Extreme Networks Inc (EXTR) 2003 Q3 法說會逐字稿

Good morning ladies and gentlemen and welcome to the Extreme Networks Third Quarter 2002, 2003 earning release conference.

At this time, all participants are in a listen-only mode.

Following today's presentation, you will be given a chance to ask audio questions.

If you have a question, please press star, followed by the one on your push-button phone.

If anyone needs assistance at any time during the conference, please press star, followed by the zero.

As a reminder, this conference is being recorded today, Monday, April 7, 2003.

I would now like to turn the conference over to Mr. Hal Covert, Chief Financial Officer.

Please go ahead, sir.

Thank you.

Good morning.

On the call with me today is Gordon Stitt, President, CEO, and Chairman of Extreme Networks.

Earlier this morning, we issued a press release announcing our financial results for Q3 FY 2003.

A copy of this release is available on our Web site at ExtremeNetworks.com.

A couple of reminders - this call is being recorded and broadcast live over the Internet Monday, April 7, 2003.

It will be posted on our Web site and available for replay shortly after the conclusion of the call.

Some of the remarks made during this call may include forward-looking statements as governed by the Private Securities Reform Act of 1995.

Any statements about future events and trends including steps we plan to take to improve our financial results or financial conditions should be considered as forward-looking statements.

These forward-looking statements may differ from actual results and are subject to risk and uncertainties as detailed in our filings with the SEC and in our press release today.

I would now like to turn the call over to Gordon.

Thank you, Hal, and thank you for joining us so early in the morning.

The press release that went out even earlier this morning represents the final results for the quarter.

As indicated in that release, we generated revenue of $85.2 million and we had a loss for the quarter of seven cents, which was higher than we had expected and is related to our service line of business and affected the gross margin.

Hal will address that later in the call.

What I'd like to discuss are the four main points of how we are taking product and technology leadership.

First, today we are announcing ahead of schedule what we put into works two years ago when we began developing our third-generation ASIC chipset named Triumph.

Over the years, we have engineered two full generations of ASICs and successfully built product lines based on those platforms.

Those product lines have had very long lives, which serves to preserve and protect our customers' investment.

With today's unveiling of the third-generation platform, we are three months ahead of our announced schedule with a chipset that gives our enterprise and metro customers enhanced gigabit and 10-gigabit Ethernet connectivity.

This morning we issued two product-related press releases - one that details the strengths of our Triumph technology and chipset - the second on the first products based on Triumph, which are blades for industry-leading BlackDiamond platform.

These new blades increase the fiber gigabit Ethernet density by 2X and the copper gigabit Ethernet density by three times.

They provide extensive new features such as multi-level queuing and fine-grained traffic shaping, all the while being fully compatible with existing [Inaudible] based systems, thus preserving our customers' investment.

Second, we're very excited to tell you that we'll be shortly unveiling a new access architecture initiative.

This new access architecture enables networks to connect tens and even hundreds of thousands of devices that include PCs, PDAs, phones, and many other types of devices.

This new access architecture provides secure, high-performance connectivity.

While we aren't revealing details today, I can tell you that you'll be hearing much more about this as we move through the year.

When we have more to tell you, we'll invite you to take a closer look.

Third, even as we're unveiling our third-generation platform, we're gearing up to introduce our fourth-generation chipset.

Codename Genesis, this strategic program was started almost three years ago.

It is one of the most ambitious ASIC developments undertaken in our business.

Genesis is truly a rebirth of Extreme technology - takes everything we've learned over the last seven years of building some of the world's largest enterprise and metro networks and positions us for industry technology leadership and we believe for future growth.

The products, based upon Genesis technology, are in alpha phase and are currently being shipped to customer sites.

Products based on this fourth generation of technology will compliment our current product families and primarily be focused on the very largest enterprise and Ethernet metro service providers.

By employing leading technology, we believe this product family will dramatically improve performance and functionality and continue to position Extreme as a technology leader and provider of comprehensive solution networks of the future.

There are a lot of so-called new technology or next-generation products being introduced into the enterprise market, but many of these products are, from our perspective, little more than a short-term bet largely driven by price alone.

But technology is never just about price - it's about the value proposition.

Our value proposition has always been and continues to be best-of-breed, end-to-end Ethernet switching solutions from the wiring closet to the network data center to the network core.

We engineer our products off of the best architecture and operational simplicity, high availability, redundancy, scalability, and security, lowest cost of ownership, both from initial capital expenditure and ongoing operating expense, which brings us to the fourth point I'd like to make.

With these new technology platforms that we're introducing, Extreme Networks has strengthened our market position into a provider with a more robust end-to-end solution set.

We have new technology and access in the distribution layer and in the core of the network.

We believe that the value proposition greatly strengthens our position in the marketplace.

Again, where many have taken a more opportunistic approach of developing technology, Extreme has always taken a longer view, making major investments to design technological platforms with long lives.

Customers have always looked to Extreme Networks because of our reputation for designing and implementing superior technology based on a simple value proposition [Inaudible] simpler and more cost-effective.

This is why we continue to win customers.

I'd like to take a moment to tell you about some new customer wins that occurred during the March quarter.

Discovery Channel is building a new Extreme-based network to support their many activities, including their cable television programs and growing online presence.

We are pleased that we can help them achieve their goals.

The media vertical has been very strong for us recently.

Media companies are at the leading edge of where enterprises want to go.

Problems of distributing streaming media to a large audience can be daunting.

Part of our Triumph technology development has been focused on solving this problem.

