Extreme Networks Inc (EXTR) 2004 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Extreme Networks fourth-quarter financial results conference call. (OPERATOR INSTRUCTIONS).

I would now like to turn the conference over to Bill Slakey, Chief Financial Officer with Extreme Networks.

Please go ahead, sir.

Thank you, operator.

Good afternoon, everyone, and thank you for joining us.

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

This afternoon we issued a press release announcing our financial results for the fourth quarter of fiscal 2004.

A copy of this release is posted on the Investor Relations section of our Web site at www.ExtremeNetworks.com.

I would like to remind you as well that the recording of this call will be available on our Web site for replay shortly after the conclusion of the call.

Let me also note for you that 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 (technical difficulty)-- conditions or product introductions and their success should be considered as forward-looking statements.

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

And with that, let me turn the call over to Gordon Stitt.

Thanks, Bill, belt and thanks everyone for joining us.

I would like to start by saying that the results of the quarter were in line with our expectations, and we accomplished our business goals, our product goals and our operational goals.

Speaking for the team here at Extreme, we are very pleased with our results for the final quarter of fiscal 2004.

This was a strong quarter for us, and our results demonstrate that our business strategy driven by our focus on innovation is working very well.

We grew revenues sequentially and year-over-year, and we were within the anticipated topline range that we laid out for ourselves last quarter.

We remain on target to deliver on our calendar 2004 goal to grow revenues in the December 2004 quarter by 15 to 25 percent above the 83.4 million we reported in December 2003.

U.S. revenues continued strong, and we are essentially in line with the third quarter in which we had had a substantial 33 percent jump.

We continue to benefit this quarter from additional customer wins in key vertical markets including healthcare, education and government.

International revenues were up sequentially in contrast to the third quarter in which we had seen declines.

Our book-to-bill ratio was above one-to-one for the quarter with very strong sequential bookings in the North American market.

We saw sequential growth in bookings in our strategic product areas and through our strategic partnerships.

We saw an increase in bookings for our BlackDiamond 10K or chassis switch which began shipping last December.

We also saw sequential increases for Unified Access architecture edge solution that allows for wireless connectivity.

Our partnership and resell agreement with Avaya continues to generate results.

We had strong sequential increase in bookings from this strategic alliance.

We are also very pleased that we have returned to profitability on both an operating profit basis and the GAAP basis.

Our profit after other income and taxes was 2.3 million or 2 cents per share on a GAAP basis.

On an operating basis, we achieved profitability as we had set out to do by keeping expenses roughly flat sequentially in actual dollars, thereby improving our operating leverage.

R&D was in line with the previous quarter, and we continue to lower G&A through further cost reductions as well as lowered legal expenses.

Sales and marketing did go up sequentially, again as we expected, as we increase some of our marketing activities as well as some year-end commissions and expenses associated with our sales 100 percent club.

I am very proud of the expense and operating discipline that our team has put into place.

Our gross margins were in line where we expected to be.

Gross margins overall were 52.2 percent during the quarter, with product gross margins flat at 55.5 percent, and service margins improving to 34.5 percent.

As we have been saying since last December, we do not expect to expand our gross margin sequentially each and every quarter, but our goal remains to be operating within a total margin range of 52 percent to 55 percent by the December 2004 quarter.

We are encouraged by what we are seeing in the marketplace, and we continue to believe that Extreme Networks is well positioned, in fact uniquely positioned, to take advantage of an environment in which companies are increasing their network infrastructure spending.

The key factor that allows Extreme to be uniquely positioned in this market is our strategy of being the innovation leader.

During the past few quarters, we have been delivering on our vision of providing customers with the systems to build a converged communications infrastructure that can easily accommodate voice, video and data on a seamless wired and wireless network.

These two aspects of conversions, that of voice, video and data and that of wired and wireless, are the underlying demand creators in the enterprise market.

Our networks deliver predictable performance, deliver unique security capabilities and deliver enduring value through cost of ownership and future extendibility.

During the quarter, we continue delivering on our strategy, and before Bill provides details on the financial results, I would like to take a few minutes to discuss a few key initiatives that enable us to maintain and enhance our unique position.

The first item I will discuss is our global strategic partnership with Avaya which we announced last November.

Most of you who attended the Las Vegas NetWorld+InterOp show in May had a chance to see up close some early results of our partnership.

Together with Avaya we demonstrated IP telephony, delivered over the interop network, a temporary but comprehensive network that was built by Extreme.

This move enabled us to really show end-users a best-of-breed network IP infrastructure for voice and video and data applications and to demonstrate IP telephony solutions.

We also demonstrated some of the technology coming from our joint R&D, which included joint network management applications, which for the first time allowed users to manage a multivendor IP telephony network from a single console.

We also demonstrated some new protocols that will be implemented later this year that will enhance the availability and management of IP telephony.

It was rewarding to get such positive feedback from attendees looking for an alternative to single vendor solutions.

