Extreme Networks Inc (EXTR) 2005 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen.

Welcome to Extreme Networks fiscal Q2 results. [Operator Instructions].

I would like to turn the conference over to Mr. Bill Slakey, Chief Financial Officer.

Please go ahead sir.

Thank you operator.

Good afternoon, everyone.

Thank you for joining us this afternoon.

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

This afternoon, we issued a press release announcing our results for Q2 FY 2005.

A copy of this release is available on our website at extremenetworks.com.

A reminder, this call is being recorded and broadcast live over the Internet and it will be posted on our website and available for replay shortly after the conclusion of the call.

Let me note for you as well that some of the remarks made during this call may contain forward-looking statements about guidance, product introductions, and customer development, which reflect the company's current judgment on these issues.

Because such statements deal with future events, they are subject to risks and uncertainties that could cause the actual results to differ materially.

In addition to the factors that may be discussed during this call, important factors that could cause actual results to differ materially are contained in the company's Form 10-Q's and Form 10-Ks, which are on file with the Securities and Exchange Commission and available on our website.

With that, let me turn the call over to Gordon.

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

We're very pleased with the results of the quarter and of our continued growth.

This is the fifth consecutive quarter that we have achieved revenue growth and the third consecutive quarter for profitability.

We also reached a few interesting milestones during the quarter.

The first of which is that we surpassed the shipment of 10 million ports.

This is a clear demonstration of the industry's positive response to our networking solutions and a positive vote for a strong commitment to innovation and R&D.

It also demonstrates that we're one of the clear leaders in building large-scale, complex enterprise and metro Ethernet networks.

Another milestone we hit during the quarter was the shipping of our second major chassis switch family in just 12 months.

As many of you recall, Extreme shipped its award winning BlackDiamond 10K a year ago December.

And this December, we began shipping an exiting new product, the first member of our voice ready Aspen 8800 switch family.

I will talk more later both of these leading products.

On the financial front, for the fourth consecutive quarter, we laid out a set of expectations and delivered on them.

During fiscal Q2, we generated revenues that were at the top end of our 1% to 5% range that we had mapped out for ourselves at the end of September quarter.

That revenue also puts us right at the mid-point of the 15 to 25% increase in revenue range that we laid out a year ago as we posted sequential revenue increases each quarter of the last calendar year.

It also puts us at a higher growth rate in the overall sector according to IDC's preliminary forecast, which means we are taking market share.

Gross margins, which we had expected to be flat sequentially this quarter, improved slightly.

Operating expenses as a percentage of revenue declined from the September quarter as we continued to tightly control expenses.

Those tight controls combined with steady improvement on the top line allowed us to improve our EPS each of the last four quarters and to post positive net income for all of calendar year 2004.

Part of what drove our results this quarter, we believe, was the continued gradual improvement in the networking infrastructure market, a gradually strengthening environment.

But equally important, we believe, that we're seeing growing demand that is specific to Extreme product.

You've heard us talk about convergence, which is the integration of voice, video and data onto the data network.

Convergence, along with security, are becoming the major drivers for network upgrades.

Most existing networks simply don't have the ability to deliver on converged applications, such as voice and multi-media.

This situation plays perfectly to the strength of Extreme's strategy for building an open converged network.

To enhance our position in the convergence market, we began shipping the first member of our new switch family, the Aspen 8800.

We formally announced the Aspen family on January 10th.

And at that time, we were already in full production with first customer deliveries made in December.

This product helps enable us to regain our position as a technology leader.

I want to emphasize and most importantly as the technology leader in areas of the market that are the fastest growing in significance, that is IP telephony and enterprise class wireless networking.

Let's look at these requirements of these two high-growth areas.

IP telephony is top of mind with most enterprises.

It is a multi-year technology trend that improves enterprise productivity.

And with IP telephony, dial tone matters.

When we pick up the phone, we expect the dial tone to be there all the time.

We've become accustomed to needing to hit refresh on our web browsers occasionally, but I doubt we will ever wait for dial tone.

So, to deliver dial tone and to effectively deliver business class voice, the data network must provide very high levels of network availability and resiliency.

The network must keep running in the case of changes, upgrades as well as in the case of failures.

I'd like to look at three technologies that we believe are key to delivering business class voice and providing the dial tone that we all expect.

First, Power Over Ethernet.

Power Ethernet, also referred to as POE, is the preferred method for delivering power to IP telephones.

Introduced in the last couple of years, POE is now becoming mission critical to voice.

It must be provided on every port, and it must be provided in a redundant fashion.

Now, you would think this would be pretty easy, but most solutions today are half baked.

They don't power all the ports or there isn't full redundancy or an external chassis is required.

To provide it on every port all the time is not common today.

