Oct 22, 2008
Executives
Paul Maritz - President and Chief Executive Officer Mark Peek - Chief Financial Officer Michael Haase - Vice President of Investor Relations
Analysts
Brent Thill - Citigroup, Inc. Kash Rangan - Merrill Lynch Israel Hernandez - Barclays Capital Adam Holt - Morgan Stanley Philip Rueppel - Wachovia Securities Tim Klassell - Thomas Weisel Partners Group Inc.
Heather Bellini - UBS Charlie Di Bona - Sanford Bernstein John Difucci - JP Morgan Sarah Friar - Goldman Sachs Jayson Noland - Robert W. Baird & Co., Inc.
Operator
Good afternoon and welcome to VMware's third quarter earnings conference call. (Operator Instructions) At this time, I would like to turn the call over to Mr.
Mike Haase, Vice President of Investor Relations. Mr.
Haase, you may begin your conference.
Michael Haase
Great, thank you and good afternoon everyone. Welcome to VMware's third quarter 2008 earnings call.
With us today are Paul Maritz, President and CEO and Mark Peek, CFO. Following our prepared remarks, we will take your questions.
Please note that this call is being simultaneously webcast on our Investor Relations website. Press release was issued today after the closing market and is also posted on the website.
I would like to remind you that statements made in today's discussion that are not statements of historical facts are forward looking statements subject to the Safe Harbor Provisions under Federal Securities Laws. This includes but is not limited to, statements regarding our financial outlook, future product offering and projected demand.
These statements are based on current expectations as of today of this call and are subject to uncertainties and changes in condition, significant value and effect as well as other risk details and documents followed with the Securities and Exchange Commission including our quarterly report on Form 10-Q for the period ending June 30, 2008 that may cause actual results to differ materially from those set forth in our statements. In addition during today's call, we will discuss certain non GAAP financial measures.
These non GAAP financial measures which are used as measures of VMware's performance should be considered in addition to, not as a substitute for or an isolation from, measures of VMware's financial performance prepared in accordance with GAAP. You can find additional disclosures regarding these non GAAP measures including reconciliations with comparable GAAP measures in our earnings release for the period ending September 30, 2008 and on the Investor Relations page of our website.
The webcast replay of this call will be available for the next 30 days on our Company website under the Investor Relations link. For refining purposes, our third quarter quiet period begins at the close of business December 16, 2008.
Also, unless otherwise stated, all financial comparisons in this call will be in reference to our results for the comparable period of 2007. With that, let me hand it over to Paul.
Paul Maritz
Thanks Mike. Well, first I would like to say that I am happy to report to you that despite some very challenging conditions, VMware had a very solid quarter being able to reach the upper end of our guidance that we gave last quarter and at this part, I would ask Mark to step in and goes through the non business some detail and give you background.
I will then return and make some additional remarks and then we will open up for Q&A. Mark?
Mark Peek
Thank you Paul and good afternoon everyone. Q3 was another solid quarter for VMware and despite the unprecedented global economic events during the final weeks of the quarter; we achieved quarterly revenue of $472 million, an increase of 32% from year ago.
Our revenue for the first nine months of 2008 increased 50% compared to the same period last year and now exceeds our revenue for all of 2007. Our growth during times when IT budgets are under intense pressure is a test to measure the strong value, proven quality and immediate return on investments that customers get from VMware products.
Offering process measured on a non GAAP basis was a $115 million, 24.3% of revenue and an increase of 26% from last year. The third quarter was marked by improved operational execution during the time of significant economic volatility and the leadership transition.
Our trailing12 months' non GAAP operating cash flows were over $700 million, increasing over 48%. Our balance sheet remains very strong with nearly $1.7 billion in cash and cash equivalents and deferred revenue of $780 million.
This quarter, revenue has included license revenues of $285 million, up 15% from last year. Deferred license revenues have not changed significantly relative to total deferred revenue over the last three quarters.
As I mentioned during last quarter's call, our third quarter 2007 license revenue included approximately $40 million of previously deferred license revenue that we recognized when we shipped lab manager last July. Factoring end of period changes in deferred license revenue and the current results, license revenue grew 35% compared to a year ago.
Services revenue was $187 million, a 70% increase to last year and up 9% sequentially. Total services revenue included software maintenance of $147 million, a 70% increase from last year and professional services revenue of $40 million, up 69% compared to last year.
Continuing the trend we observed at the end of Q2, customers continue to proceed cautiously in their capital spending decision process. In some instances, customers are deciding to forego larger discounts offered by enterprise license agreements and instead are choosing to buy for their immediate needs.
ELA as the percentage of total bookings were down slightly in the third quarter as compared to the second quarter and were up slightly from the third quarter a year ago. Our US Federal sector results were seasonally strong.
This is consistent with the government September yearend and we continue to see momentum in our government's adoption of our products. I want to spend a moment on the financial sector, an area of concern for investors over the past month or so.
Large businesses on the financial services industry have traditionally been leading adaptors of IT products and services to run their operation. We have long-standing relationships with most of these businesses and in fact, many of them have entered into enterprise license agreements with us over the last year and a half.
