May 14, 2007

Research Associate:Sumit Agarwal, CS

Editor: Christopher R. Jones, CFA

Sr. Ed.: Ian Madsen, CFA: ; 1-800-767-3771 x9417

111 N. Canal Street, Suite 1101  Chicago, IL 60606

SonicWALL, Inc. (SNWL - NASDAQ)

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$7.89

Note: This report contains substantially new material. Subsequent reports will have changes highlighted

Reason for Report:1Q07 Earnings Results (Previous:Discontinuation of Coverage, March, 22)

Recent Events

On May 2, 2007, SNWL SonicWALL, Inc. announced the launch of its TZ 180, TZ 180 Wireless and TZ 190 Wireless appliances.

On April 26, 2007, SonicWALL, Inc. announced that Potomac Hospital of Woodbridge, Va. has selected SonicWALL network security, secure wireless and remote access and data backup solutions to protect the hospital's medical staff, employees and patients.

On February 12, 2007, SNWL announced that Crabtree & Evelyn, an international manufacturer and retailer of personal care products, has implemented the company's integrated and managed security solutions to secure its retail stores in the United States, Canada and the United Kingdom. SNWL was selected for its deep packet inspection technology and ease-of-use which not only provides the company the protection it needs but enhances overall staff productivity.

Overview

Based in Sunnyvale, CA, SonicWALL, Inc. (SNWL) is a leading provider of integrated network security, mobility, and productivity solutions for small- to medium-sized enterprise networks. The company’s solutions enable secure Internet access from both wired and wireless broadband networks, facilitate Internet-based connectivity for distributed organizations, and process secure transactions over the Internet. SonicWALL’s core offerings center on unified threat management (UMT), and include firewall, virtual private networking (VPN), and Secure Socket Layer (SSL) encryption and decryption. The company has shifted its focus from hardware to a subscription based model, where it sells the initial appliance and then sells subscriptions for content filtering and other services. Through acquisitions, SonicWALL has broadened its focus into remote access, continuous data protection and e-mail message security and anti-spam. SonicWALL currently outsources its entire manufacturing requirements to Flash Electronics and SerComm Corporation in Taiwan. The company sells its products primarily on an indirect basis through a two-tiered distribution structure – first to distributors, who sell them to value-added resellers, who then sell them to end customers. SonicWALL has made a commendable turnaround over the past few years. CEO, Matt Medeiros took over the reins of the company in 2003 with a new management team, and has created a revitalization strategy. For more information on the company, please visit its website

On April 25, 2007, SNWL the company reported financial results for 1Q07. Total Product and License revenue in 1Q07 was $22.7 million and $22.4 million respectively bringing 1Q07 total revenue to $45.1 million. The results came below consensus on lower-than-expected product revenue and softening North American IT spending. 2Q06 revenue guidance was lower than Street expectations. The Revenue miss was attributed to delayed hardware purchases, primarily in North America which saw y/y growth decelerate to 10% from 26% in 4Q06 and weakness in APAC (flat y/y).

Key Positive Arguments / Key Negative Arguments
  • SNWL has a strong product roadmap as it continues to release new products.
  • The company plans to derive about half of its revenue from Subscription & License, which has a much higher margin than the Hardware business.
  • Operating margin expansion.
  • It is a zero debt company with $240 million or $3.54 per share in cash and cash equivalents
  • It has created a solid portfolio of offerings through its recent acquisitions (Lasso Logic, enKoo and MailFrontier).
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  • Increasing competition in the mid- and low-end SMB segment of the enterprise security appliance market.
  • Highly dependent on the indirect distribution channel, SNWL derives almost 98% of sales from its distributors.
  • Execution risks associated with new product roll outs and the company’s transition to the new distribution structure.
  • Potential deterioration of the overall economic environment.

SNWL’s Fiscal Year ends on December 31st.

Revenue

SonicWALL reported mixed 1Q07 results. Top-line performance was weaker than anticipated, while the company outperformed with respect to EPS. The revenue shortfall was driven by weaker than expected product revenue, with management pointing to tough market conditions and disruption with respect to its platform transition as key factors.

Revenue - FYE Dec. 31 / 1Q07A / q/q % chge / y/y % chge / 2005A / 2006A / 2007E / 2008E
Processing and Related Services / $22.7 / -9.0% / 7.5% / $75.5 / $92.8 / $97.0 / $107.5
Software, Maintenance & Services / $22.5 / 3.0% / 19.9% / $59.8 / $82.7 / $95.4 / $108.2
Total Revenue / $45.1 / -3.4% / 13.3% / $135.3 / $175.5 / $192.0 / $213.7

The Zacks Digest average revenue for the first quarter of 2007 is $45.1 million (in line with the company’s results), up 13.3% y/y but down 3.4% sequentially. Product revenue was $22.7 million(in line with the company’s results), up 7.5% y/y but down 9.0% sequentially. Product revenue growth was drivenby an increase in TZ product sales, which was somewhat offset by soft PRO family sales. License and subscription revenue was $22.5 million, up 19.9% y/y but down 3.0% sequentially.