We will be introducing some Triumph-based products during the next weeks and months that address some of the issues and position Extreme Networks to lead this emerging category.

We are winning continued business from the federal government sector, where branches of the military continue to leverage our advanced technologies.

We've also made advances in the healthcare market segment with some significant wins.

Healthcare is a key vertical for us, and many hospitals are choosing to upgrade their networks to Extreme to meet the growing requirements of their industry.

In the 10-Gigabet Ethernet arena, highly scalable networks are taking hold at places such as the University of Warwick in the United Kingdom along with Ohio State University Newark.

These institutions are deploying our 10-Gigabit Ethernet technology for expensive campus networks that take advantage of emerging educational opportunities.

We're proud that our 10-Gigabit Ethernet solution was named Editor's Choice by one of the network industry's most highly regarded publications, "Network Computing Magazine."

Our solution performed better than Foundry's (ph) during a lab test of high-capacity core switching solutions.

I'm also pleased to say that in the March quarter we shipped more 10-Gigabit Ethernet ports than in the previous three quarters combined.

February we announced that industry giant Microsoft Enterprise Engineering Center has deployed our family of switches, which helps them prepare their Fortune 500 customers for critical deployment of next-generation software such as .NET and Exchange.

And service provider Segitel of France has successfully implemented Extreme's innovative virtual manned technology (ph) , or V-mans (ph) , to scale metro Ethernet services for business customers in the region.

This delivers advanced connectivity from site to site.

Extreme's Ethernet automatic protection switching capability provides sub-50 (ph) millisecond failover on ring networks continue to demonstrate how metro carriers use Ethernet to deliver all of their services reliably.

We're very excited about being on the front end of a major new product introduction cycle that we expect will continue through this calendar year.

With a true next-generation, best-of-breed technology that we're rolling out now ahead of schedule and with what we will be unveiling soon, we continue with our history of technological innovation - engineering superior technology based on a simple value proposition of faster, simpler, more cost-effective.

With that, I'll turn the call over to Hal.

Thank you, Gordon.

I will now cover two topics - a detailed discussion of Q3 FY 2003 financial results and financial guidance.

Revenue for Q3 FY 2003 was 85.2 million versus 90.2 million in Q2 FY2003 and 111.1 million in Q3 FY 2002.

The decrease in revenue was primarily due to the uncertain global economic environment and being on the front end of a major new product introduction cycle.

Our book-to-bill ratio was greater than one for Q3 FY 2003 and we entered the quarter with backlog that was at the high end of our normal range.

On a geographic basis, the Americas represented 36 percent of our revenue for Q3 FY 2003 versus 45 percent in Q2 FY 2003 and 36 percent in Q3 FY 2002.

Europe represented 28 percent of our revenue for Q3 FY 2003 versus 26 percent in Q2 FY 2003 and 24 percent in Q3 FY 2002.

Japan represented 26 percent of our revenue for Q3 FY 2003 versus 17 percent in Q2 FY 2003 and 33 percent in Q3 FY 2002.

And Asia not including Japan represented 10 percent of our revenue for Q3 FY 2003 versus 12 percent in Q2 FY 2003 and seven percent in Q3 FY 2002.

The change in revenue contribution for the Americas and Japan for Q3 FY 2003 when compared to Q2 FY 2003 is not necessarily representative of a trend.

Order flow and the subsequent shipment of products during Q3 FY 2003 were the primary reason for the revenue contribution pattern.

If backlog is taken into consideration, both the Americas and Japan were in line with recent historical trends.

Orders from Japan were booked and shipped earlier in the quarter while some orders from the Americas were booked late in the quarter and will begin shipping this month.

For Q3 FY 2003, we had three customers that each accounted for more than 10 percent of our revenue on an individual basis - Tech Data, a large distributor, focused on our U.S. customers;

Hitachi Cable, a Japanese reseller; and Westcom (ph) , a European distributor.

Again, each of these channel partners on an individual basis accounted for 10 percent of our revenue for Q3 FY 2003.

The revenue split between enterprise and service provider segments for Q3 FY 2003 was 85 percent enterprise and 15 percent service provider.

Enterprise includes government and education customers.

Our service provider customers are primarily international.

Product mix consisted of 51 percent modular and 49 percent stackable for Q3 FY 2003 versus 56 percent modular and 44 percent stackable in Q2 FY 2003 and 48 percent modular and 52 percent stackable in Q3 FY 2002.

Gross margin for Q3 FY 2003 was 45.4 percent versus 50.2 percent for Q2 FY 2003 and 53.2 percent for Q3 FY 2002.

The primary reason for the decrease in gross margin was due to a decline in service revenue by approximately eight percent for Q3 FY 2003 compared to Q2 FY 2003 and six percent when compared to Q3 FY 2002, while service-related expenses increased in Q3 FY 2003.

Professional services revenue accounted for the majority of the service revenue decline.

During Q3 FY 2003, service expenses increased at a faster rate than normal due to a number of programs that the company implemented to improve service delivery productivity and enhance customer satisfaction.

These programs consisted of two primary initiatives - one, increasing service depot inventory levels so that we provide fast and consistent response time for our advanced hardware replacement program; and two, insuring that our service depot inventories have the benefit of the latest revisions of hardware and software to improve the functionality of a [Inaudible] repair parts and products that are used in our advanced hardware replacement program.

The advanced hardware replacement program is a service offering that enables our customers during the normal warranty period or under an extended service contract to request and receive replacement products before they send back their products for maintenance or repair.