Although a significant market, the financial sector averaged about 10% of our overall bookings over the past four quarters. Remember we have a diverse and global customer base that includes 95% for the Fortune 1000 and 87% of the Fortune Global 500.
Geographically, US revenue increased 24% from a year ago up to $249 million representing 53% of total revenue. International revenue grew 42% to $224 million.
We believe we have significant international opportunities especially in Japan, Korea, Germany and the Brit countries and have taken significant steps to improve our international growth. For example in China, we recently hired our first country manager and are aggressively increasing our sales force.
I will now turn to our non GAAP operating expenses. Total non GAAP operating expenses increased 4% sequentially to $357 million.
This included the impact from the Beehive acquisition we closed in July. The overall operating margin solution from acquisitions over the past 12 months was 80 basis points.
International expenses were also $4 million higher as the result of the year-over-year decline of the US dollar. However, given the recent weakness in many currencies particularly the euro, pound sterling and Australian dollars since we reported last quarter, this was less of an impact than on recent quarters.
Year-to-date, operating expenses have been negatively impacted by the weakening dollar by over $20 million. As a percentage of third quarter revenue, non GAAP cost of revenues decline sequentially to 11.8% from 13.1%.
This reduction is partially offset by cost increases in G&A to 8.4% from 7.5%. The differences are largely the result of changes we made in classifying certain cost of services revenues to G&A.
Third quarter R&D expenses totaled $108 million or 22.8% of revenues as compared with 23% in Q2. On a GAAP basis, we capitalized $46 million, $38 million in cash expenses as required by our legacy accounting policy under FAS 86.
Our policy is to capitalize cost after products reached technological feasibility. We believe it is important for investors to consider both our operating results and cash close as adjusted for this item.
Sales and marketing expenses were $154 million or 32.6% of revenues compared with 31.8% on the prior quarters. The increase was largely due to seasonal marketing expenses including our very well attended VMware conference, expenses related to our international market expansion and other marketing expenses related to our branding initiatives.
These increases were partially offset by the strengthening of the dollar compared to second quarter. Non GAAP operating income increased 26% from a year ago to $115 million or 24.3% of total revenue and our non GAAP diluted EPS was $0.24 on 394 million diluted shares.
Our non GAAP tax rate in the quarter was 21%, up from 20% in the second quarter. We expect this rate to decline significantly in Q4 as a result of the extension of the R&D credit by progress a few weeks ago.
For the year, we expect the GAAP tax rate to be between 13% and 15%. This guidance includes stock-based compensations, amortization of intangibles and FAS 86 capitalization representing approximately 3 to 4 points.
This translates to a non GAAP tax rate that would be approximately 3 to 4 points higher than the GAAP tax rate for the full year. Our employee stock option exchange program was completed in the third quarter.
In addition to the exchange offer, we also granted 5.4 million restricted stock units, a portion to our international employees who could not participate in the US exchange offer and a portion for retention purposes. While this does not significantly impact our non GAAP results, it will have an impact on our GAAP results.
Our 10-K will be filed in early November and will include additional details of the expected future GAAP expenses related to these equity actions. As you consider our waited average share accounts and the effect of these instruments on delusions, remember that option delusion is dependent on share price and our cue delusion as a function of time.
As a result, on a non GAAP basis, we do not expect significant delusion in Q4 or 2009 on these equity actions. Now under our balance sheet and cash flow statements, our balance sheet remains strong with cash at quarter end of nearly $1.7 billion, a sequential increase of $151 million.
At the beginning of the year, the cash balance had increased 37%. We invested in short term cash and cash equivalents and have not experienced any declines in valuation of our holdings.
Total deferred revenue increased 8% sequentially to $780 million. Year-to-date, total deferred revenue had increased 41%.
Our net accounts receivable has declined $22 million from last quarter and our DSO, which we calculate including the change in deferred revenue, is approximately 50 days. This is down from Q2 and comparable to Q1 and the fourth quarter of last year.
The interest rate on our $450 million note with EMC adjusts each quarter at LIBOR plus 55 basis points. The volatility in the credit market has resulted in the Q4 rate of 4.43%, 109 basis points higher than Q3.
At the same time, we will continue to keep our cash invested very short term and on the current environment expects a net of our investment income to the decline in Q4. Non GAAP operating cash flows, which we adjust for capitalization under FAS 86 and accept tax benefits from stock compensations, was $211 million for the third quarter, an increase of 20% from Q3 2007.
On a trailing 12 months basis, non GAAP operating cash flows were $707 million, up 49% compared to the 12 months ended September of 2007. These results exceed our non GAAP operating income largely driven by an increase in maintenance revenue for which we are paid upfront.
As we mentioned last quarter, we are slowing our second half hiring. Headcount at the end of the third quarter was approximately 6,500, a sequential net increase of 200 people.
In the fourth quarter, we will continue to make strategic hires focused primarily in product developments and market expansion opportunities. Now, moving on to guidance.
I open the second quarter conference call by saying that we had a solid quarter despite economic head wins and once again in the third quarter, we achieved solid results despite the unprecedented events that occurred in the last three weeks of our quarter. As far in October, the US and global economies continue to be challenged but we are very confident in the long term health of our business, the global financial crisis is creating customer uncertainty around fourth quarter IT spending.