Revenue Breakdown

Product Mix: Product revenue as per the Press release was $22.7 million; down 9% sequentially and up 7.6% y/y. Lower product revenue was a function of weakness in all product lines except for SSL-VPN. SSL-VPN performed solidly, up 8% sequentially and 40% y/y. Contribution to product revenue on a percentage basis was 47% from its TZ product and 32% from its PRO product. This compares to the 4Q06 mix of 49% and 30%, respectively.

License and service revenue was $22.4 million, up 3% sequentially and 19.8% y/y. License and service revenue continued to do well and was driven by strength in gateway, and anti-virus sales.

From a geographic perspective, SonicWALL also saw a sequential decline in all geographies. The Americas revenue slowed at 10% y/y growth to $31.1 million (69% of total revenue). EMEA experienced strength during the quarter with 29% y/y growth to revenues of $9.0 million (20%), while

APAC (10%) was flat y/y at $4.5 million due to weakness in Japan.

Outlook

In the second quarter of 2007, SonicWALL expects revenue to be in the range of $45.0 million to $47.0 million and expects non-GAAP gross margin to be in the range of 70% to 72% of revenue.

Overall, one analyst (Stifel Nicolaus) believes that the performance of SonicWALL over the last two quarters and its outlook for 2Q07 leads the analyst to continue the lukewarm on the story as they it believe that growth will be challenging for the company in 2007. The company is clearly coming up against a number of headwinds and it is not clear that there is any significant near-term catalyst that would cause growth acceleration. Additionally, the company will face extremely tough comparisons es in 3Q07 and 4Q07. While its 1Q07 operating margin performance was solid, some of the factors that contributed to this, such as its gross margin out performance, do not appear to be sustainable. More importantly, the analyst believes that revenue growth will be critical for meaningful margin expansion and top line growth is clearly in question. The factors which led to a recent strong operating margin may not be sustainable, and top line growth is unlikely to be sufficient to improve gross margins.

Please refer to Zacks Research Digest spreadsheet on SNWL for detailed sales breakdown and future estimates.

Margins

MARGINS - FYE Dec. 31 / 1Q07A / q/q chge / y/y chge / 2006A / 2007E / 2008E
Gross / 72.8% / 2.3% / 1.1% / 70.5% / 71.6% / 71.7%
Operating / 11.5% / -2.8% / 10.6% / 7.5% / 11.4% / 13.4%
Pre-Tax / 17.7% / -2.6% / 11.4% / 13.0% / 17.2% / 19.3%
Net / 11.1% / -1.7% / 7.2% / 8.2% / 10.8% / 12.2%

The Zacks Digest average gross margin for 1Q07 was 72.8% and operating margin was 11.5%. The total pre-tax and net margin for the quarter were as 17.7% and 11.1% respectively

Margins better than expected. Gross margins increased 185 bps (basis points) to 72.8% and exceeded management’s guidance range of 69-70% due to a favorable product mix in the quarter. This was primarily a function of lower hardware sales which carry a lower gross margin.

Total operating expenses in 1Q07 as per the press release was $31.7 million, down8.8% y/y, as compared to $34.7 million in 1Q06. Total income from operation in 1Q07 was $0.6 million, up 108.4% y/y, versus ($7.6) million in 1Q06.

Total gross margin in 1Q07 as per the press release was 71.6%, as compared to 67.8% in 1Q06. Total net margin in 1Q07 as per the press release was 5.0%.

Outlook

Management had laid out a prudent three-point plan for driving growth during 2007, these are as follows:

  • Broadening its addressable market.
  • Growing subscription based revenues, particularly multi-year deals; and
  • Growing international revenues.

Management has pointed to sluggish macro-conditions in North America impacting its business in 1Q07 and the company also cited this in 4Q06. One analyst (Stifel Nicolaus) believes that economic uncertainty is likely having some impact on its business and further believes that the company may have worked through an upgrade cycle to UTM solutions in its core security appliance business and perhaps the latest cycle has passed. Additionally, the analyst believes that competition continues to intensify from companies like Fortinet and Juniper, both of which have recently launched new products, as well as Cisco.

Please refer to Zacks Research Digest spreadsheet on SNWL for more details on margin estimates.

