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safenet conference call transcript Operator:
Good day ladies and gentlemen and welcome to the third-quarter 2005 SafeNet earnings conference call. My name is Mike and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question and answer session toward the end of today's conference. (Operator Instructions). As a reminder ladies and gentlemen, this conference is being recorded. On the call today, we have Mr. Tony Caputo, Chairman and Chief Executive Officer; Ken Mueller, Chief Financial Officer; Carole Argo, Chief Operating Officer and your host for today's call, Mr. Gregg Lampf, Director of Investor Relations. Sir, over to you.

Gregg Lampf:
Thank you, Mike. Good afternoon everyone. I am Greg Lampf, Director of Investor Relations for SafeNet. Before we begin our call, I would like to advise you that various remarks will be made about future expectations, plans and prospects for the Company, consisting of forward-looking statements for purposes of the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated in the forward-looking statements as a result of various important factors, including those discussed in the Company's From 10-K for the year ended December 31, 2004. With that, I will turn the call over to Tony Caputo, our CEO.

Tony Caputo:
Good afternoon, ladies and gentlemen. Today we released SafeNet's third quarter results and updated our fourth-quarter guidance. On this call, we will talk about both those quarters as well as be able to provide our first snapshot of full year 2006 guidance.In the third quarter, we made terrific progress in building our government business with the absolute highlight being a $150 million contract which we signed with the U.S. Department of Defense. While the large size and enormous importance of this contract cannot be overstated, the contract has tended to overshadow other important events in the quarter, including another government contract which we secured in Q3 for just under $20 million, under which SafeNet will develop and we believe ultimately produce a new generation of very high-speed satellite encryption products. At year end in total, we will end up book close to $200 million in new orders in this classified government business during 2005.Another highlight is our Rights Management business, which grew by 30% year-over-year, including acquisitions, and by about 10% on a pro forma basis. We are particularly pleased that for the first time in quite some time, SafeNet's rights management revenue exceeded that of our closest competitor in Q3.Also here in this business as you will hear from Carole, our new Sentinel RMS product which provides protection from mass-market software, generated its first multi-million dollar contract, only a portion of which has been recognized in Q3. Given the contract size and the fact that the customer has very high brand recognition, this contract was contested heavily by our competitors and is a tribute to the competitiveness of our new RMS product and I would also add, to the skill of our staff.Another highlight in the quarter was very good progress which we made in controlling operating expense, which was essentially flat from Q2 to Q3 and which we now are confident will remain flat in Q4 and only grow modestly next year.Less positive results, however, were achieved on gross margins which did not recover as quickly as we expected from Q2's lower than desired number. This recovery is now underway in Q4 as we address the causes which were an unfavorable mix of high-margin license and royalties, the delayed KIV-7M shipments which resulted in lower than planned revenue available to offset expenses that are shown in cost of goods sold as per government accounting rules and a decline in the selling price of some legacy products sold to customers in Asia and the Middle East.Turning now to Q4, let me to you that we expect both record profit and record revenue in this quarter. We will benefit from a large amount of KIV-7M revenue at increased gross margins, also from our OEM business, which is growing even faster in Q4 than in Q3 with that growth being driven by rapidly increasing licensing of high margin software products. And we also expect close to record level revenue for our borderless security products and absolute record revenue levels for the rights management division.So in summary, though our full year EPS will be at or slightly below the original low end of our guidance range, we expect that Q4's record revenue and earnings will put us in great shape as we launch into 2006. For 2006, our guidance which was issued today has a revenue range of 295 to 315 million and an EPS range of $1.67 to $1.90 per share which equates to strong growth of about 15% in revenue and 20% in earnings-per-share for 2006. The growth drivers will be our government classified business, which will reap the benefits of the investments that we made this year and enter 2006 with an extremely strong backlog, and which during the year, will also answer the HAFI (ph), or VPN market, which we estimate to be a larger opportunity than the linked market where we have already booked a $150 million contract.As a result, in 2006, our growth in classified government will be in the strong double-digit range compared to single digits in 2005. We also expect that each of our commercial businesses will enjoy double-digit growth in 2006 and that full-year gross margins will continue to increase in 2006, leading to very strong '06 financial results.Now Carole and Ken will provide further detail on business trends and financials. First, Carole.