We have limited visibility on how our customers release funds in their short-term purchasing. In addition, I will remind you that we sell in US dollars around the world and we maybe impacted by high volatility in foreign exchange.
Given these circumstances, we believe there is a broad range of possible outcomes for our fourth quarter revenue. We are cautiously maintaining our 2008 revenue guidance for growth of 42% to 45%.
However, we are clearly more comfortable at the low end of this range and believe the overall economic mood will have to improve quickly and significantly to achieve result at the mid to high end of this range. We are targeting our fourth quarter non GAAP operating margin to be between 22% and 24%.
Non GAAP operating margin excludes stock-base compensations, payroll tax on stock transactions, amortization of intangible assets and capital at software development products which are target at 6% of revenue. This target assumes 2008 revenue to be near the low end of our annual guidance.
In addition, as I mention last quarter, our business is starting to follow traditional seasonal pattern. Therefore, we anticipate our Q1 2009 revenue to follow industry seasonal patterns and decline sequentially from Q4.
Before I hand it to Paul, let me underscore that we are in this business for the long term and we believe we have tremendous opportunity ahead of us to maintain our leadership in one of the fastest growing and far-reaching technology sectors. We are managing the business prudently, mindful of providing a reasonable return while making investments for the long term.
We have great faith in our ability to execute on unique on front of us and I look forward to speaking with you again in January. Paul?
Paul Maritz
Thanks Mark. Well, I have been here to VMware for three months now and well, this is spent fair amount of time meeting with people in the Company and our customers really getting to understand the issues and dynamics and opportunities and challenges that we face.
I came here expecting to find certain things. I expected to find a company that had great foundations in terms of great people, great technology and excellent relationships with our customers and significant partnerships.
I also expected to find a company that was experiencing the challenges that having undergone rapid growth, having added the 2,000 people approximately with proceeding 12 months and I did find that. I also found some unexpected things.
I found that we have incredibly passionate customers who are making tremendous use of our product. These customers have been able to achieve both direct results in terms of cost savings from civic consolidation as well as indirect benefits from seeing the environment become fundamentally more flexible and manageable as they virtualized.
Accompanying to this enthusiasm from our customers was that that our VMware event in Las Vegas in September, we had nearly 14,000 customers come and attend that event. Last week I was in Australia where we ran a smaller but similar event for our customers there and that market alone, we had 1600 customers turn out to spend the day with us.
Now obviously it is the primary job of management to really focus on the challenges for the business string ahead. Over the last three months, I had begun to focus on three major challenges; first of all, our organization; secondly, our near-term execution in terms of revenue expense and product delivery and then thirdly, on looking with our organization to create strategic framework to guide our efforts going ahead.
Well, I like to take few minutes now and take a step back with some heavier approach on each of the three challenges. In terms of the organizations, my first start at business was obviously to work here and try and make sure that the transition from Diane to myself went smoothly as possible and that certainly as of any transition, we have had our challenges there but I can report that we are making our way through them and our organization is moving ahead.
Despite the market turmoil and the loss obviously of Diane herself and her husband, Mendel and in addition, Richard Sarwal, our organization is stepping up in the challenges. We are arching internal people to take on additional responsibility and I most are looking to augment our executive team with some key hires.
I will return to that in a few minutes. I do not want to be complacent here, maintaining the health of our organization going forward is my first objective and I would continue to spend a lot of time as I had been doing, listening and communicating with several levels of the organization.
But on the whole, I am very pleased to be part of a team of talented, hardworking and very capable people. In terms of the challenge of near-term execution, the first is obviously to make sure that we hit our revenue targets in challenging economic times and I would really like to thank Carl Eschenbach and his sales team as well as the marketing support people in our organization who worked very hard to bring home the quarter and not only bring it home but reach the upper end of our guidance.
As Mark said, it was certainly very challenging. As we went into September, uncertainty set it on a big way.
We saw this leading along the sale cycles, additional level of review as we had started to see in the second quarter as well as customers adopting the buy as they go approach as oppose to buying for the long term VM ELA. Despite that we were able to get our customers, many of whom had delayed decisions from Q2 to come into Q3 and bring in the business.
I can also report to you that during this period, we did not see any major losses to Microsoft. Currently we take Microsoft very seriously and keep our eyes very closely focused on them.
We did see a couple of customers indulge in vehicles direct head-to-head product comparisons and buying a lot of stocks work to our favor. In addition, despite the series of announcements over the last quarter, Microsoft is still behind in terms of their product roadmap and we do not see them catching up to us until the next 12 to 24 months, by this time we hope to move on.
So, we are not complacent there but at the same time, we have not seen at this point any major losses. In terms of products and execution, I have been working with our product teams to make sure that they are on track to deliver products and key product development pipeline full so we have a major list of our client management sold currently that will be going on to this quarter and as we go into 2009, we will see new releases of our several product lines as well.
In terms of expenses as Mark said, we are keeping a very close eye on the bottom line. In the third quarter, we instituted what we are calling a hiring polls which is to suspend hiring except for important and strategic hires and we will continue that into the fourth quarter and quite frankly, I see that continuing into 2009 as well.