Earnings per Share

The Zacks Digest average EPS for 1Q07is $0.07(in line with the company’s results).

The company reported in 1Q07 Non GAAPnet income of $5.0 million or $0.07 per share, compared to a net income of $1.6 million or $0.02 per diluted share in the year-ago period. Non-GAAP net income excludes amortization of purchased intangible assets and share-based compensation expense primarily associated with the expensing of stock options in accordance with Financial Accounting Standards

Non-GAAP EPS - FYE Dec. 31 / 1Q07A / 2Q07E / 3Q07E / 2006A / 2007E / 2008E
Zacks Consensus / $0.02 / $0.03 / $0.11 / $0.28
Company Guidance / $0.05-$0.07
High Estimate / $0.07 / $0.07 / $0.09 / $0.22 / $0.33 / $0.44
Low Estimate / $0.07 / $0.05 / $0.05 / $0.21 / $0.24 / $0.33
Digest Average / $0.07 / $0.07 / $0.08 / $0.21 / $0.30 / $0.37
Company GAAP Guidance / ($0.01)-($0.03)

The highlights from the chart are as follows:

The Zacks Consensus model estimates EPS of $0.11 for 2007 and $0.28 for 2008

2007 forecasts (11analysts) range from $0.24 to $0.33 and the average is $0.30

2008 forecasts (11analysts) range from $0.33to $0.44 and the average is $0.37

The reconciliation of GAAP and non-GAAP EPS for 4Q06is shown below:

Outlook

Management’s forecasts for non-GAAP EPS to be range bound from of $0.05 to $0.07. On a GAAP basis, inclusive of a total of approximately $4.4 million, before taxes, in combined amortization of purchased intangibles assets and share-based compensation expense, the Company expects earnings per share to be in the range of $(0.01) to $(0.03). Share-based compensation expense associated with the expensing of stock options is estimated to be approximately $4.0 million for the second quarter of 2007.

Given the guidance, recent quarterly results, and view of the market, one analyst (America's Growth Capital) have tweaked down its estimates for the upcoming quarter and the year. The analyst’s current outlook includes non-GAAP EPS of $0.07 in 2Q07 (flat from its prior estimate) and $0.31 for the year (down from $0.33).

Please refer to Zacks Research Digest spreadsheet on SNWL for more extensive EPS figures

Target Price/Valuation

Target price for SNWL varies from $10.00(Lehman, RBC Cap.) to $12.00 (Raymond James). The consensus average price target provided by 3analysts with published target prices is $10.67(down $0.16from the previous report). Most of the analysts have used price multiples on estimated revenue for FY08 to calculate the target price.

Rating Distribution
Positive / 22.2 %
Neutral / 77.8%
Negative / 0.0%
Avg. Target Price / $10.67
No. of Analysts with Target Price/Total / 3/11

Impediments to reaching the price target include competitive pressures, a prolonged IT spending recovery period and geo-political risks. Shares may trade with volatility. Margin pressure or failure to meet expectations may pressure share valuation. Back-end loaded quarter sales linearity increases risks of missing expectations.

Important Ratios / Company / Industry / Sector
Quick Ratio (MRQ) / 2.88 / 2.88 / 2.65
Current Ratio (MRQ) / 2.93 / 3.47 / 3.19
LT Debt to Equity (MRQ) / NM / 0.16 / 0.20
Total Debt to Equity (MRQ) / NM / 0.20 / 0.23
Interest Coverage (TTM) / NM / 10.38 / 16.44

Please refer to Zacks Research Digest spreadsheet on SNWL for further details on valuation.

Capital Structure/Cash Flow/Solvency/Governance/Other

Balance sheet

Cash

SNWL continued to produce healthy cash flow despite the slower revenue base. Cash from operations totaled $12.2 million, raising cash balances to $240.0 million. Overall, the financial health of the Company remained strong. Net cash provided by Investing activities was ($4.8) million and the net cash provided by financing activities was ($6.9) million.

Accounts Receivables

The total receivable in 1Q07 was $21.0, down 9.4% sequentially,versus $23.2 million in 4Q06.

Deferred Revenue

Deferred revenue increased to $65.3 million from $61.6 million, largely on increased subscription licenses and service contracts. Deferred revenue on non current account was $7.2 million in 1Q07, up 13.9% sequentially, versus $6.3 million in 4Q06.

Inventories

The total inventories in 1Q07 were $4.2, down 19.2% sequentially, versus $5.2 million in 4Q06.

DSO

DSOs decreased from 45 days to 42during the quarter with the y/y change of 13 days.

Repurchase

The company repurchased 1.1 million shares for an average share price of $8.52. $19.6 million remains available for repurchase under the current $100.0 million authorization.