Carole Argo:
Thank you, Tony. As in the past, I will discuss performance and trends related to each one of our product categories; first, communications and borderless security. In this area, revenue grew slightly year-over-year. Within this business, we saw that the High-speed Communications segments suffered by comparison to Q3 '04 where we had a very large deal large from a government customer, DISA (ph). Borderless Security, however, continued with its terrific growth, which is well above our 20% growth target. Despite the negative year-over-year comparison for Communications Security this quarter, the overall year-to-date growth of Communications Security Borderless remains above 50% year-over-year. While we strive to have growth every quarter in all of our revenue categories, we understand that large deals within a quarter will make this difficult.In addition to the broad needs borderless serves as it secures networks and identities, we have a series of new targeted borderless security bundled offerings ready to hit the market this quarter, such as for the pharma biotech industry, related to SAFE -- that's secured assets forever (ph) (indiscernible). And the education community in which our products serve to authenticate transcripts, an area that's of growing interest in the education community. Look for these and other product announcements along with key large customer wins during the quarter.Our OEM business, next let me move into the OEM business, and in this area, we're really seeing extremely positive growth trends in our OEM business. It's grown 40% year-over-year. Again, we had another quarter of record toolkit sales. We've been consistently releasing a series of new toolkit products throughout this past year and we've really seen the toolkit revenues take off.We also had a significant increase during the year in our chip sales from one of our largest OEM customers and we're seeing a general increase in business from specifically telecom and mobile customers.During the fourth quarter, we introduced a new chip which we believe will be a top performing product in 2006 and beyond. While a smaller component of our overall revenue, we view OEM as another unique and important part of our business, and that having leading companies license our technology demonstrates the breadth of our capabilities and the trust these leaders have in SafeNet, not to mention we get extremely great margins out of this OEM revenue.Rights Management. In our Rights Management business as Tony mentioned, strong growth year-over-year, 30%. In our core Sentinel business, which focuses on the larger software companies, we experienced another strong growth quarter with growth at approximately 10%. Last quarter, we announced the release of Sentinel RMS. That's our next generation licensed management software, and this dramatically improves the richness as of our LM offerings. New product includes a role-based management system and it provides connectivity for back-end systems and this is for ease-of-use of integration for existing distribution of software companies and the product just has so much more incredible benefits. Significance here is that there is a product that allows us to compete effectively in the mass software product.RMS is also our anchor application for our unified software protection program. What is this? It's a combination of hardware, software and services that protects software from unauthorized use, representing the broadening of our approach in this market's segment, which certainly is much more competitive than the single-focus token vendors. The unique combination of hardware, software and services gives SafeNet its strong competitive position and this is where we will grow market share. Let me tell you about three recent events during the quarter.First of all, in our traditional Software Protection business, we made a press release announcement that showed that the combination of our product was really one of the reasons why that we won against our major token competitor. We won the business for a leading manufacturer of mobile cranes in Germany. Another win, which Tony talked about in the beginning of the call, is that in our RMS product -- which remember, we just released in the second quarter -- in our first full quarter, we had two major wins with very large name accounts. One of them is a multi-million dollar win and it's for a very large brand-name technology company. And this account again as Tony had mentioned was our first very extremely competitive win and a large account and we are extremely pleased to say that we won that account and it's a great start for this new product.We also saw growth in the entertainment market and the media companies. As you know, they have a strong push towards piracy management and we won a very significant deal with a major studio to help them manage and track pirated content. And as you know in this business, this is a managed service business, so we book a very large award that we'll recognize over a period of time. And overall, we're feeling extremely strong about our Rights Management business and we're expanding market share in our core business and making great progress moving into the entertainment sector.Okay, now, moving to the Classified Government. As we previously announced, as we have announced at least 100 times, we have won a $150 million contract with the Department of Defense for the new KIV-7M Link Encryptor, again, our largest contract in SafeNet's history and we believe this is the first contract and it will have a multiyear effect. And as we've said before, that this ultimately could yield between 650 million to $1 billion to this business. We're clearly ramping up during this quarter and the KIV-7M is currently in full production as we're fulfilling the first $18 million delivery award which we received at the very end of Q3. The contract represents a significant milestone for SafeNet in that we're the very first company to bring a product to market that meets other requirements of the government's crypto modernization program.The KIV-7M also opens a new market for SafeNet in that it actually represents two products in one. It's the updated or the new KIV-7M and it's also a replacement for KIV-19, which was previously manufactured and sold by a competitor. In fact, a significant amount of the new products that we're shipping in Q4 really represent competitive replacements, which are not cannibalizing existing revenue from our older generation KIV-7M for this quarter.Another important point of this contract is that we're the only company that currently has a product for this contract and the product pricing is a significant improvement our over our predecessor product. Let me see if I can try to give you a comparison on pricing. If you look at the single unit pricing for the KIV-7M today, that would be sold for 11,800 and at significant volumes, which certainly the $150 million contract represents. The pricing for this contract would be $7850 per unit. Let's contrast to the KIV-7 contract, which is our predecessor product. In single-unit pricing, we would sell that product for 5800, and in volume quantities, we would sell that $3930. So again, much higher selling price on this new contract, in fact a doubling. And in addition to that, that improved pricing will lead to improved margins in the overall business.Our classified business is well positioned for strong growth and we are extremely enthusiastic moving into 2006. Tony presented you a preview of what 2006 will look like; let me give you a little bit more. First of all, we are -- we expect to be in 2006 halfway through the current $150 million KIV-7M contract. We're introducing the classified VPM product next year, which will bring us into a brand-new market segment and we expect this market to even be a larger market than our classified link encryptor market. And finally, we are continuing to win additional contracts to develop classified products that extend our existing market reach and a lot of that is based on its existing technology that we have already developed. So you heard Tony mention that we had in the cost by business another significant contract for $20 million that we booked in the third quarter. This is to develop a high-speed 4-gigabit classified cryptographics system, it's a flight ground unit. And really what's important there also is to show you that that's based on KIV-7M technology. So again, leveraging existing technology to be able to develop products and to move into new markets. And again just repeating, in the third quarter, we had almost $200 million of new classified contracts booked.Looking forward, if we look at revenue in the fourth quarter, we do expect it to increase significantly. I'll just repeat real quickly the areas that are driving this. We expect our Classified Government business to fulfill the existing backlog that we have booked at the end of the third quarter. We do expect Communication and Borderless Security to grow sequentially at the range of approximately 10%. We expect another strong, very strong quarter from our OEM business, which are primarily high-margin deals -- toolkits, IPM royalties -- we expect very strong in the fourth quarter. In fact, we do expect our fourth quarter for our OEM business to be our strongest quarter ever in OEM. And our Right to Manage business, just general, if you look at just general trends on the core business, fourth quarter is our strongest quarter due to seasonality. And we also expect to have a positive impact on our RMS product and products in our entertainment sector.So that's at a lot of exciting things happening moving forward in 2006, and now let me turn the call over to Ken, who will go over the financials.