In terms of helping the Company mature and be able to execute on multiple funds and deliver on the key products and initiatives that we need to do in order to keep growing, I had been working with our organization here to enable us to move forward into a divisional or business unit structure as we go into 2009. So, we will be looking to organize ourselves at the top level along our major product lines, server and desktop, as well as major geographies, North America, EMEA and Asia Pacific.
I expect to promote and hire senior people to manage these product units, so business units and as well as promoting people internally into these positions. The third challenge is really to set and place the strategic framework.
We have become strategic to our customers and partners. I am interested when I meet with customers to hear them say to us that they need to understand where we are going in order to fund their futures that they will be making decisions about how to equip and invest in their data centers and infrastructure technology based upon what they know about our roadmap.
Our product is to need to know where we are going. They are making significant investments in products that work with in or around our basic product line.
And finally, we need to guide ourselves. We need to have a framework in which we can set priorities and plan as we go forward.
Accordingly at VM world, we articulated the strategies that have three initiatives, all of which support the same basic theme of enabling our customers to do more with less. The first initiative builds of our current virtual infrastructure product offerings that enable several consolidation and help customers move forward to get additional benefits of flexibility and efficiency.
Often our customers articulate this need as designed to build the internal cloud. They increasingly want to look at their infrastructure, their IT infrastructure, as a single giant computer in which they can very flexibly and efficiently position application loads and a plan evolution of their application infrastructure independently from how they plan the evolution and positioning of the underlying infrastructure.
To that end, we could see a part to take on our current virtual infrastructure product line and strengthen that and harden that into what we are calling a virtual data center operating system. The virtual data center operating system will be this layer of software that effectively isolates application loads on the one hand from the underlying IT infrastructure on the other and will enable that flexible positioning and additional benefits of manageability and efficiently going forward.
So, we are engaging on a part to evolve our virtual infrastructure product line into a fully virtual data center operating system. This virtual data center operating system will allow partners to plug into it, the right products that compliment it.
A good example of this is a Cisco in their development of the Nexus 1000V soft switch. What Cisco has done is take a key part of their technology and reengineer it completely in software so as to plug into our virtual data center operating system lab.
This enables Cisco trained professionals to manage both the physical and virtual network through a common council. Our next initiative leads directly of our virtual data center operating system initiative.
If we during the work to enable our customers to isolate their application loads from the underlying IT infrastructure, then we will also be enabling them to take those application loads and migrate them from their own infrastructure to infrastructure provided by clog ends in the future. But we see this as an additional way that will allow our customers to have increased efficiency and flexibility going forward.
To do this, we need on the one hand to make sure that we have the standards and the technology that allow application loads to be correctly described and packaged up in such a way that they can be flip walk internal infrastructure into the cloud and on the other hand we need to work with the product providers to make sure that they have the message through technology and infrastructure on the one hand to accept this application loads. So, we are working on the one hand the status groups to further define, how to describe the application loads and make sure that they are efficiently and correctly packaged.
On the other hand, we are working with the community of service providers to ensure that they have the capabilities and the correct software to accept these loads. We have at VMware over a hundred clients provider signed up to the new club initiative, small known names like Teramac, then with Sunguard, T-Systems, Telecom, etc and we look forward to working with these companies to open up this new dimension of flexibility to our customers and further increase the value of the investments they are making in our software.
Our third initiative is called the V-client initiative and this speaks to the need that our customers have to more efficiently position the depth of competing. They need to have a framework that allows them to achieve much more efficient central management of the complete resources that they provide to their users.
The date that is largely met working through as end client's approach which is a very profitable way of achieving this and we will continue to invest in its end client approach. We recently announced a joint development with [Teraichi] or will be developing a new protocol to provide very efficient traffic between the server environment and its end client environment on the other hand and we will also be, as I said earlier, releasing a new release of our Sweden management software for the client environment and that will happen in this quarter or fourth quarter.
But there is also a need to extend this framework to address both thin clients and thick clients. Our customer is charged that there is certain parts of their company that can be very efficiently and effectively address various thin client approach but there are other parts of their organizations that need such capability as mobility or additional graphics capability that require a thick client instead.
We need to revive them with the common way but basically satisfying the needs to manage both thin and thick clients. The correct approach we believe is to provision to user, to provide the user with a virtual environment that holds all of these information, data applications and necessary software and that virtual environment will be provisioned wherever the user happen to sit down and log on.
If he happens to sit down and log on to a thin client, that virtual environment will be made available to in view of this client approach. If he happens to sit down and log on to a thick client, that environment will be made available to him on his thick client.
This unified approach of addressing both thin and thick clients actually makes full use of VMware's set aside virtualization assets as well as our client side virtualization asset and VMware is unique in having deep service side virtualization assets as well as deep client side virtualization assets. I wanted to stress again that these three initiatives build off like we have.
They are a serious steps that we need from our current products towards the future. Like I said earlier, we start with a major release of our client management software in the fourth quarter and we are expecting major releases of our service software in 2009.
In terms of funding these initiatives, I expect that we will be able to fund these initiatives probably within our current resource pool with only very targeted and focused additions to it. We have 2,500 people in our R&D organization which makes this one as the largest system software developing shops in the world but we have both deep and new risk resources that we can pull upon as we go forward into these initiatives.
