetScaler reps as well as your own reps, your own Citrix reps on the product sale and I’m just trying to get a sense of how much impact that had on the sales and marketing expense sequentially and how that plays out going forward. I guess the last few years you’ve gotten a little bit of leverage coming into Q3 on the sales and marketing plan and I understand some of it has to do with the hiring so I’m just trying to isolate that comment and its influence.

[David J. Henshall:]

Yeah, specific to that comment, the answer’s not much. The biggest increase in the sales, marketing and services line came from an increase in marketing programs including some of the Citrix Online programs. Second behind that was increase in compensation from the addition of heads and increase in commission. So it’s just a whole bunch of things but specifically comping the Citrix sales teams on the NetScaler was not a driver.

[Walter Pritchard:]

Okay, and then just pull up on the comp side, so you do an annual raise on April 1 and you’re not doing anything six months from now, it’s a once a year event?

[David J. Henshall:]

That’s correct.

[Walter Pritchard:]

Okay. Thank you very much.

[Operator:]

Your next question comes from Todd Raker with Deutsche Bank.

[Todd Raker:]

Hey, guys. Two quick questions for you. First, can you just comment on the getCurrent penetration rate of the install base and how much more can you do there?

[Mark B. Templeton:]

Good question, Todd. I think that, you know, our best estimates are that there are somewhere in the neighborhood of, you know, 2 to 4 million really, hardcore active users out there that are not currently on subscription. We go back through our getCurrent programs and others and try to recapture those obviously and we’ll pull back 50, 100 licenses or so a quarter but at the same time, you know, there’s also that 20% each and every period that is letting lapse. So I think the opportunity pool out there is huge and it’s just a function of going through the process, getting the people in place to execute against the programs and we’re seeing a lot of success. Whether that’s driven by better execution or driven by the end of life of some of the older platforms or the power of 4.0, it’s probably a combination of those factors. So I think there’s a lot of legs left there.

[Todd Raker:]

Okay, and then the last question for you. Can you give us some insight in terms of Reflectant software, what the revenue contribution was in the business this quarter, what expectations are in the September quarter?

[David J. Henshall:]

It’s really immaterial in the prior period. As Mark mentioned in his prepared remarks, we’re really focused on a launch into the channel over the next several months so we’re not expecting a material revenue contribution, really this year at this point in time.

[Todd Raker:]

Okay. That’s guys.

[Operator:]

Your next question comes from Jason Kraft with SFG.

[Jason Kraft:]

Thanks. Two questions. One, deals over $1 million. How many were there?

[David J. Henshall:]

There was, last period there was only one deal over $1 million, actually. It was a large deal which, however, was more of a multiyear term agreement.

[Jason Kraft:]

So there was one deal over $1 million and it was in the U.S.?

[David J. Henshall:]

Yes, it was.

[Jason Kraft:]

Just back to the geographic expansion and growth of Citrix Online and the App Networking Group, I assume that a large chunk of both of those businesses are North American mix compared to international. Can you talk, just kind of confirm what the North America versus international revenue split is on both those business lines and where you want that to go into 2007?

[David J. Henshall:]

Sure. I think that if you look at the broader, call it non-VSG business, that would include the full Application Networking Group, you would probably be looking at, I don’t know the exact number, but we’re probably looking at about 80% or more than 80% of the revenue coming from the North American market at this point in time. I would expect that over, you know, some period of quarters to look more like the overall split from the business with somewhere roughly half coming from the North America market and half coming internationally. As far as Citrix Online, probably a similar split. You know, we’ve certainly got a lot more strength in the U.S. and in the plan throughout the balance of this year and into next year include a fair amount of geographic expansion there. So we’ve got a lot of untapped markets for those services.

[Jason Kraft:]

So how would you quantify just the incremental growth opportunity when you look at probably everyone’s street models and when everyone’s modeling the next several quarters and into 2007 with Citrix Online and App Networking, I’m sure a lot of it’s still assuming a pretty large chunk coming from North America. So if we add on top, where can you peg the incremental growth as far as on top of what you’re guiding for next year?

[David J. Henshall:]

I wouldn’t change guidance, per se. I think that there’s incremental opportunity but as Mark mentioned, I mean, it’s a slow process to expand across the various geographies and localization work that needs to be done and, you know, you name it, a lot of activity and so I wouldn’t consider it to be upside to the model. I mean, there’s always the opportunity for us to execute to the upside. It’s essentially baked into our guidance, is the way I would think about it, if I were you.

[Jason Kraft:]

Thanks.

[Operator:]

Your next question comes from Katherine Egbert with Jefferies.

[Katherine Egbert:]

Hi, good afternoon. A couple questions. First, you’re at a 93% gross margin right now which is the lower end of what you had said going into the year and now you said there’s a possibility you could go to 92% for the year. So can you tell us maybe the mid-term targets over six or eight quarters forward? Where does, you think, gross margin kind of base out? And then a similar question in the operating margin. The mid to upper 20s is quite a wide range. Dave, do you think it’ll be more mid or more upper over, say, the next two or three years?