As we continue to work very closely with Avaya, I am happy to report that we are right where we planned to be at this point.

In financial terms, the Avaya relationship had a modest positive financial impact on the quarter as we told you it would, and sales were sequentially up from the previous quarter.

We currently have trained in excess of 700 sales reps and 150 systems engineers on Extreme products.

These sales and systems engineers were either for Avaya or for Avaya business partners.

We expect these training and certification programs to bear more fruit as we move through this fiscal year.

Looking at our channels, our channels delivered excellent results during the quarter and during the year that just concluded.

We saw sequential increases in our U.S. national channel partners, as well as our U.S. regional VARs.

During the quarter, we began working with Catalyst Telecom.

Catalyst Telecom is a value-added distributor of communication solutions, including voice, convergence and data equipment.

Through this relationship, we have already entered into authorization agreements with approximately 70 resellers.

These resellers are authorized to sell Extreme combined with Avaya IP telephony into a broad range of market segments.

Among those resellers, MACR and Cross Telecom are two of the largest converged resellers in North America.

During the quarter, MACR closed a deal with the Chicago Sun Times for a converged Avaya and Extreme solution.

As we move through this year, we expect to see continued strong results from our channels, both national and regional.

Should we see a stronger economic turn in the Americas, we can expect even greater leverage from our strengthened distribution channels.

So let's talk about products and technology.

As many of you may be familiar, our strategy is to offer customers true innovative networking solutions that enable them to build a converged communications infrastructure that can handle today's bandwidth intensive applications and scale to accommodate new applications and devices.

Our view of how to architect a network encompasses three major areas -- the edge, the core and the software that makes it all work.

We have been delivering solutions for these areas, and during this quarter, we announced an enhanced version of our revolutionary platform called ExtremeWare XOS v11.

This is a new software foundation that for the first time delivers adaptability, scalability and increased responsiveness for enterprise and metro networks through a uniquely open extensible architecture.

High resilience capability, also called high reliability, is increasingly important with converged environments.

For example, a several second network outage is not a problem for most Web-based applications.

Users can tolerate that type of delay.

But for IP telephony applications, a several second outage can be very disruptive.

Now Extreme's BlackDiamond systems have always had redundant switch fabrics and redundant power supplies.

What we are adding with XOS is high availability software.

XOS v11 adds dynamic loading of software modules and process restart.

These features along with the core architecture of XOS provide for highly available operation.

Users striving for 5/9's reliability recognize that 5/9 means roughly five minutes of downtime per year.

Now some switches require several minutes just to reboot.

With ExtremeWare XOS, new software can be loaded or processes restarted live without shutting down the switch and without rebooting.

ExtremeWare XOS is the result of a four-year investment to develop a fully modular highly resilient operating system.

It is currently available on our BlackDiamond 10K core switch.

We will drive this technology through our product line.

We will drive it into large and mid enterprise, and we will drive it into the metro Ethernet space.

This is a platform for further innovation and provides a significant competitive advantage for Extreme.

The next area is Unified Access.

Now when we introduced our wireless solution approximately a year ago we took a different path than many in the industry.

Were many in the industry took the path of building a complex overlay type network, we took the view towards a converged wired and wireless infrastructure that we called Unified Access architecture.

Our vision is of a universal jack on the wall into which a user can connect a traditional PC and IP telephone or a lightweight wireless access point.

This jack delivers consistent security, user authentication, policy and quality of service regardless of what type of device or media.

Our vision of this integrated wired and wireless world resonates with users and prospects.

We are proud that many customers have selected Extreme, and here are some profiles on just a few in our key vertical markets, that is healthcare and education.

First example is Jacobi Medical Center, a hospital in the Bronx, that has recently selected Extreme's Unified Access architecture solution to add to its 10 gigabit core solution.

The hospital will be implementing this integrated approach to simplify access to patient records and critical information throughout its facilities.

As a benefit, our Summit 300 wired and wireless switch delivers 48 ports of connectivity with power over ethernet for an extremely flexible wireless LAN solution.

Another hospital, Children's Hospitals and Clinics of Minnesota, has also recently selected Extreme's Unified Access architecture wired and wireless solution to enhance access to information and streamline patient care throughout a number of locations.

By deploying the Summit 300 switch within its facility, the hospital is gaining a secure high bandwidth wireless LAN solution that is both simple to configure and manage.

And finally, the Rochester school district in Michigan is also deploying Extreme's Unified Access architecture switches in hundreds of access points to serve students and faculty throughout its more than 20 schools in the district.

Our BlackDiamond 10K, which we introduced in December, is based on our fourth generation programmable ASICs and brings together such advanced services as security, mobility, user policy, integrated management and application optimization.

The 10K extends the network beyond mere connectivity to actually enable applications.

As we have indicated in past communications, the core of the network is less about speeds and feeds and more about security, control and new services.

Users are resonating with our strategy and adopting the BlackDiamond 10K at the core of their networks.