These initiatives are well underway, but will take several more quarters to be substantially complete.

Starting with Q2 FY 2003 and for Q3 FY 2003, service revenue was more than 10 percent of total revenue.

As a result, we have undertaken the actions necessary to determine a gross margin for a service line of business.

We expect to provide this level of information in our 10-K that will be filed for FY 2003, which ends on June 30, 2003.

In the 10-K for FY 2003, we will also expect to reclassify elements of service expense from operating expenses wherein it has historically been classified to cost-of-service revenue.

For Q2 and Q3 FY 2003, the amount of service expense, including [Inaudible] expenses that we expect will be reclassified when we file our 10-K for FY 2003 will be 4.8 million for each quarter.

This forthcoming reclassification to cost-of-service revenue will decrease total gross margin, but will not impact operating profit.

Turning to product pricing, while at the macro level there is always competitive pressure for specific deals, we did not experience a major change in the macro environment for modular products.

Stackable product pricing was lower than historical trends, due to a tightening of the competitive environment for such products.

Operating expenses were 49.8 million in Q3 FY 2003 compared to 50.5 million in Q2 FY 2003 and 56 million in Q3 FY 2002.

For Q3 FY 2003, R&D expense represented 16.1 percent of revenue; sales, marketing, and service, 35 percent; and G&A, 7.4 percent.

Operating expenses were lower in Q3 FY 2003 as a result of cost reduction activities.

The operating loss for Q3 FY 2003 was 11.1 million versus a $3.5 million loss for Q2 FY 2003 and $3.2 million profit for Q3 FY 2002.

The unfavorable comparisons are due to lower revenue and a lower gross margin as a percent of revenue and on an absolute dollar basis.

Other income and expense for Q3 FY 2003 was $1 million compared to $1 million in Q2 FY 2003 and $.8 million in Q3 FY 2002.

Net loss for Q3 FY 2003, not including special charges and deferred compensation, was $6.6 million compared to a $2.6 million net loss for Q2 FY 2003 and a $2.6 million profit for Q3 FY 2002.

Net loss per share was six cents for Q3 FY 2003 not including special charges and deferred compensation versus a loss of two cents per share for Q2 FY 2003 and two cents earnings per share for Q3 FY 2002.

Including special deferred compensation totaling 1.6 million, the net loss for Q3 FY 2003 was 7.6 million or seven cents per share compared to a net loss of 19.7 million or 17 cents per share for Q2 FY 2003 which included special charges and deferred compensation totaling $28.6 million.

For Q3 FY 2002, the net loss was 139.8 million or $1.23 per share, which included special charges and deferred compensation totaling 178.4 million.

Our long-term estimated tax rate remains at approximately 35 percent.

Moving to the balance sheet, I would like to highlight several items.

First, our cash, cash equivalents, and marketable securities balance on March 30, 2003 was 407 million compared to 406 million on December 29, 2002 and 397 million on March 31, 2002.

Capital expenditures in Q3 FY 2003 were 1.7 million versus 4.6 million in Q2 FY 2003 and 10.6 million in Q3 FY 2002.

Accounts receivable were $19 million on March 31, 2003, which equates to a DSO of 20 days.

DSO for Q2 FY 2003 was 22 days, and DSO for Q3 FY 2002 was 45 days.

Net inventory on March 30, 2003 was 24 million compared to 28 million reported on December 29, 2002 and 36 million on March 31, 2002.

Channel inventory was within targeted levels at the end of Q3 FY 2003.

Keep in mind that we recognize revenue based on sell-off to distributors; therefore, the impact of inventory into the channel does not impact the reported revenue.

Revenue related to resellers and direct sales to end users is generally recognized when we ship product to the reseller or end user.

Resellers and end users do not have inventory return privileges.

Staff, including temporary personnel, as of March 30, 2003 was 889 versus 900 on December 29, 2002 and 1,006 on March 31, 2002.

As of March 30, 2003, the company had 116 million shares of common stock outstanding on a fully diluted basis.

Now we'd like to address financial guidance.

As we announce and begin shipping new products over the remainder of this calendar year, our goal is to achieve sequential revenue growth.

However, given the uncertain global macro economic environment and the highly competitive nature of our addressed markets, we cannot provide any assurance that we will achieve our goal.

Turning to gross margin, we have and expect to continue to achieve improvements in supply chain management.

However, it is likely that the impact of competitive pricing pressure and higher than normal service expense will offset any favorable gross margin improvement from supply chain management over the next several quarters.

Finally with the recent reduction in our operating expenses and capital expenditures, we believe that we will minimize cash utilization to approximately $10 million in each of the next several quarters to support revenue-driven increases in accounts receivable and inventory.

I will now turn the call back over to Gordon.

Thank you Hal.

Before concluding and opening up for questions, I would like to summarize how the senior management team believes that Extreme is well positioned as we move into the new calendar year.

We ended the quarter on a positive note, with strong booking momentum as we began taking orders for our new products.

We're pleased that the first of the Triumph products are now shipping three months ahead of schedule.

We have a strong series of Triumph product lined up for announcement throughout the quarter.

These products significantly strengthen our solutions and provide customers with a smooth upgrade path and high return on investments.

These products significantly change the competitive landscape.

For example Triumph provides significantly more functionality than jetcorp (ph) , not only is our copper Gigabit density 50 percent higher in comparing BlackDiamond to Big Iron (ph) , but the functionality's much greater and BlackDiamond is almost 20 percent less expensive on a published price for port basis.