Ken Mueller:
Thank you, Carole. We are pleased with the continued revenue growth in the quarter, especially while we're working through the product cycle changes in our Government Classified business. On a pro forma basis, which includes Rainbow in for the entire 2004, our business grew 12% for Q3 and 24% year-to-date, excluding the Government Classified business, which is down year to date. As the Government Classified business picks up in '06, we feel that our overall growth will continue to be very strong.So let's talk about the details of the business, starting with revenue, revenue for the third quarter increased 7% to 63.4 million compared to the same quarter last year. This was within our updated guidance range of 63 to 65 million. Year-to-date revenue increased 35% as reported and on a pro forma basis, we grew 12%, and As I mentioned, 24%, if you take out the Classified business.Now I will discuss each part of the business within the Enterprise and Embedded business groups from a pro forma perspective. First, Rights Management. Rights Management business was up 30% in Q3, 14% year to date. OEM business was up 23% in Q3, 12% year-to-date. Government Classified business was down 1% in Q3 and down 3% year-to-date and our Borderless and Communication business was flat in Q3, up 35% year to date.Turning to gross margins, as Tony indicated, the increase in margins that we expect in Q3 did not materialize from Q2. The margins were around the same in Q2 with the exception of a slight mix with the Classified being a little bit higher in Q3 than Q2. The margins, as Tony went through, were less than expected due to lower license and royalty, COGS were higher than expected in a few areas. We had some product mix of high margin products which were below expectations and the KIV-7M cost; because we didn't get them out late, we're still not being able to pass those onto the Government.So when you take all of those together, we ended up not increasing from Q2 as we had previously expected. We're very focused on the Company as Carole went through and we really believe that in Q4 and '06, we're going to get those margin numbers back up. We have teams of people that are constantly looking at how do we continue to improve that.From an operating expense perspective, as Tony mentioned, we're relatively flat on expense, even though we had a full quarter of Media Sentry, so we really have tightened down on the expense line and Q4 will be no exception to that. And actually full year '06, we're going to only reap increased expenses what we need to grow the revenue, the 15% that Tony talked about, but we should not see anywhere near a 15% increase in expense.Moving onto the charges perspective, from an integration and non-recurring costs, it was 3.1 million; that was 2.8 million of employee-related and 300,000 of facility. Again, that's a little bit higher than what we thought last quarter. It's mainly due to one area. We had eliminated our French operation all but a couple of people, and in that operation, the cost we expected to go into the charge let's just say was much higher than we would have thought. That's really the biggest difference in the charge. I will point out that the detailed breakdown of the charges are in the press release, and when you look in there, you will notice that integration charges were really only $700,000 and the rest were non-recurring based on the decisions we made in Q2. So the integration costs are really virtually nil now. It's really the decisions we made in Q2 to continue to reduce costs.From a headcount perspective, we're virtually flat in the quarter. DSOs were 71 days from 63 in Q2. It's about the same as we were in Q1. This is largely due to seasonality and number of large shipments late in the quarter, especially in our Government Classified area, which was over half of the increase. As I've mentioned in other calls, our goal overall is still to be around the 60-day level and we're working very hard to get there. And on average, we believe we will get there in '06.Cash and short-term investments, we had 159 million at the beginning of the quarter, operations from cash flows around 6 million, about a million from interest income, and less cost for investments and acquisitions and non-recurring costs, as I just went through. We ended at 163, so we're up 4 million overall, so 7 million up and about 3 million down for those costs, so 4 million net up.Now turning to '05 guidance, that's non-GAAP. Our fourth quarter guidance, 78 to 82 and adjusted EPS is $0.55 to $0.60. Guidance for the revenue remains the same for full year -- 255 to 275 -- and adjusted EPS is 145 to 155. We're still trying to get up to the range, but at this point, we believe that that's the -- 145 to 155 is the most prudent thing to model.I'm not going to provide guidance for every part of the business, but investors have asked that we continue to break out since this is the first year we're doing this, the business numbers for 2004 for various units, so I'm going to do that one more time. For a Q4 2004, Rights Management was approximately 12 million, 46 million for the year. OEM was 5 million for Q4 '04, 14 million for the year. And Government Classified business was 25 million for Q4, $98 million for the year. Borderless Communications was 22 million for Q4, 70 million for the year.Now turning to '06, as Tony mentioned, our guidance for '06 is 295 million to 315, an adjusted EPS of $1.70 to $1.90. As a couple of reminders also on our guidance, seasonality is expected to remain the same as it has the last year or two, which is 45% of the revenue in the first half, 55% in the second half and EPS is usually about 40% in the first half and 60% in the second half because our expenses are relatively fixed across the year, other than sales commissions. From a modeling perspective, for gross margins we believe 55 to 57% on average would be good guidance and about approximately 10% expense growth or less. So from a guidance perspective, I think that pretty much wraps it up and I'd like to turn it over to Tony for any further comments.