I'm pleased to say that bookings of this chassis were up significantly over the previous quarter.

Users love the extensibility of the system, the rich security features including industry-leading access control and support, and our upcoming revolutionary capability of (inaudible).

Here are some examples of customers who have adopted the 10K.

In Japan, Osaka Prefecture University is deploying a number BlackDiamond 10K switches to handle extensive research and benefit from dense 10 gigabit ethernet connections.

The resiliency intelligence and flexibility of this system was a key factor in the University's choice of Extreme Networks.

Also, the Max Planck Institute of Stuttgart, Germany has deployed our BlackDiamond 10K switch to enable the accelerated research dedicated to physics, molecular structure and chemical engineering.

The 10K's distinct capabilities to handle dense gigabit and 10 gigabit ethernet allow it to underpin critical studies that are at the leading edge.

And in the United Kingdom, both Imperial College of London, as well as Reading University, have also deployed Extreme's BlackDiamond 10K.

The switch will work within their computing science divisions and carry them well into the future.

It serves as an ideal backbone infrastructure for their surrounding gigabit ethernet networks.

Now a few words about metro ethernet.

During the quarter, we also continued to execute on our innovation strategy for the metro ethernet network market.

We advanced our metro ethernet services platform by adding traffic management, scalability and resilience and capabilities.

These new capabilities allowed metro ethernet service providers to build a cost-effective network for triple play.

That is the combination of voice, video and data.

We have successfully leveraged our expertise in building converged communication infrastructures to enable metro ethernet service providers to maximize revenue by supporting a wide variety of services for their customers.

We're seeing a high level of response from metro ethernet providers, many outside the U.S., for our new services platform.

A few comments about some other customers.

Now a number of enterprise customers are determining that Extreme Networks and our global partner Avaya offer superior technology integration and value for their converged voice and data communication solutions.

The Chicago Sun-Times, one of the nation's 10 largest newspapers, is adopting converged data and voice solutions from Extreme and Avaya.

The newspaper, moving into an entirely new facility, required a secure converged network for its various media requirements.

With a unified network management view gained from the combined Extreme/Avaya solution, their new network infrastructure allowed them to migrate gracefully to an IP infrastructure while realizing the benefits of increased scalability of ethernet.

Local governments are also sponsoring metropolitan IP network projects aimed at delivering advanced applications and services.

The state of Florida's Department of Transportation recently completed a network upgrade that relies on our BlackDiamond 6800, Alpine 3800, and Summit line of switches to establish its intelligent traffic management system across its east-west interstate highway.

The network regularly carries more than 100 high-quality video streams, delivered using Extreme's advanced multicast capability.

And in Canada, Toronto's GTA net, the new expansive metro area network has selected the BlackDiamond 6800 platform to carry traffic across the backbone of one of the largest advanced research and education networks.

This dark fiber gigabit network is aimed at collaborative research and development projects and will allow researchers from different institutions to work with colleagues in real-time throughout the Toronto area.

And finally in the federal IT market, one of our key vertical segments, Extreme's footprint continues to expand with the Pentagon's ongoing wedge renovation project.

Also, on the topic of federal business, we announced during the quarter that our network solutions have been certified in conjunction with Avaya for use in military command and control applications.

This solution was rigorously tested by the Department of Defense joint interoperability test command and met the critical interoperability requirements for certification and use by national defense agencies.

So a few final comments about changes in our management team.

We're very pleased that we have strengthened our management team through the addition of two senior individuals to our sales organization.

As you know, Chris Todd, who is our former Vice President of Worldwide Sales, announced his resignation in April and worked through the end of the quarter.

We would like to take a moment to thank Chris for his efforts during the quarter and for the last two and half years.

He and his team finished very strong, and all of us here at Extreme are proud of the results that Chris and the team delivered.

Starting this quarter, we're very pleased that Frank Carlucci has joined the Extreme team at Senior VP of Worldwide Sales.

Frank has an extensive background in sales, sales management and general management.

He comes to us from Avaya where he oversaw global outsourcing and was intimately involved in helping many of their Fortune 1000 customers build and maintain communications infrastructure.

He also oversaw planning for Avaya's enterprise communications group and previous to that was in charge of Avaya's second-largest sales region.

Now in addition, Frank has in-depth experience in the federal market having served as Director of Major Programs with Federal Data corporation, a leading system integrator for the federal market.

We are all very excited to have Frank on board and hard at work at Extreme and believe that his experience will be an enormous boost as we move into this new year.

I am also pleased to announce that Shawn Darcy has joined us as Vice President of Sales for North America.

Shawn joins us from ISS where he was VP of Sales Western Area.

Previously he was VP of Worldwide Sales for TiMetra, a startup company focused on metro area networking that was purchased by Alcatel.

Previously Shawn spent four years here at Extreme Networks initially running our European sales and then as Vice President of Sales for the Americas.

And before that, Shawn spent eight years at Bay Networks in sales and sales management roles.