[David J. Henshall:]

Okay, so let’s talk about 2006 first, which is the only thing we’ve really provided guidance for at this point in time. I think that if you look at the gross margin line, you know, we’ve targeted somewhere between 92% and 93%. We’re in that range right now, so we were about 93% in the second period and guidance will put you to probably about 93% in the third period. A lot of that’s just predicated on, you know, how quickly we can ramp up the emerging businesses and Citrix Online, to some extent. So when I look at gross margins going down modestly, you know, one or two percentage points over a couple of years, that’s driven by the fact that we’re being very successful in those markets and we’re driving growth and we’re expanding there. So that’s a good thing in my opinion because that’s contributing to, ultimately contributing to the bottom line. Regarding operating margin, if you look back over the last, call it six quarters, we’ve operated anywhere from about 24% to about 30%, and we look at that as kind of the mid to upper 20% range. It gives us a lot of profitability to the bottom line, but also allows us to continue to invest into the long-term business, to generate significantly above industry average growth rate on the top line. So, you know, generally, at least if you look back over the historical period, you see a progression of operating margin as the year goes by, with the second half, you know, usually posting better operating margins than the first half of the year and I would expect that pattern to probably continue over the next few years. But really as we get into the latter part of this year we’ll give more granular guidance in terms of our expectations into 2007.

[Katherine Egbert:]

Okay.

[Mark B. Templeton:]

Katherine, I’d like to – I’d just like to add, because I think this question comes up in different forms and, you know, the way we’re running the business is actually, you know, sort of top line growth. That’s the financial way we’re running the business, and then doing that with top quartile in peer group profitability. I think that’s the message that we’ve been trying to very consistently give. Now the question is, why? The reason is that we believe that we’re in a number of green field, early stage markets with lots of places to invest where we’ll get a return in terms of top line growth and which then puts us in sort of a strategic position when it comes to enterprise customers, being a single source, supplier, as well as puts us in a product market-based position to be Number 1 or Number 2 in every product market that we’re in. So that’s why we’re doing it from a financial and strategic perspective, and that’s really how we think about it when we build plans, etc. When you see us somehow exceed operating margins in a given quarter or even a half, it will probably mean that we’re, you know, trying to spend prudently, we’re not, you know, we don’t try to spend everything that’s in the budget just to spend it. We’re doing it wisely, and it’s because maybe the revenue’s outperforming our ability to spend to the, you know, the investment level. That’s the way to think about this on an ongoing basis and how we’re running things.

[Katherine Egbert:]

Okay. That’s fair. That definitely helps. One last thing. Your R&D expenses are up as a percentage of revenue. You know, historically it looks to me like R&D has gone up at the times that you’ve not been as acquisitive and then gone down during time when you’ve been more acquisitive. So, it’s been up the last couple of quarters. I mean, should I take that as an indication that maybe you’re doing more internally these days?

[Mark B. Templeton:]

Well, I think you should take it that way and I think, you know, it’s pretty easy to explain. First of all, we’ve accumulated, you know, quite a few very successful acquisitions in markets where we have very direct, head-to-head competition and to beat that competition and to, you know, be part of sort of the development of those markets, we’ve got to keep up the innovation pace. So that’s what’s happening there. Then in sort of the, in the Virtualization Systems Group, we’re making a huge investment right now in not only, you know, sort of the interim releases of Presentation Server, but we’re making a major investment in the class form transition from Windows 2003 server to the Longhorn server which is, you know, involving a tremendous amount of work for frankly, not a lot of what will be perceived as, a lot of new incremental value. But, you know, that’s what platform transitions are about and why the spending in R&D looks that way.

[Katherine Egbert:]

Okay, Mark. Thanks for that.

[Mark B. Templeton:]

Okay.

[David J. Henshall:]

All right, Katherine. Thank you.

[Operator:]

Your next question comes from Dino Diana with UBS.

[Dino Diana:]

Thanks, guys. Big upticks in the interest income line. Were there any kind of gains or one-time items there, or is that a pretty good baseline we should use for going forward?

[David J. Henshall:]

There was nothing unique this period. It’s just a function of our generating a lot of cash and interest rates keep going up, so I think on a go forward basis, certainly into Q3 and Q4, somewhere in the $10, $11 million range is probably a good number.

[Dino Diana:]

Okay, and the timing of the hiring on the sales and marketing front, was it earlier in the Q2 so we should expect that the impact’s already baked in or was it kind of skewed towards the end?

[David J. Henshall:]

I think with all hiring it happens throughout the period so I think of it in terms of mid-quarter.

[Dino Diana:]

Okay.

[David J. Henshall:]

Yeah. There was no real heavy skew, one end or the other.