Tony Caputo:
Thanks, Ken. The summary of what you heard was Q3 revenue consistent with our guidance, margins not yet improved but currently improving in Q4. We expect Q4 is going to be a record quarter and we are quite optimistic about 2006. With that said, I would like to ask our operator if you could rejoin us and see if we have any questions which we might answer.

Operator:
(Operator Instructions). Michael Tieu, Southwest Securities.

Michael Tieu:
Good afternoon. I just wanted to circle back to the gross margin. Maybe you can give us a little more color in terms of what are the gross margins in each of those business units that you talked about, Classified versus Rights Management and OEM and so on?

Ken Mueller:
We really don't break that out, Michael. We have said though consistently that the Classified business is approximately 25% and the balance of the business would be the difference.

Michael Tieu:
Okay.

Tony Caputo:
I think the other way to look at it is, when we break out license and royalties, obviously that's very high margin. Our product margins are currently in the low 70's and service and maintenance about 70 also.

Michael Tieu:
And then in Q4, how much do you think the classified government unit will be, given that you have such a nice backlog for the KIV-7M? Any sense in terms of that kind of business in Q4?

Tony Caputo:
It's got have a record quarter and it's quite likely to be in excess of $30 million for the quarter.

Michael Tieu:
Alright, that's all I have. Thank you.

Operator:
Matt Robison, Ferris Baker Watts.

Matt Robison:
Just a couple of housekeeping questions. Capital expenditures -- what were those for the quarter?

Ken Mueller:
Maybe (ph) 250,000.

Matt Robison:
That's real low. What percentage of your business was embedded versus enterprise?

Tony Caputo:
Give us a second and we'll answer that question. If you have a third one, please go ahead. It'll take just a minute.

Matt Robison:
The only other question I had was, if we could maybe go backwards here, rehash the unit discussion, the pricing per unit on the KIV-7M. You went a little fast.

Tony Caputo:
What Carole said was that the new model covered by the $150 million contract has significantly higher pricing than the prior model. And Carole, actually you have the notes, so why don't you go through the numbers again.

Carole Argo:
So essentially in volume pricing, the KIV-7, the predecessor product, was at roughly $3900 -- 3930 -- per unit, and volume pricing for the KIV-7M is $7850.

Matt Robison:
So it's about double the price?

Carole Argo:
It's double in volume. We do sell the KIV product also individually, and that individual price of the KIV-7M is 11,800, and for the KIV-7M, the predecessor, it was 5800.

Matt Robison:
Okay, I appreciate you doing that.

Ken Mueller:
And to answer your first question, it's 30% for embedded, which is consistent with pretty much how it is. Sorry, I don't have that answer, I'm so used to breaking the business down into four areas now.

Matt Robison:
I appreciate it. Thank you.

Operator:
Sean Jackson, Avondale.

Sean Jackson:
Good afternoon. Can you comment on, first of all, the $18 million order -- how much of that do you expect to ship in the fourth quarter?

Carole Argo:
We expect to ship significantly most of that in the quarter.

Sean Jackson:
And again, just the revenue expectation in '06, regarding the classified area, I'm just trying to think this through. You said that half the $150 million contract will be finished by the end of '06. Is that correct?

Carole Argo:
Right. We expect that we'll be through more than half of that contract through the end of 2006, and that's for the KIV-7M, which you remember, is part of the revenue for the Classified business.

Sean Jackson:
Right. And are you expecting additional revenue -- again, this is in your guidance -- regarding the VPN KIV-7 product?

Carole Argo:
No. We expect that product -- I think we will be well positioned, and of course we're hoping to have revenue on that. But for 2006, that product we expect to come out sometime in the third quarter of next year and we will need time to be able to get that product positioned and to the market. So no, it's too early for us to include that in 2006.

Sean Jackson:
So that's not in guidance, but you did say that that opportunity is even bigger than the first opportunity?

Carole Argo:
That's correct. The market that we looked at for, the link encryptor market versus the VPN market, or the HACI (ph) market, the market estimates that we put out there is significantly higher.

Sean Jackson:
So is that different than what you said previously?

Tony Caputo:
No, this is exactly the same. In fact, Sean, I happened to make some notes on the projections that we did in May at NASDAQ, which was the first time we did projections in this area. And we said that -- I'll use the low end of the range for each one. For link, 300 million; for HAPI (ph), 450 million; for voice, 80 million and satellite, 30 million, for a total of 860 million. And so far, what we have accomplished is that 150 million contract, which is half of the link forecast, and we expect to introduce the HAFI (ph) product somewhere around mid-year, probably third quarter next year. And we hope to be able to update guidance at that point in time. But as Carole said, we think it's too early to do that now.