During his previous 10 years at Extreme, Shawn delivered exceptional growth in North America, and we welcome him home to Extreme to lead the region to strong growth again.

So to summarize, we have delivered on our plans, we are profitable, we have held our costs in line, and our major initiatives, our partnerships and our channels are delivering.

Our new products are gaining traction, and our new sales leadership team is in place.

With that, I would like to turn the call over to Bill.

Thank you, Gordon.

I'm going to briefly review our financial results for the quarter, as well as review our expectations for future performance.

Starting with revenue, revenue for the quarter was $92.2 million, up 4 percent sequentially and up 6 percent year-over-year.

Revenues consisted of $79 million in product revenue and $13.2 million of service revenue.

Service revenue was up 3 percent sequentially and up 24 percent versus the year ago quarter.

This was the fourth consecutive quarter in which our service revenues were flat to up sequentially and up year-over-year.

For the full-year, service revenues grew 26 percent and represented 14 percent of total company revenue.

As I will review shortly, service gross margins also improved significantly during the year.

We are benefiting in this area of our business from a focused sales team and ongoing effort to optimize our services supply chain.

This has been a real success story for us in fiscal 2004.

Product revenue was up 4 percent sequentially, 3 percent year-over-year.

As you heard from Gordon, our book-to-bill was above one for the quarter.

Shipments of modular products represented 52 percent of sales, and stackable products represented 48 percent.

This is a shift toward stackable products relative to last quarter and is consistent with higher international revenues in Q4 and consistent with the pattern we saw in Q1 and Q2.

For the fiscal year in total, our mix of product shipments was 54 percent modular and 46 percent stackable.

Of particular note in the quarter was sequentially higher revenue and bookings contributions from new products and channels we are looking to for growth going forward.

We saw sequential improvements in revenue and bookings for the BlackDiamond 10K, our Unified Access products, our recently announced Summit 400 stackable product, and from a channel prospective a modestly higher contribution from our Avaya partnership.

These are encouraging results as we look forward to the second half of 2004.

We did see small sequential declines in revenues from some of our older products.

This is consistent with transmission and demand of newer products like the 10K and Summit products.

Looking at revenues geographically, revenue in the U.S. was $38.4 million, in line with 38.8 million reported in Q3.

You may recall that our Q3 revenues in the U.S. were up 33 percent sequentially from Q2 due in part to shipments of the BlackDiamond 10K.

Maintaining revenues in line with this strong Q3 result is I believe a very good performance.

Bookings in the U.S. were up nicely from Q3, and the book-to-bill in Q4 was above 1.

From a channel prospective in the U.S., we saw a small sequential increase in revenues from Avaya and a larger sequential increase in bookings.

In the U.S., our national resellers -- Dell, SBC, Siemens and Verizon -- accounted for just over 25 percent of our U.S. bookings and increased from just over 20 percent in Q4 a year ago.

In Europe total revenue was 24.7 million or 27 percent of total revenue.

Revenue in Europe was up from 23.5 million in the previous quarter.

We saw sequential increases in revenue in Northern Europe in particular.

In Japan revenue was 19.2 million or 21 percent of total revenue, down slightly from $20 million in Q3.

We did see a small sequential increase in our service provider revenue in Japan.

For Asia outside of Japan, revenue was 9.9 million or 11 percent of total revenue, a good recovery from 6.6 million in Q3.

Both Japan and Asia are markets which can be lumpy for us because they have a higher percentage of large deals, many of which are with service providers.

As a result, quarterly revenues in both markets can move up or down sequentially for us quite easily.

Some additional statistics for you on revenue.

We had one 10 percent customer during the quarter, Tech Data in the U.S., and the split of enterprise to service provider business was 78 percent to 22 percent.

That is 78 percent enterprise and 22 percent service provider.

That was a slight shift toward service providers versus Q3.

Turning to gross margins now.

Total gross margin was 52.5 percent of sales, up sequentially from 51.2 percent of sales.

Product margin was 55.5 percent, up .8 percent of sales sequentially.

Product and channel mix shift actually worked against us a bit in Q4 compared to Q3.

However, a strong cost reduction effort, particularly in overhead and warranty areas, lead to a slight sequential improvement in overall gross margins.

As for competitive pricing, our overall discounts did increase slightly in Q4 relative to Q3.

We were able to offset this through cost reductions during the quarter, but this is an area we are watching closely going forward.

Service gross margins were 34.5 percent, up from 29.9 percent in Q3.

This expansion was due to revenue growth sequentially, as well as an ongoing focus on reducing per unit repair costs, failure rates and overheads.

I think it is important to note the year-over-year improvement in service gross margins from a negative gross margin of 16.7 percent in Q4 a year ago.

Looking at our operating expenses now.

Total operating expenses on a GAAP reporting basis were $52 million, including a $5.5 million restructuring charge.

This charge was taken to increase previously established reserves for excess facilities.