Potentially Severe Problems

There are none other than those discussed in other sections of this report.

Long Term Growth

The lowest projected long-term growth is 10.0% (Lehman, RBC Cap.,) and the highestprojected long-term growth is 22.4% (America’s Growth Capital).

Analysts view SNWL as having made a commendable turnaround over the past few years. The present CEO, MattMedeiros, who took over the controls in 2003 with a new management team, has revived the company with what some have termed an aggressive renewalpolicy. The company has evolved from a hardware company selling firewalls to a company delivering subscription services on integrated appliances and is now a leader in unified threat management (UTM). Under Medeiros, SonicWALL refreshed its product portfolio and has a strong product array as it continues to release new products into mass markets. The company has consolidated its focus on the SME market, delivering products specifically designed for its target market.It has pursued an acquisition strategy to strengthen its portfolio. While some investors are disappointed with the dilution associated with recent acquisitions, some believe that the company is improving its long-term competitive position and expect growth to resume in 2007.

SNWL reported continued strong sales in EMEA, Australia, and India, and steady progress in China. It expects faster growth rates in international markets than in the U.S. On the product side, management expects to move their next generation platform through their products over the course of 2007. In addition, it expects to introduce new feature sets throughout the year. Management stated that it will continue to explore tuck-in technology acquisitions in near future.

Over the long term, SonicWALL will likely derive about half of its revenue from subscriptions and licenses, a much higher margin and sustainable business model than the hardware business. Following its strategy of accessing new markets after they grow past the early adopter stage, SonicWALL released new products in the SSL/VPN market and secured content management.

SonicWALL is a leading player in the small and medium business (SMB) market, which is the fastest growing segment of the firewall/VPN industry. In addition to providing affordable solutions for its target market, SNWL has demonstrated technology leadership in its offerings. In its firewall business, the company’s fourth generation deep packet inspection is on the leading edge with numerous patents. To further expand its leadership in the SMB market, the company recently acquired a data backup solutions company Lasso Logic, Inc. Analysts believe this gives SNWL a unique offering for the SME market, which currently relies on outdated solutions such as tape backup.

Upcoming Events

July 28, 2007: 2Q07 earnings results (expected)

Individual Analyst Opinions

POSITIVE RATINGS (22.2%)

Lehman – Overweight ($10 target price): 04/26/07–The analyst has maintainedanOverweight rating but has reduced the target price from $11 to $10 to reflect disappointing guidance. INVESTMENT SUMMARY: With little in the way of a near-term catalyst until new Gen 5 products start to ramp in 2H07, the analyst expects the shares to drift lower from the present level. The analyst believes that sector consolidation activity should help support stock near current levels.

Raymond James – Outperform ($12 target price): 04/16/07.INVESTMENT SUMMARY: Even if SNWL experiences a top-line slowdown in 2Q07, the analyst expects improving profitability and reaccelerating growth in 2H07 from new product releases and returns from channel training to enable the company to reach it 2007 free cash flow estimate of $45.0 million.

NEUTRAL RATINGS (77.8%)

Needham – Hold (no target price): 04/26/07 – The analyst has downgraded the rating from Buy to Hold to reflect cost concerns. INVESTMENT SUMMARY:The analyst believes that costs from the technical support build-out are likely to run through CY07 and the revenue catalyst from recently acquired products is likely to be initiated in late CY07 or early CY08 event. The analyst further believes that shares will be flat near-term as top-line growth remains elusive and opines that margin expansion would be challenging as the year progresses.

Lazard – Hold (no target price): 04/25/07 –The analyst has reiterated the Hold rating. INVESTMENT SUMMARY: With a focus on the small and medium enterprise and distributed network environments, the analyst believes that company is poised for operating-margin expansion and accelerating EPS growth in 2007.

Pacific Crest –Sector perform (no target price): 04/25/07. INVESTMENT SUMMARY: The analyst believes that a soft outlook on 2Q07 prompts a modest downward revision to estimates. While the analyst believes that guidance for 2Q07 was likely conservative, management’s hesitation is likely to keep shares of SNWL range bound at current levels.

First Analysis – Equal weight (no target price): 04/26/07.INVESTMENT SUMMARY: Despite a fairly interesting valuation profile, the analyst thinks a hazy near-term SNWL outlook renders it tough to be compelled about the stock. Concerns: A handful of factors cloud the picture, including 1) a new security platform that's driving a product upgrade cycle (freezing some buyers), 2) amore competitive environment in SME a somewhat uncertain environment that is characterized by a marginally tighter competitive SME security landscape and 3) rolling out a new channel education and incentive structure that will likely take a few quarters to bear good results.