Sean Jackson:
Okay. Also in your comments, you made mention of, there were some higher-margin products that were below expectations for you. Can you just identify which ones those were?

Tony Caputo:
It's essentially license and royalty products, and they run across various business units. So it would be the software products and the license and intellectual property.

Sean Jackson:
And also just comment on your, within the Classified Security area, your non-crypto mod revenue. Where is that going? Is it struggling? Because I'm just looking and I'm trying to do the math as far as the opportunity you have in crypto mod, but yet to Classified as a whole, it seems like it's not growing as quickly as may math indicates. So what's the status of that non-crypto mod Classified Security?

Tony Caputo:
As we have said for quite a while, 2005 is a transition year for the top-secret business. The transition has essentially been developing new crypto mod products while we continue to generate revenue from prior generation products, as well as some revenue from development contracts. KIV-7M is the first crypto mod product. It will contribute significantly to revenue this quarter, and you heard Carole say that by the end of 2006, we will have eaten through more than half of that $150 million contract. The rest of the projects are either revenue from existing products, which represents product revenue in total for that business, it represents about 60% of its revenue, or about $60 million this year, and 40% of the revenue, or $40 million, is contract development.

Sean Jackson:
Okay. So for '06, the contract development part, should you expect that to go down somewhat?

Carole Argo:
We will be selective in the development, and we're seeing that even last year versus this year, we're not taking development dollars just to be able to develop things. Where only taking development contracts only if it helps and (ph) accelerate us moving into the new market segment. So for example, the $20 million contract which is based on the KIV technology to be able to help us move into the satellite -- crypto mod satellite market.

Sean Jackson:
Alright, banks.

Operator:
Graham Tanaka, Tanaka Capital Management.

Graham Tanaka:
I'm just wondering, help me out a little bit, the fourth quarter, that all finally came in. If you would have had the win of KIV-7M earlier, the same month earlier as you were hoping for, would you have in fact made the numbers or was it kind of -- was there some other factors going on which made it harder to have made those numbers?

Tony Caputo:
We certainly would have achieved our initial revenue guidance. And I'm not sure if we would have hit EPS or not. We probably would have been a little short.

Graham Tanaka:
And the reason for that were on expense side, or on which products?

Tony Caputo:
No, the expenses are under control. It's an area that we worked on for quite awhile, and quite frankly we feel great about the expense control. The area would have been gross margins that I talked about before. In Q2, our gross margins came down from Q1. We identified a couple of areas that were problems and we thought that we would be able to fix all of them in Q3 and we have not fixed all of them in Q3. We now believe that we will have gross margins back up to prior levels or close to prior levels in Q4.

Graham Tanaka:
And those gross margin fixes would be related to what -- price, or --?

Tony Caputo:
As I said earlier when I was talking, the problems that we faced in the quarter related to gross margin were unfavorable mix of high margin products, the KIV-7, and a decline in the selling price of some legacy products in the Middle East and Asia. The KIV-7 problem takes care of itself once we start shipping, the other two require effort on our part, which has Ken mentioned in his prepared comments, has a great deal of attention here right now. And as a result, we believe we will deliver improved gross margin in Q4.

Graham Tanaka:
So I gather then that the legacy products, either you're going to do price increases, or the mix is going to take care of itself?

Tony Caputo:
I don't think I want to answer that question; it has some competitive implications.

Graham Tanaka:
I'm sorry, okay, thanks. Thank you, Tony.

Tony Caputo:
Thank you.

Operator:
Eric Suppiger, Pacific Growth Equities.

Eric Suppiger:
Good afternoon. First off, I just want to be clear. What was it that was going to be 30 million in Q4? Is that your total Classified business?

Tony Caputo:
Yes.

Eric Suppiger:
Okay. Is there a significant cannibalization of the KIV-7M? Is that why you don't see any more uptick from it, as the previous caller had been referring to?

Tony Caputo:
Actually, Eric, as Carole said in her prepared remarks, the new KIV-7M is capable of replacing our existing product as well as the competitors' and the bulk of the initial orders that we have received totaling $18 million replaced the competitor's product.

Eric Suppiger:
Are you shipping a -- have the shipments for the KIV-7M been consistent, or are they in decline?

Tony Caputo:
You mean, the older KIV-7M?

Eric Suppiger:
Yes.

Tony Caputo:
It's a downward decline, as expected.

Eric Suppiger:
Is it taking a step function this quarter at all?

Tony Caputo:
Probably not. I'm not sure, to be honest with you.

Eric Suppiger:
It just seems odd that you're adding somewhere between $9 and $18 million incrementally, and yet you're only going up by 5 million?

Tony Caputo:
What I actually said was that the Government Systems business would be at a minimum of $30 million.

Eric Suppiger:
Okay. High-speed encryption, you say that was off. Any sense for what we might expect for that part of the business going to the December quarter?