Many of you know the commercial real estate market in the Santa Clara Valley remains very soft, and as a result, we have reduced our estimates for future sublease income on facilities we have vacated in the valley previously.

This leads to a need to increase our reserves for excess facilities.

This charge had no cash impact impact in the quarter.

Not including the restructuring charge, operating expenses for the quarter were $46.5 million, essentially flat with 46.6 million in Q3, but down as a percentage of sales from 52.4 to 50.4 percent in Q4.

This is consistent with our previously stated goal of improving operating leverage by holding total operating expenses flat while growing the topline.

In Q4 sales and marketing expenses increased 1.4 million sequentially, primarily as a result of fiscal year-end commission accelerators and marketing activities.

G&A expenses were down 1.6 million sequentially, primarily as a result of lower legal, insurance and professional services fees.

R&D expenses of 15.2 million in Q4 were essentially flat sequentially.

Looking forward on operating expenses, we anticipate the total level of operating expenses in Q1 will be flat to slightly lower than Q4 spending.

Spending will vary line item to line item with sales and marketing expenses most likely down and G&A and R&D expenses most likely up somewhat.

The operating loss for the quarter on a GAAP basis was $3.6 million, an increase from $1.1 million loss in Q3.

Not including the 5.5 million restructuring charge, operating profit for the quarter was $1.9 million, an improvement from Q3 of slightly higher sales, expanded gross margins and flat operating expenses.

This result is in line with expectations we laid out for investors on our call at the end of last quarter.

Other income and expense deserves a bit of attention this quarter.

We saw two unusual items on that line which contributed to our overall profitability and cash flow.

First, there was a $5.7 million payment from a component vendor to settle claims we previously had made.

This payment was received during the quarter and settled all claims by us.

Second was a $2.5 million foreign consumption tax rebate received in the quarter by one of our larger foreign subsidiaries.

This was a refund for consumption taxes which are akin to sales taxes in the U.S..

The taxes were originally paid in 2002 and 2003.

These two items together accounted for $8.2 million of other income in Q4.

Absent these items, other income and expense would have totaled a net expense of $200,000.

Pretax profit for the quarter on a GAAP basis was $4.4 million.

The three unusual items I have just discussed added in total $2.7 million to our pretax GAAP profit.

Profit after tax on a GAAP basis was $2.3 million or 2 cents per share.

The total shares used to calculate EPS were 123.5 million shares, up from 118 million shares sequentially.

Please note that this difference is driven primarily by use of diluted shares when calculating EPS over profit versus the use of basic shares last quarter when calculating EPS on a loss.

Total shares outstanding at quarter-end were 120.4 million, up from 120 in Q3.

Moving to the balance sheet now.

Total cash, cash equivalents and marketable securities on June 27th were $425.7 million, up 8.8 million sequentially and up 23.5 million compared to the end of fiscal 2003.

This positive cash contribution for fiscal 2004 in a year in which we posted a net loss is the result of a focus on solid working capital management and cash management through the year.

Accounts Receivable at the end of Q4 were $33 million.

DSOs at quarter-end stood at a very respectable 33 days.

Net inventory at quarter-end was 25.9 million with inventory turns at an also respectable seven turns.

Accounts Payable balances at year-end were $19 million, slightly lower than Q3 and in line with Q4 a year ago.

Some additional cash flow information for you.

Depreciation and amortization for the quarter was $6.7 million.

Capital expenditure for the quarter totaled $600,000.

Headcount stood at 784 regular employees at quarter-end.

That is flat compared to the identical number at the end of Q3.

Turning now to guidance.

Our expectations for the September quarter are consistent with expectations for calendar year 2004 that we first laid out for you last December.

As a reminder, our goal is to grow through calendar year 2004 so that revenues in December 2004 quarter are 15 to 25 percent higher than the 83.4 million in revenue we reported in December of 2003, and we want to expand our operating profitability as we grow.

For revenues in the September quarter, our expectations are that the environment for networking vendors will improve modestly and provide a backdrop to revenue growth.

And for opportunity specific to Extreme, we think that a continued focus on new products, what appears to be an improving environment in the U.S., and a modest contribution from our Avaya relationship can collectively provide the basis for revenue growth from the June quarter to the September quarter.

We expect that the majority if not all of our revenue growth will be in the U.S. and that revenues outside the U.S. are more likely to decline sequentially due primarily to typical seasonal patterns.

Let me note for you for instance that in Europe revenues declined 16 percent sequentially in Q1 of 2004 and by 13 percent sequentially in Q1 of 2003.

There are risks associated with our expectation of revenue growth.

Seasonality and the pricing environment being two of those.

Also it is important to note that after two quarters of revenue growth, we are still in the beginnings of a return to sequential growth for Extreme, and it is too soon to call any trend.

We are encouraged by the growth in BlackDiamond 10K revenues and bookings, as well as Avaya revenue and bookings in Q4.

But it is still a case where one or two large deals a quarter can make a difference between sequentially up or sequentially down revenue.