And Triumph provides smooth migration and is fully inoperable with existing inferno systems.

Triumph is just the first step in a series of product announcements.

You should expect to see a new access architecture from us that will change the way people look at the edge of the network, and at the fixed configuration segment.

And our Genesis technology is on track with the first external alpha unit shipped.

Genesis redefines how people view the network core, both enterprise and Metro Ethernet.

The next several weeks we will schedule a conference call to go through some of these important technology developments.

And finally customers continue to adopt extreme.

In this challenging business climate, leading companies around the world choose extreme networks for the mission critical enterprise and Metro-Ethernet needs.

Thank you, and with that, we'd like to open up the call for questions.

Thank you sir.

Ladies and gentlemen, at this time we will begin the question-and-answer session.

If you have a question, please press star, followed by the one on your push-button phone.

If you would like to decline from the polling process, please press star, followed by the two.

You will hear a three-tone prompt acknowledging your selection.

If you are using speaker equipment, you will need to lift the handset before pressing the numbers.

One moment please for our first question.

Our first question comes from Sam Wilson.

Please state your company name followed by your question.

Good morning gentlemen.

This is Sam Wilson from JMP Securities.

Just two questions for you this morning.

Can you talk a little bit about how the competitive environment's changed lately, in particular at the stackable end?

You mentioned that there's increased competition there and it's having some effect on the pricing environment.

Can you just go into a little detail?

And also on the new products, can you just talk about how far they are in terms of channel inventories?

Do all your channel partners currently have the new Triumph on hand on and are ready to sell them?

Thank you.

Hi Sam, this is Gordon.

First of all on the stackable side, you know, stackables were significant part of our revenue during the quarter and we saw strength in some product lines there.

So although there's certainly very price competitive, we continue to do very well.

I do believe that that market will vipricate (ph) here over the next months and quarters into two distinct segments.

That is a very low-cost segment, which currently we do not participate in, and you know, a high-value enterprise segment, which is where our products lie.

So the second part of your question in terms of where Triumph is, we did have some shipments of Triumph over the last couple weeks, you know, to customers who had placed early orders, and we continue to ship out.

I would say at this point, it is not widely stocked within our channel, but I expect that that will be resolved here in the next couple weeks.

Thank you.

Our next question comes from Alex Henderson.

Please state your company name followed by your question.

Thanks, Salomon Smith Barney.

I was wondering if you could go back to the guidance for a second Hal.

You'd indicated I think that you're looking at usage of $10 million per quarter of cash over the next several quarters.

In your prior conference calls you'd indicated that your breakeven would be approximately 90 million.

Should we then assume then that you're solidly below that break-even on a revenue basis for the next couple of quarters, or is there something unusual about that mix that would cause the cash flow out at that level?

Yes, I think just two points Alex.

Number one, if you look at our working capital management, it's in actually pretty good shape today with 20 days DSO and our inventories are quite low.

So we believe as we start growing revenue we will have to spend some money on working capital.

And depending on where our revenues come in, you know, if they're essentially close to where they were at this quarter, which we, you know, again, we don't expect to be in that range, but we're not certain.

Then we would use some cash for operations.

But it's reasonable to think that it's probably under 90 million in the upcoming quarter?

Yes, because if you look at the growth margin level we're at now, that is true.

OK, and the gross margin commentary, I'm a little confused about, I mean it's stepped down quite sharply here in the current quarter, because of the revenue mix.

At 45, that's pretty a low gross margin.

I know you've been talking about gross margins expanding to the mid 50's.

Now you're seemingly implying that gross margins are going to hang pretty close to these levels and not come back up over the near term?

Well the primary drivers, or driver I should really say, pushing gross margin dollars related to our service business, and we had three things happen.

Number one is our service revenue drop off, which accounted for roughly about a third of the gross margin impact.

And then we put new equipment into our depose on a global basis, which cost us again, about a third of the gross margin impact, the third being the difference between 45 and 50.

And then finally, we enhanced the number of our products in the depo to get them up to the latest revision of hardware and software.

So our belief is once we get these service-related actions behind us, that we would return to a more normal gross margin for us, which is in the 50 percent plus range.

Again, I'm a little confused, are you implying that there's some quasi one-time charges associated with revamping the way you were handling service that's in the gross margin that accounts for a third of the drop of the gross margin?

Is that what I'm understanding you're saying.

I'm saying that the drop was primarily related to our service-related initiatives that we believe for the most part are a one-time, and we'll take a couple quarters as we indicated in the message here to work through.

But once those are out of the way, then we'll return back to a normal level for us.

OK, so gradually trimming back to 50 percent by say the ends, towards latter half, first half, end of the first half of next year, fiscal year?

Yes, I think that's a reasonable way to look at it.

OK, thank you.

Ladies and gentlemen, as a reminder, if you have a question, please press star, followed by the one on your push button phone.

Please limit your questions to one question and one follow-up question.

Our next question comes from John Anthony.

Please state your company name followed by your question.

It's Fulcrum Global Partners.

I guess I'm a little confused with a couple of things.

To begin with, even if your gross profit margins were to get back up to 50 percent, Hal, you had said in prior quarters that a 90 million run rate you'd need higher gross profit margins to become profitable.

So where's kind of the break-even rate at this point in your opinion for revenue and gross profit margin.

And the other question I have is in the past you said that you really aren't seeing Foundry, and now you're talking about Foundry pretty extensively on this call.

So could you address that a little bit?

Yes, I'll take the first part and then Gordon can handle the second part.