Finally, I want to close by saying as Mark said that we will also be investing in geographic expansion. We have significant opportunities in the near term to grow our businesses particularly in Asia and the emerging markets.
Well, into 2009 in addition to these focused investments in our product capability, we will be looking to expand in our sales and marketing capabilities in these high growth areas of the world. Finally, I want to say that for 2009 as we look forward to that, things are uncertain and as Mark has noted, we are not going to change our 2008 guidance.
We are staying with the range that we provided you last quarter for 2008 that we have to say that given on the uncertainty at this point in time, it will be very hard to divide very specific guidance for 2009. On the other hand, our products speak to fundamental needs that our customers have.
They enable our customers to do more with less. Our customers report to us that virtualization remains at the top of their priorities as they look strategic IT investments going forward.
It will enable them to achieve levels of efficiency that will become only more important in the current economic environment. Well given our firm foundations in terms of technology, equal financial resources, our customers and partners, I expect that VMware will be one of the Companies that weather this current storm well and I certainly believe that we can emerge from it stronger at a more fitted company ready to exploit the opportunities that will open up.
So, with that, I would like to close and take any questions. Operator, let us start the polling process, please.
Operator
(Operator's instruction) Your first question comes from Brent Thill - Citigroup, Inc.
Brent Thill - Citigroup, Inc.
Mark, you could just clarify the seasonal comment you made around Q1. I think you mentioned you are expecting a more experience software seasonality similar to the industry.
Does that mean 5% to 10% or does that mean less than 5%? I guess just trying to understand what base you are talking through as it relates to how we look at Q1.
Mark Peek
Brent, it is premature for us to talk too much about 2009 and it is largely, what we expect in 2009 is largely dependent upon how we end 2008 but what I have been saying for a couple of quarters is that our business is beginning to experience seasonality. You saw some of that in the third quarter in which we grew sequentially in the third quarter but not as significantly as we had historically in the third quarter.
So, if we look ahead to 2009, we expect that Q1 will be down sequentially. We will give you more color in January.
Brent Thill - Citigroup, Inc.
Okay and just a quick follow up, can you just comment on some of the deals that slip from Q2? Did you close the majority of those deals or are those selling it to you?
Mark Peek
We closed approximately 90% of the deals that slip from Q2 to Q3 during the third quarter.
Operator
Your next question comes from Kash Rangan - Merrill Lynch.
Kash Rangan - Merrill Lynch
Congrats for being a bright spot in the middle of not-so-great earning season. I have couple probably few questions for you Mark and then maybe one strategic question for you Paul.
Mark for you, I know you talked about how the licensing, you said it had grown. If you exclude the drawdown from the deferrals from Q3 of last year, I am just wondering if you benefited this quarter at all from any license component of the deferred from Q2 that may have followed the licenses in Q3.
Mark Peek
Kash, the deferred license revenue over the last three quarters is relatively static. We may have net drawdown $3 million or $4 million during this quarter but did not have a significant effect and the 35% year-over-year license growth that I quoted included adjusting for that.
Kash Rangan - Merrill Lynch
Okay. Well, that is actually quite a bit of change because I think you had been benefiting from the deferred drawdown and that has been considered actually but it is good to see that the net drawdown is actually on the $3 million to $4 million which gives you more a true count from year-over-year.
That is good to see. Secondly, the margins, it does look like as you have this, correct me if I am wrong is you have this ELAs what seems to be a good chunk of the deal is going on the balance sheet as deferred revenues.
Principally, major [Inaudible 56:09] type revenues, it occurs to me that your margin should start to expand and we are seeing some of that already happened as far because I noticed that the services margins went up by several hundred basis points. Is it not the case that a good, we are going to see some national margin lift just from the fact that makes it 70, sitting under deferrals are going to be recognized and therefore you got bigger contribution maintenance overall revenue structure and then from margin lift as well?
Mark Peek
Yes, during this quarter we have a reclassification from a certain class that we have been categorizing as the services revenues to G&A. So, we had some benefit probably 150 basis points or so from that during this quarter.
Clearly, as we build the deferred revenue base and amortization, we should see some expansion at margin on gross growth margins from services.
Kash Rangan - Merrill Lynch
Yes. You mean, if you x-out that one few basis points, I could see that the gross margin and services went down from 68% to almost 74%.
That is a pretty big jump.
Mark Peek
Yes and part of that is the expansion that we are going to get from deferred revenue overtime.
Kash Rangan - Merrill Lynch
Final question for you Paul, just on the topic of execution around multiple core competencies, I am just wondering how you gauged the Company and how the preparers assessment or readiness because nine ready sales execution consistency surrounding sales execution and processes are already being fair amount. What is your satisfaction or how much more will they have to do in terms of pipeline management in getting the sales lieutenants, etc to set them today top run?
That is it for me.
Paul Maritz
Well, I think you cannot do enough of that, sir. It is just something that we are focusing on and we will continue to focus on.