Tony Caputo:
Absent big orders which took place in Q3 and Q4, the core business there is growing. But we don't expect that it will be able to grow fast enough to overcome those really big orders which took place in the second half last year. Those orders, just to refresh everyone's memory, totaled between $12 and $13 million in the second half of last year. And though the product revenue is growing and the pipeline is growing faster, we're not strong enough there yet to replace $13 million in orders.

Eric Suppiger:
That was between the September and December quarter last year?

Tony Caputo:
That's right; Q3, Q4 last year. One customer, a Department of Defense organization called DISA (ph), was responsible for $13 million in orders.

Eric Suppiger:
So it will grow again in the December quarter sequentially from this quarter?

Tony Caputo:
Yes, I believe it's likely to grow. Let me just take a look at -- probably grow by a couple million sequentially in Q4 versus Q3 '05.

Eric Suppiger:
Okay. And last question, they HAFI VPN product, was that anticipated to come in the second quarter, and now it's in the third quarter, or has there been any change in terms of timing there?

Tony Caputo:
It has always been anticipated to be late Q2, and quite frankly, we are just trying to be conservative today.

Eric Suppiger:
So there's no change from your perspective in terms of the timing there?

Tony Caputo:
There's no substantive change.

Eric Suppiger:
Very good, thank you.

Operator:
Todd Raker, Deutsche Bank.

Todd Raker:
Hey, guys, a few questions for you. First, the competitive environment, I think you commented on the KIV-7M has one competitor, but they don't have a product that's crypto-mod compliant. Does that mean you're seeing 100% share of the opportunity, and do you expect that to continue?

Tony Caputo:
It does mean that we are currently seeing 100% share of that opportunity and we do expect it to continue until the competitor gets a product to market and we have varying estimates on how long that will take, probably ranging between six to close to 12 months.

Todd Raker:
Okay. And then if you look at the larger market opportunity there, which I believe is HAFI, who's the competition there and where do they stand? Your midyear next year, where do they stand on the crypto-mod compliant product?

Tony Caputo:
The competition is General Dynamics, L3 and Biosat. Each of them have a product out, but none of those products are crypto-mod compliant. So they are working on producing -- they also are working on crypto-mod compliant products. And I'm not able to predict that race with exactitude.

Todd Raker:
Okay. And from a high-level perspective, if you look at the federal spending environment, there have been a lot of comments made that post-Katrina, there's going to be some pressures on some areas of spending. Do you guys see any impact on any of the programs you're focused on going into '06?

Tony Caputo:
Here's what we're seeing. We're seeing that in areas like civilian government -- Department of Treasury, Department of Health and Human Services, Education, et cetera -- spending is tightly constrained. It is less constrained in the Department of Defense generally and even less constrained in the top-secret area because those products are focused on fighting the war on terror.

Ken Mueller:
And to be clear, that's less than 10% of our business.

Carole Argo:
The civilian government.

Tony Caputo:
Civilian government is less than 10% of our business.

Todd Raker:
And if you look at kind of the typical Q3 budget flush from the government, would you have said in this current quarter that it was lower than expected?

Tony Caputo:
You know, it's kind of funny from our point of view. In certain agencies, it was definitely lower than expected. But at the same time, we booked $170 million in orders coming from the top-secret community. So it really is bifurcated.

Todd Raker:
Outside of your KIV-7M product, it sounds like it was probably a little bit weaker than expected?

Tony Caputo:
That's right, yes, definitely.

Todd Raker:
Okay. And then last question for you. The discussion around gross margins, I was wondering if you could comment -- the improvement in '06 to kind of 55 to 57% range -- how much of that's driven by KIV-7M being higher priced and seeing additional traction versus other components of the business?

Tony Caputo:
This is a little bit of a sensitive area to some of our customers, so I don't think we can give you a perfect answer here. Obviously when the selling price of a product goes up like the KIV-7M product has gone up, that's a favorable event. So it is contributing. But basically, the contribution should come from other areas also where we have some work to do to correct situations that we don't really like, as I outlined earlier.

Todd Raker:
Okay, great, thanks, guys.

Operator:
Craig Nankervis, First Analysis.

Craig Nankervis:
Thanks, good afternoon. Did you guys say on your development contract for the ground units, declassified ground unit for the satellite project at 20 million -- did you talk about the product's opportunity once the development is complete?

Tony Caputo:
No, I didn't. All I said is that we believe that we will -- there will be that product opportunity, but I don't think we can quantify that for you at that time. We do have in our overall projections for the top-secret business, the satellite segment suggesting that that's a $30 to $50 million opportunity, but I can't tie any of this new product yet to specifically to that number.

Craig Nankervis:
But it is additive to that number?

Tony Caputo:
It should be additive.

Craig Nankervis:
And is the 20 million over roughly what period of time, Tony?

Carole Argo:
It's over next year, through '06.

Craig Nankervis:
Okay. And then just another take on the '06 gross margin guidance. That is not in any way a downward revision, is it? At one point a couple of quarters ago, we were talking about the 58% range as I thought a medium-term goal. Am I misunderstanding what was previously communicated, or --?

Ken Mueller:
On the average for this year, we will be in around the 55% range in general. So we're not looking for a huge uptick or a downtick.