Second, the switch, itself, must provide redundancy with no single point of failure.

That means redundant switch fabrics, redundant management as well as redundant power.

It means a system's design approach that delivers five-nines availability and more.

Dial tone needs to be delivered even when hardware has problems.

In addition to pervasive POE and hardware resilience, having the next generation operating system that delivers high availability is a critical part of delivering dial tone and business class voice.

The monolithic operating systems introduced in the 1990s forced network managers to make availability tradeoffs.

For example, any process within the monolithic operating system can bring the whole switch down.

In the days of mounting security threats and attacks, a particular process or protocol could be exploded.

True modular operating system, on the other hand, allows the failed process to be restarted without bringing the switch down.

The development of this type of operating system takes time and extensive experience and is not something that any vendor can do overnight.

This requirement for highly resilient software will only become more important in the future.

Dial tone must be delivered even when the software has problems.

The first two requirements, which are systems (inaudible) requirements, have been met in the past by poor land switches but not by products built for the edge of the network.

The total of these three requirements both systems and operating systems to deliver resiliency and dial tone must be met at all points on the network and this creates an opportunity for Extreme.

The second area that I talk about is increasing significance is enterprise wireless.

There have been a number of reports talking about the growth of enterprise wireless, and we have been advocates of this technology for more than two years now.

The events of last week with Cisco paying such a high price for a start-up in this area underscores two things.

First, the importance of the sector and secondly, the endorsement of the thin AP or thin access point approach.

A combination of thin APs and wireless switches is clearly the way to deliver enterprise wireless.

Some 18 months ago, we introduced our first wireless products and our vision for enterprise wireless.

Where others have treated wireless as a bolt-on, our vision is a full integration of wired and wireless network access into a single, seamless network that delivers secure, reliable communications.

We call this vision unified access architecture, concept of the universal jack on the wall into which can be connected an IP telephone, computer, or a lightweight access point.

Technology leadership in these two areas is critical as these are both rapidly growing.

The technology by itself is important.

However, the integration of these two technologies along with the traditional data is what creates value.

Users want a simple, easy-to-manage network.

With our recent product introduction, no one except Extreme can manage data, IP telephony and wireless from the same console.

Vendors who cannot meet these requirements will have no choice but to compete on price.

So, let me take a moment to introduce our latest product family and address how these new systems complete our solution, meet the requirements and will further separate us from those who can only compete on price.

As I mentioned earlier, we began shipping our newest switching solution, the Aspen in December.

The new Aspen switch family is part of our strategic vision for building a converged network.

Our vision involves simplifying the typical three-tier enterprise network into a two-tier architecture.

With two tiers there are fewer network layers and fewer networking boxes.

Fewer boxes and fewer layers, not only simpler, but can deliver lower latency and more predictable network performance.

The overall result is better performance and lower total cost of ownership.

The two tiers of the network consist of the unified access tier and an intelligent core tier.

At the edge our unified access architecture enables users to ready their network for voice and for wireless.

Now, a year ago, we introduced the BlackDiamond 10-K as the product for the intelligent core.

Now we're adding Aspen as the access product in the two-tier architecture.

Each system is purpose built; and each runs ExtremeWare XOS our modular open network operating system.

Now the Aspen 8800 switch family leads the market in offering robust full-scale IP telephony deployments.

In a nutshell, Aspen readies the network for voice and since voice is the key driver for upgrades Aspen is an ideal solution.

Aspen combines enterprise simplicity and performance to support a variety of devices and the most demanding applications, which is what customers ought to expect of any network and only we can deliver.

Today, the restrictions that dictate where and how to work are quickly being eliminated with new technology.

Customers need networks that can take advantage of the new capabilities, and that's the beauty of a true open converged network.

Up until now, most networks either had to make compromises in performance or to layer in all kinds of complexity that have made supporting them very expensive.

The complex networks are harder to manage and harder to protect against security threats.

With the Aspen family, you have the performance and simplicity without compromise.

Network administrators love the Aspen for several reasons.

It has high density, easy-to-use Power over Ethernet for redundancy.

It has high density gigabit to the desktop and delivers the so-called universal jack that offers powered 10, 100 and gigabit ports that can support a wide range of connective devices, including PCs, IP phones, cameras and lightweight wireless access box.

Aspen supports our unified access architecture and meets the requirements that we discussed earlier.

Aspen provides calculated "five-nines" availability to redundant switch fabrics, redundant management, and redundant power.

Aspen's hardware is designed to deliver enterprise class voice.

And as I mentioned, Aspen runs ExtremeWare XOS providing a robust modular operating environment.

Aspen has been certified by Violabs (ph) for inter-operability and for supportive voice applications.

Aspen was built for our two-tier architecture and forms unified access tier.

So, let's talk about the core tier.