In terms of the break-even point, we have said was roughly about $50 million in operating per quarter, and our 52 to 53 percent gross margin, we would be at break even.

With, you know, the 45 percent gross margin that we currently have, and our operating expenses being in line with our target, our gross margin is a little bit more than $100 million in revenue per quarter.

So as we push back and get our margins back up again, we should get more in line with our overall targeted break-even point.

So Gordon, you want to?

Yes, John, the comments I made were just to give some examples of where Triumph technology sits in terms of the very high copper Gigabit density, which it provides, which is something we really didn't have before.

So I think that that puts us in a stronger competitive position versus all of the folks out there.

OK, thanks.

Our next question comes from Brian Molloy, please state your company name, followed by your question.

SoundView Technology Group.

Thanks Gordon.

I was just wondering, obviously a lot of the competition out there is introduced new product lines over the last couple quarters and obviously you're seeing the emergence of Interasys and Nortel seems to be from its enterprise business, where do you think going forward you could take market share and where do you think some of this growth will come from over the next several quarters?

Thanks.

Yes, I think that if you look at growth over the next couple quarters, it comes from some, you know, two areas.

Fundamentally it does come from taking share from all of our competitors, if you look at Interasys and Nortel, you know, Foundry and Cisco, we are in a very strong competitive position with these new products.

Also in opening up some segments that we haven't participated in, which you'll see from some announcements a little later as we move through the year.

Do you think that is will, I mean, what does your competitive position look like in Japan right now?

Obviously it was a little bit stronger this quarter, but moving into a little bit weaker seasonal period.

Do you think that'll drop back off and what might that look like.

Japan has been difficult to predict.

Our business there has been heavily oriented to the carriers and carriers, you know, operate on a project-by-project basis.

So it's been kind of stop-start.

As you know the enterprise business in Japan due to the Japanese economy has been pretty tough.

So we expect Japan to be stable over the next, I should say over the near term.

Thanks.

Our next question comes from Mark Sue.

Please state your company name followed by your question.

Thank you.

It's Unterberg Towbin.

Hal, what is a normal range of backlog, and maybe Gordon, your qualitative thoughts on bookings for Triumph-based products versus the traditional products, or maybe how many data customers have actually become deploying customers.

Yes, I'll take the first part again, Mark.

Typically our backlog including service for the quarter is somewhere between 25 to $30 million at the beginning of the quarter.

Yes, Mark on the competitive front, I think that if you look at Triumph products, we put those in the beta sites, you know, earlier in the March quarter, and you know, all the beta sites have been very happy with the product and it has sold through nicely.

Once again, we opened up for, you know, for bookings during the month of March and we're very pleased with results so far.

So if we look out a quarter, how would the mix shape up for new products versus old products for the June quarter?

Yes we expect the June quarter to certainly, you know, to be a mix.

We will have a shipment of the BlackDiamond Triumph blades, which we started shipping already and you know, I expect that those will do pretty well.

I'm not sure I could call a particular percentage mix, and you know, one of the advantages we have with the Triumph products is that these interoperate within an inferno-based chassis.

So a customer can buy a couple of the new blades and install them in existing systems, you know, rather than having to upgrade, you know, the switch fabric or you know, the whole chassis itself.

So I think we'll see, you know, gradual growth as we move through the quarter and as we introduce these new products.

All right.

Thank you.

Our next question comes from Tim Luke.

Please state your company name followed by your question.

Thanks.

I was wondering Hal if you could just clarify the timing of when you became aware of all the fairly significant sort of changes in your gross margin?

And then maybe talk a little bit about how you see the impact of the new products on your gross margin going forward?

It sounds as if what you're saying is that you're now going to be modeling a gross margin around this kind of level that we're now at for the next several quarters.

Thanks.

Yes, no, I think that is right, Tim.

We made a number of decision about midway through the quarter towards the backend to enhance our service capability, productivity and so forth, as I indicated earlier.

And that did have the impact on the gross margin that we described going from basically a 50 percent down to 45 percent.

Now moving forward, we believe that the new products will help our gross margin from the standpoint that they are less expensive to manufacture, and as you indicated we think it will take a couple quarters to return to back to what we would consider a more normal gross margin in the 50 percent plus range.

Could you also just remind us of the regional breakdown this quarter versus the prior quarter and talk about some of the trends that you saw within the regions?

Yes, just quickly, the Americas were 36 percent of our revenue for the quarter versus 45 percent last quarter.

There was a drop-off there, but it way primarily due to the timing of orders coming in late in the quarter and we'll have shipments going out this month for the Americas.

And again if you look at the backlog, it was more heavily oriented towards the Americas at the end of this quarter than normally.

Europe performed good at 28 percent versus 26 last quarter, and we've seen a good turnaround in Japan going to 26 percent of our revenue versus 17 percent.

And Asia held pretty close to last quarter, roughly at around 10 or 12 percent in both quarters.

And Gordon you referred to the Genesis and could you talk about the timeline for that and in terms of beta, and then also in terms of revenue?

Sure.

You know, we have shipped the system to an external customer and external alpha site.

We expect to go to beta sites, I would call it mid to late summer, and you know, to have revenue really, you know, towards the end of the year.

You know, this is a very complex system and we expect to have pretty extensive deal trials.

Thank you.

Our next question comes from John Wilson.

Please state your company name followed by your question.

Yes hi, it's John Wilson at RBC Capital Markets.

I guess just a couple things here.