Our quarters are back-end loaded with approximately 50 percent of our business done in the last month of the quarter.

That was the case in Q4, and we expect it to be the case in Q1.

So it is fair to say our visibility is a bit limited.

Turning to gross margin.

To remind everyone of our previously stated goals for calendar 2004, our goal is to expand gross margins as a percentage of sales through the year.

We may not expand gross margin sequentially each and every quarter, but our goal is to be operating within a range of 52 to 55 percent total company gross margin by the December 2004 quarter.

Against this metric, we had a good result in June with overall margins up sequentially.

Looking into September on the product side, we expect a higher mix of revenues from the U.S., which is typically good for gross margin, but at the same time we also expect a higher contribution from stackable sales from our Avaya channels, all of which may lead to a slight reduction in product gross margins as a percentage of sales in Q1.

In service we do expect a sequential improvement in service gross margin as a result of the continued focus on this area, but it is likely to be much more modest than the improvement we have reported over the last two quarters.

All things considered we expect that overall gross margin for the Company are likely to be flat to down sequentially, depending largely on the mix of product and channel sales.

On improving operating leverage in our business, as we have said previously our goal is to improve operating leverage by holding operating spending very close to current levels of $46.5 million a quarter while increasing our quarterly revenue run-rate.

We may not hold expenses entirely flat or improve our operating leverage sequentially each and every quarter, but our goal is to be operating with expenses in a range of 42 to 47 percent of sales by the December quarter of 2004.

In the September quarter, we expect operating expenses will be flat to down slightly in dollar terms compared with Q4, with sales and marketing down sequentially and R&D and G&A likely up.

As for profitability, as ever there are a number of moving parts to the equation, but we would expect within the range of expectations I have just described that we would once again be profitable in the September quarter, and we will continue to track toward achieving the expectations we have laid out for our results in the December quarter as well.

There are certainly risks associated with this.

The pace of revenue growth we actually achieve being the largest of those.

So let me summarize my comments this way.

We are very pleased with the revenue growth and improved profitability that we have delivered this quarter.

A number of parts of our business showed solid improvement sequentially and year-over-year.

We are also very pleased that for the second consecutive quarter we have laid out our expectations for investors and then delivered on those.

We are looking forward to and planning for additional progress in the second half of calendar 2004.

That said, there are several risks associated with our plans, and we will be watching those closely in the coming months.

And with that, let me turn the call back over to Gordon.

Thanks, Bill.

Operator, we will go ahead and open things up for questions.

(OPERATOR INSTRUCTIONS).

Sam Wilson, JMP Securities.

Good afternoon, gentlemen.

I will take the one per person question to mean one per each one of you.

So one for Gordon.

Gordon, on the BlackDiamond 10K you mentioned that bookings were up significantly quarter on quarter.

Two things.

Are you starting to see some pull-through sales to your other products as part of selling the big core switches?

In other words, are these coming in packaged deals?

And are you winning new customers, not previously historic customers?

And a question for Bill.

Bill, can you discuss deferred revenues briefly?

They were down quarter on quarter.

I just wanted in know if there's anything in particular going on there.

Next time I think that counts as like four questions.

On the BlackDiamond 10K, in reviewing the customer base for that, it is a good mix of new customers and existing customers.

We do have some existing customers that have upgraded the core of their network.

Without having the exact data in front of me, my speculation would be that most of the installations were new and with new customers.

I can say from some of the accounts that I personally worked with, these were large-scale, new investments and typically would be our BlackDiamond 10K in the core and our Summit 400 and Summit 300 Unified Access products at the edge.

And Sam, on deferred revenue, deferred revenue moved from 54.7 million in Q3 to 53.8 million in Q4, so about a $900,000 decline there. 95 percent plus of our deferred revenue represents service contracts awaiting amortization, but there is always a little bit in there for for products in transit at the end of a quarter or an order awaiting final delivery.

That last category can move the number a million or so a quarter, and that is what we saw in this quarter, just sort of the typical noise that we would see in that account.

Jason Ader, Thomas Weisel.

Good afternoon, everybody.

I just wanted to ask you on the Avaya business, could you give us some quantification?

Are we in the millions at this point, and where do you expect -- I mean when we go into the December quarter, can you give us some sense of where you think it will be as a contribution?

Is it going to be 5 percent?

Anything that you can put out there in terms of quantification would be helpful.

Jason, this is Bill.

So we previously noted that in the March quarter Avaya revenues were $1 million.

They have grown this quarter.

I will tell you they are still below 5 million a quarter, but they are ramping and we would anticipate continued ramp in the September quarter.

So by December, you expect it to be I would guess greater than 5 percent just doing the math.

I don't want to get into setting too many expectations on a line by line or channel basis, but we would expect to continue to ramp Avaya through the rest of this calendar year and into next year as well.

Okay and then on the pricing side, you mentioned that you had to discount more heavily.

Why do you think that has happened if there's an overall improvement in the environment?