Craig Nankervis:
But Ken, in Q1, you had 58% gross margin and there was a revision. I thought there was a revision in expectations of what it was going to be going forward. You had these issues in subsequent quarters, but in terms of getting out of the noise of the last couple of quarters and where you're going to go medium-term, I thought this might be a downward revision.

Tony Caputo:
No, it's not intended to be a downward revision, but we are not completely through our '06 planning process at this point in time. We have several more meetings that take place, big off-site meetings next week and I don't think we're sufficiently calibrated yet that we can be more specific. But we don't think in general that there will be big differences between '05 and '06 gross margins. And the next time we talk to you, we accept the responsibility to be more specific, but we're just not able to do it yet. It's just too early for us.

Craig Nankervis:
Very good. I think most of my other questions have been asked. Thanks.

Operator:
Philip Winslow, Credit Suisse First Boston.

Philip Winslow:
Hi, guys. Tony, I was wondering if you could just characterize your DRM business, or just how you see that going forward, both from the software license authentication tokens, but also, you had other products you announced over the course of this year. And then also, just how your communications business has been trending. It had been a strong point through the first half, just sort of how you see that -- how that came in Q3, but also your expectations?

Tony Caputo:
First, the Rights Management business. Our view is that the vision that we laid out for this business 18 months ago when we merged with Rainbow is coming through. The loss is pretty obvious at this point in time. To give you some point of reference, when that merger took place, we acquired a business that had a $40 million revenue run rate. It had just finished a $40 million dollar year. Ken said when he broke out the 2004 numbers in his prepared comments that in 2004, that business did 46 million. This year, it will do revenue in the mid 50's and next year, it will be in the high 60's. So that business is growing very, very nicely. Part of the growth is coming from some small acquisitions that we did with cash, but stripped them out and our business is growing at at least 10% per year in the core business that we acquired.So when we have a business which has good profitability -- and that business does -- and is growing both core and in total in a market that is a hot market, we are extremely pleased with the business. The communications business, I think our characterization would be that this is one of the businesses which we have consistently been saying to investors to expect us to grow on a year-over-year basis, but also to expect that there will be some bumps in quarter-to-quarter revenue because the deals in that business, particularly with our new high-speed SONET products, are quite big. I talked about the DISA deal before, but even some of the "small deals" that we're doing are -- get to be pretty close to $1 million and sometimes over. So until we can build that business further, it's going to have some bumps.In terms of building it, we're very optimistic because we're beginning to see pipeline deals in our pipeline for the SONET products outside of the United States. We first introduced the product in the U.S., so the revenue that we're generating now is virtually all U.S., but recently introduced the product outside of the U.S. and now we are seeing SONET deals in the pipeline outside the U.S. On top of that, we have a new family of products ready to launch. In fact, the first test units will go out to customers this quarter and those are our family of high-speed encryption products that work on ethernet protocol and that will expand our available market there also. We'll have more work to do in 2006, but I think that the strategy there is a quite strong one and the size of the business is pretty good already.

Philip Winslow:
Thanks guys.

Operator:
Michael Tieu, Southwest Securities.

Michael Tieu:
Just quickly on the Classified business, Carole, you mentioned that you expect maybe half or even more of that $150 million contract to contribute to revenue in '06. My question is, how much of that is net incremental to revenue? Basically, what I'm trying to ask is, had you not won that contract, how much revenue would you have had from the older products?

Carole Argo:
You saw that we were going through a transition with that, so the product line was declining and the business, our business was essentially flat year-over-year. And in fact, the KIV product was declining each quarter and we were supplementing that with our other products and -- our other products and some of our key development contracts. So without this product going forward in 2006, we would have had a substantial decline in our KIV-7 product.

Michael Tieu:
Okay. So I guess what would you say is the net incremental from that contract?

Michael Tieu:
We expect the KIV-7 product incremental '06 over '05 to be at roughly 40%.

Michael Tieu:
Okay, great, thank you.

Operator:
Horacio Zambrano, Wedbush Morgan Securities.

Horacio Zambrano:
Good afternoon. Just a question on the DRM business to follow-up on Phil's question. We heard Aladdin (ph) report today and in the DRM area, they're growing the business at around 16.5 to 17% year-over-year this quarter. How do we reconcile -- obviously the 10% organic growth looks good next to last quarter. I think it was 5%, so that is a good improvement. But how do we reconcile Aladdin's numbers and what may be happening in the market, in terms of displacements or net new business?

Tony Caputo:
Our business was up subsequentially, our competitor's was not. And the other thing that we feel really good about is that we looked at total revenue in our business in Q3 versus our competitor's, and for the first time in a long time, we have a larger number. So while some of our business did come from the small acquisitions, that's okay with us, because those were cash acquisitions that opened new high-growth market segments for us and we're projecting that in Q4, growth will accelerate again in this business. So in summary, last quarter we were not ahead; this quarter we are, and we see our growth accelerating next quarter. And as a result, we're pretty happy with the business.

Horacio Zambrano:
Okay, thank you very much.

Operator:
(Operator Instructions). Jonathan Ruykhaver, Raymond James.