Just to be clear about this whole service initiative here, this is completely unrelated to the warranty issues you went through, you know, a few quarters ago, and it's, I'm guessing again, unrelated to the introduction of Triumph into your channel?

So it's not, you're not loading your depos here to handle the new product?

Is this something completely different from that?

It's not related to the warranty or quality issues that we talked about a couple quarters back.

So there's no relation at all there.

As we enhance our field inventories in the service depos and so forth, it will help the transition to our new products, because we'll have the latest version of hardware and software essentially in all of our parts in the depo.

So that will smooth the transition.

OK, so I guess what I'm really trying to get at is what was the decision criteria what's a pretty, you know, it's a pretty meaningful impact into your gross margin.

I mean you don't just sort of decide hey let's just lower gross margin by five points, it's got to be a pretty dramatic benefit or at least problem that's existing that it makes you make that kind of decision.

So is, that sounds a bit more, maybe that it was sort of like part of the planning process to introducing Triumph?

Well there was really two primary reasons for doing it.

Number one is that we wanted to make sure that we could respond on a fast and consistent basis for our advanced hardware replacement program.

And to do that we had to add more depo inventory and we ended up adding that inventory with new products, which is very costly.

We did it because of customer satisfaction.

And then again, the second thing we wanted to make sure that we did was to bring all the depo inventory up to the latest revisions for hardware and software, which again is related to customer satisfaction, and that will smooth the transition to our new products that we're going to be introducing over the balance of this calendar year.

OK, thank you.

Our next question comes from Jason Ader.

Please state your company name followed by your question.

Yes, Thomas Weisel Partners.

Yes Hal, just back on the gross margins, you said the drivers a third, a third, all have to do with services.

Are you saying there was no product impact or price pressure impact or mix impact from products this quarter?

Yes I am.

I'm saying on balance our product mix and also the pricing environment did not have a negative impact on our gross margin for the quarter.

OK.

It was primarily all related to the service initiatives that we discussed.

OK, and you also mentioned for the 10-K, he 4.8 million going to be added to the cost for Q2 and Q3, is that, that's already in Q3, right?

Yes it is.

It's in operating expense right now.

For Q3?

Yes.

OK, so Q3 actually will have a lower gross margin?

It will have a lower gross margin, but the operating loss in this particular situation will not change.

OK, so going forward, should we expect roughly that amount at 4.8 million or so, that's going to be in cost?

Are you going to be reporting that way for Q4, or are you going to be, do you know what I'm asking?

Where's that 4.8 million going to be for Q4?

For Q4, we'll report the information essentially the same way we did for Q3.

And then as we head into fiscal '04 our plan is to, in effect report a gross margin for our products and for our service lines of businesses.

OK.

I see.

All right, and then so the overall gross margin could be actually lower next fiscal year than the 50 percent target, based upon this new reporting?

That's correct.

OK, all right, and then, just last question, you did mention in the guidance that 10 million cash use for revenue-driven increase in AR and DSOs, so you know, implicit in that I guess, there would be a cash use for revenue growth.

So is that what I heard?

Is that what you said?

Yes, I think, you know, the first point I made about guidance, we said that tour goal is to grow our revenue sequentially and given the solid position of our working capital today, again 20 days DSOs and very low inventory levels, as we grow revenue, we will have to add to working capital.

OK, so that's above and beyond the cash use that you, that the 10 million is above and beyond the cash use that you will need, because of the lower gross margin, or is that 10 million include the, you know, below break-even?

It's inclusive.

OK.

All right.

Thank you.

Our next question comes from Raj Srikanth.

Please state your company name, followed by your question.

Thank you.

Deutsche Bank.

I have two questions.

The first one is Hal, does this sort of that the new gross margin number that we are talking about, does that include any inventories write-offs for the old, sort of chipsets, or old products that you may have in the channel?

Yes, at this point, we are not anticipating any write-offs, so it does not include them because we are not anticipating any.

Okay.

And then the second question for Gordon, can you sort of talk about the environment out there given the war and everything else that's going on, going by geography starting from the U.S.

International, and what do you feel out there has the war impacted you from the war in terms of orders on an ongoing basis.

How do you look at it?

Thanks.

Yeah, it's hard to say what the impact of the war has been, but going through the geographies and looking at the U.S., although for the U.S. it was a challenging quarter, the U.S. finished up strong with some excellent wins and good backlog coming into this quarter into the U.S., so we generally feel pretty good about that.

I would say Europe was on track.

We really didn't notice any disruption there.

And just Japan and Asia also continued to perform.

I think although the war will have some impact.

I don't see it being material at this point in time.

So the comments of that Gordon, is that, so just the ending of the war per se, you don't expect any boost or any growth in terms of order rates for any one of these sort of geographies.

Would that be fair?

I'm hopeful that with the uncertainty of the war being cleared up in a lot of people's minds that, that will strengthen the business here in the U.S.

Okay.

Thank you.

Our next question comes from Richard Church.

Please state your company name, followed by your question.

Thanks, Mockogias (ph) Securites.

Harold, you mentioned that professional service revenue experienced a significant decline in the [Inaudible] .

I was just wondering if you could give us some color on that?

Yeah, I think a couple points.

I think customers in this environment are really tightening down on any expenses they can and unfortunately I think professional services was part of that.

And for us, because of the fixed expense base that we have in place now and the way we account for the service revenue, the majority of that directly impacted the gross margin.

So they were hopeful as we moved forward and the uncertainty as Gordon was just mentioning starts to go away, that line of revenue will start to increase again for us.