We are as I said strengthening our executive management team and in particular, looking to bring on additional talent in the sales management area where we go on to reach the ramp up in North America who is very experienced from both BA and IDM days and we are looking on as I said to move to a geographic business unit structure and have very season management responsible for both Europe and Asia. So, we are looking to both continued current focus that all the team has provided in terms of bringing home the quarter and I want again to congratulate and thank you for that effort.
That is very truly heroic effort towards the end of September and I have every confidence that they will be able to do that again in the fourth quarter. But we are looking to deepen and strengthen our capability down that.
Operator
Your next question comes from Israel Hernandez - Barclays Capital.
Israel Hernandez - Barclays Capital
Can you comment on what you are seeing in October? You indicated that things had some slow start.
Are you seeing deals to get push out at this point? Are you getting downsize or they are just evaporating?
What does that imply as we kind of look out to 2009 in terms of your ability to build pipeline?
Mark Peek
It is very early in the quarter and over the last 18 months or so, we have had a business that has been backend loaded towards the end of each quarter. We have a rigorous process to go through our pipeline.
Currently, we are evaluating both from an ELA and from a transactional business perspective where we are and what we are seeing is just caution among our customers as they, like all of us, look out unto the financial markets and the current turmoil also in the credit market. We are cautiously optimistic that when, in the fullness of time, our pipeline will come through but at this point, we are just being cautious about it.
Israel Hernandez - Barclays Capital
Great. Are you seeing any changes in customer buying behavior so your competitors come to market with the new full feature products in terms of sales cycles and pricing?
Paul Maritz
This is Paul, I think at this point in time, we are seeing much more of effect from the macroeconomic conditions than from competition but I did not say we are seeing customers in certain cases slow down their decision to have an explicit product comparison between ourselves and Microsoft and buying large, those work to our favors at this stage but we will have to say that the economy in general is much greater concern at this point in time.
Operator
Your next question comes from Adam Holt - Morgan Stanley.
Adam Holt - Morgan Stanley
Congratulations on the quarter. I had a couple of questions about the headcount comments.
So, it sounds like you are effectively for you has heading into the fourth quarter and probably as well into the first part of next year. Does that mean, I understand you are not going to give a lot of detail on next year, but would you expect to see operating expenses growing slower than revenue into calendar 09?
Paul Maritz
Obviously, this is Paul, that is usually dependent upon what revenue does in 2009 and for two reasons, we are being very cautious about expanding our headcount if at all which is number one, as this we have a period of very rapid grow so it is a healthy thing in any case because you take a pool, you take stock, makes sure that we have people focused on the right areas. But also, as Mark was saying, it is too early to say what will happen in 2009 so we are again being cautious there.
Mark Peek
And the one thing I would add, Adam is that as you, beyond headcount cost as you look at depreciation, we have done a lot of capital expansion this year. We are currently building a data center in Washington State and that will come online sometime at the end of the fourth quarter and fall into the first quarter and just from depreciation expense perspective going into 2009, depreciation expense will go up 50% just based on being capital expenditures of 2008.
Adam Holt - Morgan Stanley
And if I could just ask two other question about '09, you are going to start to see at the anniversary some of the early ELAs as probably in the second quarter of next year. Would you expect to see the bigger impact of ELA when it moves in the back half and then on the tax rate, with the reduction in the fourth quarter be extrapolated out in '09 as well?
Thanks.
Mark Peek
On the question on renewals of enterprise agreements, most of our enterprise agreements have cap license deployments and although there are perpetual licenses, it gives us an opportunity to go back in with our customers and to take account of additional license that they may need to have deployed. Historically, we have had very strong renewal rates and we fully expect that our customers under ELA would renew.
Most of the enterprise agreements, however, are three years and so as you look at the ramp, there are not that many that are going to renew in 2009 that will much of that will come either end of 2009 or into 2010.
Adam Holt - Morgan Stanley
And just on the tax rate?
Mark Peek
Yes, with respect to the tax rate, the primary driver, back in January we mentioned that our tax rate was impacted by 4 full points as a result of the R&D credit. That was finally passed by congress so we would expect maybe a little awkward pressure on the adjusted tax rate.
It is really depending on our mix of operating profit between international and the US and how we, and also the allocation of where our expenses are but it is a good part in 2009.
Operator
Your next question comes from Philip Rueppel - Wachovia Securities.
Philip Rueppel - Wachovia Securities
Sort of focusing back in the pipeline, as you look forward, have you been able to dissect which upcoming deals represent ongoing projects, existing customers versus new deals and does that give you sort of more or less confidence in your reiteration of guidance? I guess, then that is, are you still seeing large enterprises starting new projects in virtualization?
Paul Maritz
We still see continued interest in virtualization. As I said, one of the virtues of virtualization, the current cycle is that it does offer comparatively short return and it is actually one of the ways that customers are looking to achieve great efficiency as they grow forward.
So, unlike some of other projects, this virtualization is one of the ones that has the capacity to continue to be attractive even in a downturn. So, we see continued interest both in terms of existing deals and new deals.
With that being said, as we have said last quarter and this quarter, any proposal whether it be, no matter what the return it is being taken up for additional scrutiny. So, we see these two forces operating against each other which is on the one hand with the continued interest in virtualization as a way of achieving greater efficiency and on the other hand the extreme reluctance of organizations to get prudent with purchases of any kind.