[Dino Diana:]

All right. Most of my other questions – one final thing. Access Essentials. My understanding it’s been kind of a low-cost distribution model, mostly telemarketers like Bell. Did you mention today, did I hear you say that that’s one of the areas you’re investing in a higher touch model, or you didn’t say that?

[Mark B. Templeton:]

No, no. We did not say that.

[Dino Diana:]

Okay. So it’s maintaining that same distribution model? You’re not doing any more on the investment side there in a big way?

[Mark B. Templeton:]

No. Well, we plan on having additional products that will, you know, again reward the channel partners that are focused on SMD and obviously we’ll continue to, you know, have expansion in the distribution footprint in the work we’re doing with – actually, quite a few ISPs that are taking Access Essentials to market along with their small business, you know, applications and giving customers a way to deliver them and install them more easily.

[Dino Diana:]

Okay. So do you have any expectations when Access Essentials becomes a material contributor?

[David J. Henshall:]

I think that - not this year. This year’s a building year, and I think that we’ll have an opportunity through the year to lay down a good foundation with the SMD partners and an opportunity then for next year feed them some new products that will then make the SMD segment actually more material to the company.

[Dino Diana:]

Okay. Thanks.

[Operator:]

Your next question comes from Steve Ashley with Robert W. Baird.

[Steve Ashley:]

First of all, just a clarification. The first question today had to deal with asking for a revenue contribution from the NetSix, NetScaler products and I thought you had given license of 6 and 16. Was that correct or was that total revenue?

[David J. Henshall:]

No, that was license revenue.

[Steve Ashley:]

That was license? Then, do you know what the revenue then was in total approximately for those products?

[David J. Henshall:]

You know, I’d add about $4 million on top of that.

[Steve Ashley:]

Okay. So, if we look at that, let’s say $26 million, was the guidance for the Application Networking business of $25 to $25 million for the next quarter, was that total revenue?

[David J. Henshall:]

Yes, it was.

[Steve Ashley:]

Is that flat sequentially?

[David J. Henshall:]

I think we look at everything in the business on a year over year basis. We generally, that’s the one that makes most sense. So we’re going into our typical summer quarter. You know, I’d expect some growth on a sequential basis but, you know, not as strong as we’d see in the other periods.

[Steve Ashley:]

If we looked at the NetSix, NetScaler, Reflectant all together impact on the earnings per share line, it might have been dilutive by $0.01 or $0.02?

[David J. Henshall:]

Well, Reflectant’s the only one that’s still a reasonably self-contained entity and, you know, I mentioned it was $0.01 or so dilutive. The NetSix and the NetScaler businesses are more integrated at this point in time with the field organizations now part of our broader go to market engine so it’s harder to measure at that point. Modestly dilutive to breakeven is the way I’d think about those.

[Steve Ashley:]

Okay, great. Thank you very much.

[David J. Henshall:]

Okay.

[Mark B. Templeton:]

Thanks, Steve.

[Operator:]

Okay, our last question is from Adam Holt with J.P. Morgan.

[Adam Holt:]

I was starting to get my feelings hurt. I just have two quick questions. The first is, how penetrative do you think you are on the Presentation Server side within your install base and should we still be thinking about this as a four to six quarter cycle and secondly, can you update us on the Tech Data transition? Thank you.

[Mark B. Templeton:]

Sure, Adam. The penetration of Presentation Server in our customer base, we consider it to continue to be our biggest single sort of opportunity given that our best estimates are somewhere between 10% and 15% penetrated. The upside and the growth opportunity are really not tied to sort of a four to six-quarter cycle because we don’t license Presentation Server in a model, you know, where you rebuy the product when there’s a new release. That’s what our subscription and license update business is all about, so that customers can move to new versions of the software on their schedule, not ours. So the way the cycle works is that we continue to enhance the product and improve its applicability within the customer base in terms of the kinds of applications it can support, the kinds of devices it can support, the kinds of users it can reach, etc., and then through that look to increase the penetration within customer accounts by adding more applications to the environment, adding more users to the environment, which then increases the customer penetration rate. But that, then, translates into two things

[Adam Holt:]

And then the second part of the question was just on the Tech Data transition, if you could. Thank you.

[Mark B. Templeton:]

You know, the transition there is, you know, we’ve got two other great distributors in North America and we’ll be looking for additional distribution as appropriate to fill any gaps that we might have. I think that’s all I probably can and should say about Tech Data. They were a great partner for a long time, going back to when I joined the company over 11 years ago.

[Adam Holt:]

Terrific. Thank you for your help.

[Mark B. Templeton:]

Okay, Adam.

[Operator:]

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. I will now turn the call back over to management for closing remarks.

[Mark B. Templeton:]

Thanks very much. I appreciate your time, attention, great questions and we’ll look forward to seeing you three months from now. Thank you again.

[Operator:]

Thank you for participating in today’s Citrix conference call. You may now disconnect.