Okay, and Gordon, with regards to the [Inaudible] , do you get the sense that customers are holding off on purchases until that's more widely available?

Richard, once again, the production is ramping on these triumph products.

We don't expect this to be a supply problem during the quarter.

And then I think this is a very well planned transition that once again is a little bit ahead of schedule and the product is flowing out, so we don't see any hold ups.

As customers order these products, we'll be able to deliver them very quickly.

Okay, and can you give us whatever color you canon this access initiative?

Do you plan to have partners with this initiative and what is the timing for this?

Oh, I guess Richard, what I say there is to stay tuned, we did plan to schedule another conference call sometime in the next several weeks just to talk about technology.

Okay.

Thanks a lot.

Our next question comes from William Becklean.

Please state your company name followed by your question.

Thanks.

It's Commerce Capital Markets.

Your announcement of your initiative in the access architecture, suggests an effort to try and rebuild some market share in the service provider market, so I'm wondering, are you putting together a strategy that would include access as well as the new Genesis product to try and increase your provision in the service provider market and what percentage of revenues do you think you might be able to drive that back to?

Yes, this is Gordon.

The service provider market revenue, or I should say the percentage of our overall revenue has been trending down over the past couple quarters and I think some of the issues among the service provider market are pretty well known and understood.

If you look at our Genesis Program in particular, it has many capabilities that are targeted specifically at the Metro Ethernet segment and certainly we hope that, that product will be widely adopted as we begin to deliver for revenue late in the year.

Thank you.

Our next question comes from Steven Kamman.

Please state your company name followed by your question.

It's Steven Kamman from CIBC.

I'm just going to ask question more because we'll get the question anyway.

Any of those products out on the returns on the repair centers, were they either written off or made up of any of the defective inventory you wrote off a couple quarters ago.

Again, just asking it to be fair.

And then secondly, to what extent is the lower expectations for lower gross margin in the quarter going forward?

Does that have to do with expectations of having to sell out older inventory perhaps at a discount?

No, the material in the depot, it is recent material that we [Inaudible] , the enhancements that we're making to the products out there, again bring everything up to the latest revision levels.

It had nothing to do with the charges that we've taken in the past.

Okay, I figured that out.

Yeah, that's no problem at all.

To what extent to you expect to have to discount the older product this quarter in order to wrap up that inventory and where do you think you are in that?

Yeah, we don't really expect to have to do any heavy discounting because we manage are finished good inventories very closely, and we think we have a fairly smooth transition plan now going to the new products.

Okay.

Thanks very much.

Our next question comes from Andy Schopick (ph) .

Please state your company name, followed by your question.

Thank you.

Nutmeg (ph) Securities.

I've got a lot of things moving around here Gentlemen.

First of all, what was the percentage of revenues this quarter in direct versus direct sales?

It's in line with our historical patterns which has been roughly about 50 percent resale or 40 percent distributor and in the neighborhood of about 10 percent direct.

So no real changes there.

Okay, now, with respect to the 10 percent of customers, did I understand you to say that Tech Data, Hitachi and West Con (ph) were all approximately 10 percent each in this quarter?

That's right.

Okay.

Also, with respect to provisions, it does seem a little odd that there is no provision for either doubtful account or excess and obsolete lessons.

Given what we see happening here, the acceleration to new products platforms, I know you've kind of answered that question but I just, I'm hard pressed to understand how you've been able to accomplish that without taking any additional reserves in the recent quarters, especially given the acceleration of the new product platforms into the market.

Yeah, just let me clarify.

We do on a quarterly basis, review our resource for bad debt and excess and obsolete inventory and we think we're more than adequately reserved at this time.

So, there's been no addition.

That's all I'm saying.

Yeah, there's been no addition and again, that's because we very closely manage our finished goods inventory.

Our production lead times are very short, so we try to match that with order demand on a routine basis and prevent excess inventory write offs.

So we think we're in good shape there.

OK, Gordon, can you comment at all about the efforts or the ongoing efforts now to transition the company to more of a direct sales model, what has to be done, what are some of the milestones or goals now in the quarters ahead, that you're trying to accomplish?

Sure, Andy (ph) , I can comment on the channel strategy in general.

The, as Hal mentioned, the actual direct part of our sales has been, were consistent with previous quarters and we only sell direct into the U.S.

So, you know, we will continue to maintain that strategy.

One of the things we have been doing is adjusting our U.S. channel strategy and that is really investing in the partners, you know, that have invested in us in terms of regional VARS (ph) and also in terms of a national VARS (ph) , you know, and that process is going very well and continues.

We haven't made any channel shifts outside of the U.S. and our European, Japanese, and Asia channels are all doing well.

OK, thank you.

Our next question comes from Gina Sockolow.

Please state your company name followed by your question.

Buckingham Research.

Cisco announced a new blade for the catalyst that has very deep discounting.

Have you factored this into your pricing and gross margin guidance and how much do you, what is your per-port pricing now and how does that compare with Cisco's new blade?

Thank you.

I'm sorry, Gina, this is Gordon.

Which new blade are you referring to?

For the CAT 5 (ph) , there's a blade that's, I think it's $175 for a port.

For the CAT 5 (ph) .

Catalyst 5,000 (ph) , for the, yes, for their Ethernet switch implementation.

Yes, the 5,000 is an obsolete product.

You talking about the 6509 (ph) ?

Well, it's for the, it's for the 10, it's for the high-end Gig E (ph) , 10, 100 that was announced, so what, I can look up the product model later.