Knowing how those two forces will balance out is what makes the uncertainty.
Philip Rueppel - Wachovia Securities
Right. Could you also, you talked about the transition and its effect on upper management, could you also talk about any changes that have been made in the direct sales force if any regarding comp plans, incentives for ELAs or not quote as going to from half year to full year?
Have you made any changes so far or yet this year or those kind of on the table for next year? Thanks.
Mark Peek
With respect to comp plans, as we have had historically we have some annual comp plans so we started the new comp plan in the third quarter and we made some, I would not call them at all radical but some evolutionary changes in our comp plans to focus on new license revenue and we are beginning our planning for our 2009 compensation plan so to speak.
Operator
Your next question comes from Tim Klassell - Thomas Weisel Partners.
Tim Klassell - Thomas Weisel Partners Group Inc.
Yes, I just wanted to extend my congratulations. A lot of times about the new organization, will you have separate sales forces and R&D staff for each one of these new product line divisions or is going to be able of a more a matrix structure going forward?
Paul Maritz
We are still working our way through this and our intent is to have this ready to be implemented by the time we enter 2009 that it will be heading for a new definition probably more of a matrix organization in that we will not have separate sales forces. At this point in time, our products are closely aligned in that but they do not merit having separate sales forces but we will have separate R&D organizations and separate P&L responsibility for our major geographic areas.
Tim Klassell - Thomas Weisel Partners Group Inc.
Okay and will you be breaking up the numbers for this street to how is their visibility and how they are performing?
Paul Maritz
We have not made that call yet.
Operator
Your next question comes from Heather Bellini - UBS.
Heather Bellini - UBS
A couple of quick questions. One, I just wanted to touch a little bit on capitalized software expenses, I know Mark you mentioned that in your remarks but they are growing pretty fast especially when you look at the taste of R&D growth.
I was just wondering how should we think about the trend and the capitalized development expenses going forward and then my other question is going back to I guess Brent's question earlier. You made a comment for us to assume normal software industry seasonality for Q1 which means you must have done some works to see what normal software seasonality is.
You guys might comment on it but you kind of did comment on Q1. I mean what were the companies I guess that we should be looking at because depending on which companies you look at, you got a very different view of what typical seasonality is.
So, in the sense that you are trying to guess to think that way now, I am just wondering if you could provide a little bit more clarity seeing that you brought up the comment in the first place.
Mark Peek
Yes, Heather, on the first question, with respect the capitalize software expense, we capitalize about $45 million this quarter and we have a fairly stringent policy around software capitalization that requires this one we have data with products to capitalize those expenses until we actually have a release candidate. We would expect that that trend for Q4 will continue and then we will give you more color around it as far as 2009 but I expect the similar level of capitalized software in the fourth quarter.
With the seasonality trends, my…
Heather Bellini - UBS
Yes, I am sorry but I just wanted to try and to get a little bit more visibility…go ahead.
Mark Peek
Okay, with respect to seasonal trend, it was purely directional rather that I was expecting the first quarter to be up sequentially from the fourth quarter. We would expect revenues to be down sequentially and we have not really mapped it or benchmarked it against other software companies that are more just general industry direction.
Heather Bellini - UBS
Okay that is helpful.
Operator
Your next question comes from Charlie Di Bona - Sanford Bernstein.
Charlie Di Bona - Sanford Bernstein
I just want to turn back to the ELAs and Paul, you mentioned sort of two things about the selling environment for ELAs right now that you are both seeing the sell cycle lengthen up but you are also seeing a shift to people moving from ELA to transactional. I assume that means customers that had been to ELA moving to a transactional environment.
Can you really characterize the midst of shift of sort of lengthening the sell cycle versus people actually just stepping out of the ELA process altogether and then actually, I have a quick follow up for Mark on the same topic.
Mark Peek
So, Charlie, this is Mark. Well, the trend that we have seen is that companies that are not necessarily ready to pull the trigger on an enterprise agreement at the end of any particular period still have needs for their plan quarterly deployment and so they will do a transactional, a smaller size transactional purchase with us and then reenter into an enterprise license agreement discussions in the following quarter.
So, it is really a continuation of the, so I think it is not mutually exclusive that the selling cycle is longer and that people are going into transactional modeling by.
Charlie Di Bona - Sanford Bernstein
So, are you seeing people drop out of the ELA process or are you just seeing some sort of rolling from quarter to quarter?
Paul Maritz
I think, this is Paul jumping in, most of what we are seeing is that people are rolling from quarter to quarter. The metric of that was these months that really have the probably the ELA deals that we saw slip from certain quarter to third quarter.
We were subsequently able to close some of those deals in the third quarter. So, it is uncertainty creating lengthening sale cycles I think is the major issue.
Charlie Di Bona - Sanford Bernstein
Just a quick follow up, you had back way the quarters, is there any difference in the composition of ELA signings versus on transactional signings because it is more of the other more exposed to the last three weeks of last quarter for instance?