You know the discounting was slightly more than in the past, and you know a lot of it is just to do with product transitions.

I have got you.

So there is really no change in the overall competitive environment from your standpoint?

It is hard to see any major change.

Mark Sue, RBC Capital Markets.

The September quarter is typically the toughest quarter for Extreme, and you are still guiding for growth up to 5 percent.

Is that mainly because the BlackDiamond, or is that maybe because of the government pipeline?

Does that get to 10 percent by December?

Separately, Gordon, any thoughts on headcount, attrition, anything like that?

Thank you.

First of all, you are right.

Typically Q1 is the toughest quarter both for typical seasonality reasons, Europe, etc. and from some of the effects you often see in moving from the last quarter of your fiscal year where the sales team is plugged into accelerators, etc. to the first quarter.

So that is a reason for some caution on our revenue growth prospects.

Nonetheless, we do believe we can grow revenue.

The reasons for that we tried to outline here.

It is stronger contribution from new products, a stronger contribution from revenues in the U.S., stronger contributions from Avaya federal and what appears to be just a little bit of tailwind in some areas.

But there are reasons to be cautious there.

Regarding the headcount, we expect headcount to be roughly flat quarter-over-quarter.

And do you feel you have firmed up all the necessary senior people now that you have added the positions?

Yes, certainly.

You know I think there was a lot of concern over in the industry about filling the sales positions.

We're really happy that we were able to fill both North America and Worldwide positions with just excellent people and have them hit the ground running.

Alex Henderson, Smith Barney.

I just wanted a quick technical question.

Can you give us the interest and other income line broken out with a little bit more clarity why that was a negative number? as we are calculating it, or am I doing that wrong?

And then on an operational question, did you see any of the weakness that the software industry saw at the end of June?

Was that a factor in anything that happened during the quarter?

How do you think about the distinction of why they came in weak and this industry may have seen a different trend?

Let me address the second part and let Bill address the first.

You know we certainly watched with interest some of the issues around the software industry.

But I think it's had less impact on us than it did several years ago.

You know I do think that a lot of the large installations have been done, and what is really driving network upgrades today is really two factors.

One is just simply the age of networks.

It has been five years since Y2K.

The other is implementation of converged applications and principally IP telephony.

I think that's had a bigger effect than new software installation has.

So is it fair to say you have not seen any -- you did not see that at the end of the quarter?

It was not visible to us let me put it that way.

And on the other income and expense, our expectation had been for a breakeven number there.

Going back over the last couple of quarters, we were 300,000 positive in Q3, 100,000 positive in Q2.

There are a lot of ends and outs in that account.

It can be a near run thing as to whether it works out to be slightly positive or slightly negative in a given quarter.

I don't have a particular breakout in front of me, but it would have just worked out to nips and nuts.

So is it actually 199 negative?

$199,000, Yes.

So in the September quarter same --?

My expectation again I would think of it is flat at sort of breakeven, zero-ish.

Stephen Kamman, CIBC World Markets.

Two questions.

One, a bit of a housekeeping on the tax issue.

You give the GAAP reconciliation GAAP to non-GAAP for above the line net income.

But any issues on the tax side GAAP/non-GAAP?

I'm not sure what you mean GAAP/non-GAAP there.

The taxes in the quarter were largely for international taxes due on subsidiaries outside the U.S. where we do run at a profit.

Okay.

Any guidance for how taxes we should be modeling that going forward?

It has just been moving around a lot.

Yes, so going forward I would expect on international taxes over the course of the year we would probably pay out $3 to $4 million in actual cash taxes out for profits in international subsidiaries.

Within the U.S., we do not anticipate being a taxpayer for some time given our tax loss, the tax loss carryforwards available to us that is on a cash basis.

Okay.

So modeling on an absolute dollar basis is probably better?

Yes.

Bekrim Karah (ph), Piper Jaffray.

Thanks.

Good afternoon.

Bill, can you quantify for us the revenues which you got this quarter for some of the newer products and how that has been trending?

You mentioned the trend has been positive.

I was just wondering if you could give us any quantification?

Yes.

New product revenue as a percentage of sales have been ramping over the last several quarters.

Were you to go back to this quarter a year ago, it would be a very very small number, less than 20 percent.

We have now coaxed that number up above 30 percent, and we are continuing to work it going forward.

Alex Burroughs (ph), Deutsche Bank.

Yes, two quick questions.

One is, could you take another cut at the Avaya revenues?

Bill, could you tell us what percentage they were up q-over-q?

I would rather not get real specific into the numbers.

But you know they were around $1 million in March, and they were up.

They were below 5 million in June.

All right, and the second question quickly is, in terms of the pricing, you mentioned the discounting.

I am wondering whether you can dig into it a little bit further maybe on a geographic basis?

You know certainly we followed historical patterns there seeing higher discounts in Asia for instance than in the U.S..

Chet White, Merriman, Curhan, Ford & Company.

Thank you.