The question is about pricing.

Your people know the pricing.

Yes, certainly, Cisco made some announcements within the last two weeks, which are what I would call more high-end product.

The introduced some directional products with a new supervisor model and some you know 10 gig, and new gig modules, but those are pretty expensive on a per-port basis, and on a per blade basis.

All right, I'll have to ask you offline.

OK.

We'll hook up Gina.

Sorry about that.

Thank you.

Our next question comes from Michael Jung (ph) .

Please state your company name, followed by your question.

Hi.

SG Cowen.

I guess most of my questions have been answered.

Can your provide just a little bit more detail on the income statement, like breaking down interest to income and expense, what the breakout was?

And just to clarify, you mentioned that you expect to increase working capital to help grow revenues, how do you see operating expenses trending over the next several quarters?

Thanks.

Yes, sure, on the interest, other income and interest expense, it was $1 million in quarter two of fiscal '03, and a $1 million this past quarter and we expect it to stay pretty much in that range.

Our operating expenses were $49.8 million last quarter and we expect them to stay fairly flat moving forward.

I mean on the net interest, can you break out what was interest income and interest expense?

Yes, we don't actually break that out.

OK.

And as we move forward, given the low level of our DSO, again 20 days, and our inventories at very low levels right now, as we increase revenue, we do expect to have to add some additional working capital.

OK, and if I could just follow up on actually the last question, yes, the new products from Cisco where the 10 Gigabit modules, which I think at the low-end, the low-end pricing was $5,000 a port for 10 Gig targeted for the enterprise.

Could you comment on how you see your products comparing with that?

Thanks.

Yes, this is Gordon.

You know, we've gone through the Cisco announcement, as you might imagine pretty carefully.

First of all, I'd not that it was really a pre-announcement and that the products that they talk about are not going to be available for quite some time.

If you look at 10 Gig pricing, it's really, it's hard to compare one vendor to another, because some do not include the cost of optics.

And the optics is really, you know, very expensive on 10 Gig, at least today.

So if you show a product without the, without the Zenpac (ph) optics installed, the price looks much lower than with the product installed.

So you know, we feel very comfortable that our 10 Gig strategy is not only solid on our BlackDiamond products, which we're shipping today, but also our Genesis systems as you might imagine, you know, do have pretty high density at 10 Gig.

All right.

Thanks.

Our next question comes from Stephen Chin.

Please state your company name, followed by your question.

Great.

Thank you.

UBS Warburg.

Just a question for Hal, in terms of sales by geography, should we expect sales to Japan to be seasonally weak in the June quarter given that we're heading into their fiscal first quarter?

And secondly, do you expect the U.S. federal government verticals to have an interest in these new Triumph products in the June quarter or do you expect the U.S. federal government to be a bit later in purchasing some of these new modules?

Thanks.

Yes, I'll answer the first part and let Gordon take the other part.

In regard to Japan, we think we'll stay within the historical ranges somewhere between 20 to 25 percent in revenue, and based on our outlook right now, we think again, our Japanese revenue for the current quarter is going to be roughly flat to up a little bit from last quarter.

So Gordon, do you want to take the part about the military vertical?

Yes, in terms of the Triumph product and the military, I think the Triumph product applies, first of all to all segments, but if you look at any high-performance compute segments, the Triumph products really shine because they bring very high density on the Gigabit ports.

So you can connect a large number of servers or a large number of work stations directly to Gigabit Ethernet, and also with very high performance.

So I do expect that to do well in the government verticals, but I also expect it to do well in our other traditional verticals such as health care education and media.

OK, thank you.

Operator, we'll take one more question.

Our final question is a follow-up from Alex Henderson.

Please go ahead with your question.

Great.

Thank you very much.

I was wondering if we just talk a little about the linearity during the quarter and put that in context with the, you're sort of implying you don't really expect much of change in revenues this quarter coming up.

Yet, you have a book-to-bill that's above one; you're going into a seasonally stronger quarter; your Japanese business, which should be seasonally weaker is supposed to be flat to up.

Can you talk about why we're not looking at the numbers getting back towards the 90 million range here immediately?

I mean it seems almost like you should be able to do that pretty easily.

Just a couple points Alex.

Our revenue linearity during the quarter was pretty close to our historical pattern, 20, 30, 50.

Our order linearity was a little bit stronger as we wrapped up the quarter.

So you know, going forward, as I indicated in our financial guidance, we would like to achieve sequentially revenue growth.

However, with the, half our revenue essentially coming in, in month three of the quarter, you know, we don't really have the visibility to project what the revenue's going to be for this quarter, but again we are looking for sequential revenue growth.

But it does sounds like, given what you're saying, that I mean, there's no reason to assume at this juncture that June's going to be a weak period.

Seasonally it's usually quite a bit stronger than March, you had a wariness and obviously a lot of angst around the current period.

Your Japanese business is supposed to be up, why wouldn't it snap back towards what you would do in a seasonally comparable December quarter at least.

Well I think your analysis is correct, so hopefully we'll increase our revenue.

I see, and so can you give us a little bit tighter quantification on the book-to-bill?

I mean are we talking about just a hair over one, or are we talking about solidly over one?

Our belief was that it is solidly over one.

Thanks.

OK, operator, that will conclude our call.

Thank you.

Ladies and gentlemen, this concludes today's Extreme Networks third quarter 2003 earnings release conference call.

If you would like to listen to a replay of today's conference please dial 800-405-2236 or 303-590-3000 followed by access number 534431.

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