Mark Peek
Well, in general the enterprise agreements are a little bit more exposed to the backend of the quarter because the transactional business is buy as you need and so that is why we tie the quarter…
Paul Maritz
And typically higher levels of review are required for ELA because there are large deals and that tends to push things towards the end of the quarter as basically been necessary steps assigned all from.
Charlie Di Bona - Sanford Bernstein
Is that true of last quarter too? If people are buying transactional deals at the end of the quarter because they are slipping up the ELAs into the next quarter, are you still seeing the same kind of relative seasonality of it or any linearity of it?
Mark Peek
There has not been a significant shift in the linearity of the quarter throughout this year.
Operator
Your next question comes from John Difucci - JP Morgan.
John Difucci - JP Morgan
Question for Paul. Paul, I was just curious, you talked about a focus on expense and execution related to that but is that somehow in conflict with this three throng strategy and now a new business unit organizational structure, I guess how confident are you that you can truly leverage spending cross these business units and initiatives?
Paul Maritz
Well, first with the business units really speak not to either adding or subtracting expense. It talk about increased efficiency of what we have and it is my belief that we will get in the long run more bankrupt not by having more focused management.
I am a strong believer in power of leadership and what I try to do is to create people underneath who are directly responsible for major areas about business.
John Difucci - JP Morgan
But you are adding another layer of management. Is not that adding a layer of expense?
Paul Maritz
Not necessarily. As I said, it is more of a, we are ranging at how we structure and how we handle things and mostly talking about four or five people here.
So, we are not talking about huge layer of expense. Back in this, as I said we are a very large software development shop and I think that we have the opportunity given that we are doing is not a left turn from what we were doing before.
What we are doing with these initiatives are not direct out process of work that is really I am referring on underway in the company or a shop being and more clear articulation, longer term articulation of what we were really doing which is what gives me confidence that with just focused additions, we can get there from here.
John Difucci - JP Morgan
Mark, just a follow up to that, it tends to such a focus on ELA, can you just I guess, go back and explain something here. At least, the way I understand it, you do have ELAs.
Are your ELAs typically for everything you sell, all you can eat over that term of the ELA or are they for a certain product or products categories and do ELA customers ever comeback before the ELA is finished and that should buy other products?
Mark Peek
Typically, ELAs are for very specific product sets and they are called out in the enterprise agreement. In most cases, they are cap to a limited number of deployments.
As a result, we do have the opportunity to continue to interact and to work with our customers for our management in [nomination's] week as an example.
Michael Haase
Operator, we are going to take two more questions please, and then Paul will have some closing comments.
Operator
Your next question comes from Sarah Friar - Goldman Sachs.
Sarah Friar - Goldman Sachs & Co.
Two very quick one for you. You mentioned that government spending was very strong, we should expect to be upon fiscal year end, but as you talk to a government client, looking forward for 2009, are you seeing them reign in a lot just given concerns about tax receipts, etc going on for government?
Mark Peek
Sarah, we have not had, I think like our commercial client customers as well, they are looking ahead to see what they will have to stand in their fiscal 2009 and it is been very seasonal for trend at Federal level, but it was very strong and a lot of the conversations that we are having with customers are just around efficiency and around saving money, and governments are, in this era, looking to do that very as much carefully as a commercial enterprises.
Sarah Friar - Goldman Sachs & Co.
And then just on the debt top side, debt has still very nice in technology and so much, it is very good in our case and yet you are going to have to spend money upfront, even do that initial trial. Are you seeing trials get pushed out or people kind of saying, "I'd rather come to project sometime next year when I understand better on my overall budget or look," how is that?
How is something young like desktop being impacted by the current environment?
Paul Maritz
Well, I guess, it is the same thing on the one hand. The customers are believing that this is a strategic way for them to save money but at the same time, wanting to be cautious about the near term spending.
So, it falls within same category as the service side which is the step to uncertain time. But, on the other hand, our products do speak to where the customers can get a hold of their cost.
So, we are going to have to see how that plays off.
Operator
And our last question comes from Jayson Noland - Robert Baird.
Jayson Noland - Robert W. Baird & Co., Inc.
A question for Paul and a question for Mark. First, Paul it seems like the Company made some changes to your reseller program specifically nationalized the program.
If so, what prompted the change and what type of feedback have you received?
Paul Maritz
Quite frankly, Mark and I are looking puzzled at each other here. We are not sure what you were referring to here.
I mean we made some incremental adjustments to our reseller program, but we are not sure what the nationalization refers to. So perhaps, we need to get back to you on that.
Jayson Noland - Robert W. Baird & Co., Inc.
Okay, good enough. Question for Mark around use of cash, how do you view cash in this environment specifically around M&A and stock buyback?
Thanks a lot.
Mark Peek
Yes, first of all, we are being very conservative in how we invest our cash. And so everything that we currently have is very short and we are willing to make that tradeoff and not have to deal with valuation concerns around our cash.
Certainly, as we look at M&A, we think that this is a particularly good environment for us to certainly be looking and they have some opportunities in M&A, maybe at prices that are better in the half end over the last year or so. With respect to share buyback, well looking at our capital structure but we are not going to comment on capital structure matters unless we make some changes.
Michael Haase
Thank you very much, appreciated you time and look forward to speaking with you again in a quarter's time. Thank you very much.
Operator