I was wondering if you could add just a little bit more color to the U.S. strength that you have seen this past quarter and are expecting for Q3.

Is that coming out of the larger Fortune 500s, or is it across the board?

Anything there would be helpful.

The strength in the Americas, particularly in the booking side, was very gratifying, and it came from actually a very good mix of accounts.

There were a couple of new large wins in there, and by large I would say Fortune 1000 class companies across a couple of sectors.

But there was also a lot of strength in what we term the midmarket, which is a couple of hundred thousand dollar up to a million dollar network installation per site.

So it was a good balanced strength and again good take-up of the BlackDiamond 10K, good take-up of Unified Access with the Summit 300 across a lot of sectors there.

Jung Cho (ph), Lehman Brothers.

Thank you very much.

I was wondering could you please comment or quantify the contribution from the BlackDiamond 10K in terms of the sales of bookings last quarter?

Roughly speaking.

We don't break that out specifically as a line item.

But is that the '05 percent or 10 percent?

Would you be able to say anything?

The only thing that we break down is by modular and stackable other than to say that we are pleased with the penetration we are getting from the BlackDiamond 10K and particularly the number of customers that are choosing it.

Okay.

All right.

Let me ask you another question then.

When you initially provided guidance for the December quarter this year for the 15 to 25 percent year-over-year growth, that was like six or seven months ago, and I was wondering now it seems you've got a half of the year behind you, will you be able to narrow that range?

What do you think directionally?

Is that going to be middle of the range or higher end it looks like or any more color?

At this point in the year, I don't want to narrow the range.

I think it was an appropriately broad range that we gave in December.

We are going to keep working towards it, and there is a lot of moving pieces both in the demand-side, the competitive environment.

Networking seems to be improving, and at the same time, we are working our product issues and our on execution issues.

So with that in mind, at this point I think we have given fairly explicit guidance actually, and I would rather not narrow it further.

Okay.

Thanks.

Pria Parsurheim (ph), Oppenheimer.

It is Bill Becklean at Oppenheimer.

I would like to have you add a little color to the idea that you are saying a pickup in the industry.

Do you think the other companies in this market are seeing the same thing, or are you taking a little share?

Any sense of that?

Can you put a little meat on the bones of what kind of evidence do you have out there that, in fact, business is picking up?

Sorry, I think from looking at the evidence it is picking up.

There are two factors there.

Certainly one is the numbers side in terms of the revenue growth, which as we have indicated we are pleased with.

Another is the core activity level, and we just see a lot of activity going on, and a lot of people going out and looking to upgrade their networks.

On the competitive side, it is always difficult to say, are we taking share as the market's growing and particularly over a relatively short timeframe.

You know every deal we are in is a competitive deal.

But as I have indicated with our new product lineup, we're really comfortable where we stand competitively in the marketplace.

So I have got to believe that we're taking some share, but again I do not have any numbers to back that up yet.

Can I follow up?

Are there particular things driving these network upgrades?

You mentioned two -- the networks are old and functionality.

I guess those are the two primary things.

Are people looking at ROI?

Are they upgrading networks because they want to do something new with them?

Are there those kinds of drivers out there?

Yes, I think the challenge with ROI on the network is sometimes it is a binary Asian in that a lot of older networks somebody wants to deploy voiceover-IP or deploy video application or often even deploy new ERP implementation that is more Web-based.

The network just does not support it very well, so it is a requirement to do an upgrade.

So you know an ROI calculation there, of course, is pretty tough because in some cases if you cannot do it, you've got to do something.

Ben Cablick (ph), Buckingham Research.

I just have a quick clarification question on the taxes you gave.

You gave a $2 million tax expense.

You gave pro forma pretax income, and I was wondering if we should adjust that tax number for pro forma net income?

Yes, we actually quite explicitly stayed away from a pro forma number.

We gave you some adjustments to get to an operating profit basis, but I do want to stay away from pro forma numbers.

The bulk of the taxes that we paid in the quarter that are on the income statement in the quarter were for international taxes.

There was a little bit of catch-up of estimates versus actuals for the year in that number, but those are international taxes.

Okay, that answers my question.

Thank you.

John Duncan, Pacific Growth Equities.

So not to beat a dead horse, but the tax issue, so if we were to use the 2 million number, we are looking at a breakeven for pro forma?

If you were to ascribe all the taxes to the revenue, yes, it would be about breakeven.

But again those taxes there is some catch-up for the year, etc..

Right.

So we are going to run about a million a quarter.

Is that what you said as far as international taxes?

Yes.

Also there has been a bit of a buzz about a high-density power over ethernet edge chassis in the reseller channel.

Is there anything that you guys can speak to on that?

We have not made any specific announcement there.

Gentlemen, please continue with your concluding comments.

Well, with that, I would just like to thank everybody for their time this afternoon, and we will be speaking with you all shortly.

Thank you.

Ladies and gentlemen, this concludes the Extreme Networks fourth-quarter financial results conference call.

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