Jonathan Ruykhaver:
Good evening. Just a question related to the December guidance. It seems to me at the midpoint of the revenue guidance, the EPS guidance implies an operating margin of about 20% -- excuse me -- 27%, which would be the highest I think we've seen since the merger with Rainbow. And then you look at the issues I think in the September quarter, some of it contributed by the fact that the OEM and license revenues were light. And admittedly, there's very little visibility I think probably in that business. What are you seeing with those OEM license partners that give you confidence that that business will come back in the December quarter? Is there anything you can mention specifically?

Carole Argo:
Well actually, we talked about our OEM business and we are saying year-over-year, our OEM business in general grew year-over-year. Now what we are seeing is we're seeing strong trends in our toolkits business, which is a licensed product, a high-margin business. And the same thing, we expect to have one of our largest IP revenue quarters ever in this fourth quarter.

Jonathan Ruykhaver:
Were there specific transactions in the September quarter that were pushed out and you have very good visibility on it as a result?

Carole Argo:
They're not -- as a matter of fact, about half of that business is recurring business related to already chip design wins as well as royalties. So we have a great indicator and now as to what that Q4 number is and we expect to see in royalties and as well as chip revenues significant increases in Q4 which we're aware of.

Tony Caputo:
Jonathan, I understand where your question's coming from. And if you assume that all our license and royalty comes from OEM, then the line of reasoning that you're going down works, but that's not the case.

Jonathan Ruykhaver:
You're saying it's also the toolkits and other software products?

Tony Caputo:
That's right, that's what I'm saying. For example in the Enterprise business, there's client software revenue in rights management, there's software revenue. So virtually all of the business units today have a mix of high-margin and lower-margin products.

Jonathan Ruykhaver:
But let me just understand, that business was weak in the September quarter relative to your expectations, wasn't it?

Tony Caputo:
The OEM business?

Jonathan Ruykhaver:
License and royalty.

Tony Caputo:
License and royalty was weak, the OEM business was not relative to our expectations, and also relative to our growth goals.

Jonathan Ruykhaver:
Okay. And you expect the weakness in license and royalty to come back because you have those deals essentially in-hand?

Tony Caputo:
Some are in hand, some are in --.

Jonathan Ruykhaver:
Not necessarily, but you have pretty good visibility, high probability on those deals closing?

Tony Caputo:
Yes, we have good comfort in the forecast.

Jonathan Ruykhaver:
Just one last question. Could you just elaborate on the accounting for those Classified revenues that contributed to weak margins in the September quarter?

Tony Caputo:
Yes, Ken?

Ken Mueller:
Again, there was about $1 million of cost in the Classified business that had to do with the new product release that didn't happen. And once the release happens, then that amount gets into the overhead cost that's charged in the product.

Jonathan Ruykhaver:
And those were in COGS?

Ken Mueller:
Yes (multiple speakers).

Tony Caputo:
Because we use government accounting for that division, virtually all costs end up in COGS.

Ken Mueller:
99.9%.

Jonathan Ruykhaver:
Okay, that's all I had. Thanks.

Operator:
Chris Hovis, Morgan-Keegan.

Chris Hovis:
I was wondering if you could expand a little bit on any trends you saw on the Network and Borderless business, particularly with regards to identity management initiative you have in place there?

Tony Caputo:
The Borderless business is an identity management business, and as Carole said in her comments, that was one of the strong areas of growth in the quarter.

Carole Argo:
A 20% growth sequentially, almost all of it coming from the identity management area.

Chris Hovis:
And what do you see driving that from a market perspective? Is it more end market demand or is it certain initiatives you guys have internally, or a combination of both?

Carole Argo:
We talked about some of the products we have that we announced; so for example, issuing certifications on transcripts. So we're seeing that there are certain market segments that where protection of identities is very important and we're starting to see -- rolling out more and more solutions related to that -- pharmaceuticals, which is a big base for us also, now we're getting into the education market. So we're seeing more and more people wanting to protect identities and we have a great solution for that.

Tony Caputo:
More specifically, the tokens in that business were up strongly and we have a line of hardware server products that are used to -- in several applications. They're used to authenticate individuals, sometimes used to authenticate transactions and also used in PKI applications. And that line of server products is doing very well also.

Chris Hovis:
And you mentioned the token business being up strongly. Were there any examples you could point to where you were displacing existing token vendors and/or taking significant share from a competitive basis?

Tony Caputo:
In general, what we try to do in selling our USB tokens as well as our smart card tokens is not look to replace existing onetime password tokens, but rather find customers who are starting new projects and then win those projects. And that's what we have been doing. Specific -- I don't think I can be specific right now. There's one great customer that I would love to talk with you about, but they are not ready to let us do it right now.

Chris Hovis:
We look forward to it, thanks.

Operator:
That concludes our question and answer session. I would now like to turn it back to the chairpeople for closing remarks.

Tony Caputo:
Thank you ladies and gentlemen. As I think you have heard from us today, we are very optimistic about the current quarter we're in plus the future that we can see, which is next year. And as a result, excited about our business in general. I want to take one last moment and congratulate our top-secret communications team for their wonderful work that they have done in securing new contracts. It puts them in a position to have a terrific year next year. And thank you very much for your interest and for listening to us today. Have a good evening.

Operator:
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation, you may now disconnect. Everyone have a good evening or a good afternoon. Thank you very much.