BlackDiamond 10-K introduced a year ago continues to gain momentum and industry recognition.

It continues to wow both customers and industry leaders.

InfoWorld magazine just awarded the BlackDiamond 10-K "technology product of the year", which is the second year in a row that we've won that award.

Designed for the core of the network, BlackDiamond 10-K is truly unique in its ability to deliver complete enterprise core solution with the predictability, scalability and comprehensive features required for reliably delivering converged applications over the network.

The capabilities of the BlackDiamond 10-K in providing control packet processing and virtualized services is industry leading.

Because we see gigabit Ethernet -- excuse me, because we see 10 gigabit Ethernet as the connection between core and access, it's very encouraging to see that during the course of this quarter, we saw 10 gigabit Ethernet demand grow 50% over the last quarter, which makes this the second sequential quarter that we are seeing increased demand for 10 gigabit Ethernet at this rate.

I think this growth rate validates our vision for building a two-tier network.

Now, an important part of our approach to convergence is our relationship with the buyer.

The relationship reached its first anniversary during the quarter and we continue to make very solid progress with Avaya.

We are noting a bit of a shift in how we are selling product with them.

Increasingly, we're selling product with Avaya rather than through Avaya.

I refer to this with you some of you at the pixie dust effect.

Whereby customers who are approached by the Extreme and Avaya sales teams no longer see Avaya gear with a Extreme networking component or Extreme gear with an Avaya voice overlay.

All they see is a converged networking solution that covers voice and data which is exactly as it should be if we're all doing our jobs right.

And I am very pleased that we have reached the point where the customer no longer sees a difference between Extreme and Avaya.

They just see the best solution for their needs.

Now, the customer isn't concerned whether it's Extreme hardware or Avaya.

All they know is that their network is able to seamlessly detect the phone, in this case, an Avaya phone, which is fed onto our network.

They see it immediately provisioned with the right levels of security and access and with a jitter in latency tract and with integration to the Avaya management platform for best of breed of IP telephony.

We are very, very pleased with how things are going.

As you know, we are selling with Avaya in Europe as well as in the US, and we are just beginning to work with them in Asia Pacific.

This partnership is more than just a reseller arrangement and in the most exciting part of the partnership is the joint development opportunities that we have.

You will begin to see those products begin shipping this calendar year.

Now I've talked about IP telephony and wireless being rapidly growing and driving enterprises to upgrade, and I have talked about our two-tier network approach with unified access and the intelligent core and how Aspen fits in.

I would like to now spend a few minutes talking about what our customers are doing.

As I mentioned, we are continuing to see momentum for our BlackDiamond 10-K switch as the advanced network core for a growing collection of our global customers.

One prime example is NCsoft, a world-leading developer and publisher of on-line video games.

NCsoft has recently upgraded four of its global locations including sites in the US and in Germany with our BlackDiamond 10-K switches.

Network enhanced with 10 gigabit scalability and high availability from our core solution benefits from the continuing operation capabilities of our extreme wire XOS software operating system.

BlackDiamond 10-K assists Ncsoft's delivery hot gaming titles such as Lineage and City of Heroes in the competitive and dynamic on-line gaming market.

Hong Kong Hospital Authority, established to manage all public hospitals in Hong Kong, has also selected multiple BlackDiamond 10-K switches to serve as the core of its data center.

The hospital benefits from security features including support of thousands of access control lists and bandwidth rate shaping as well as 10 gigabit scalability.

On a similar note, Extreme Network's advanced switching technology also helped establish a prominent record in gaming as recognized by the Guinness Book of World Records.

The DreamHack LAN party, an annual event in the Swedish city of Jonkoping, was recognized for hosting the largest number of attendees for a gaming festival.

This unique event was powered by our BlackDiamond 10-K switch, which supported all 5,200 visitors handling multiple gigabits of streaming traffic as users played feverishly against one another.

This quarter, we began initial shipments of our Aspen switch.

This switch truly prepares the network for voice and boosts our simplified two-tier network design.

Aspen uniquely delivers the necessary network availability and resiliency features that keep the network running.

We're quite pleased at the impressive collection of early customers.

Luxotica Eyewear, a leading designer, marketing and distributor of quality sunglasses and prescription eyewear, has chosen the Aspen switch and the two-tier network design along with Extreme's BlackDiamond switches.

This design simplifies the network while providing all of the necessary functionality at the edge, including resiliency, power over ethernet and high bandwidth gigabit and 10 gigabit ethernet links.

Welch's Grape of Concord, Mass., an existing Extreme customer for many years has welcomed the Aspen switch into its network to serve as a redundant core.

Welch's selected Aspen for its high reliability features and its support of power over ethernet giving them the ability to smoothly support the future migration to IP telephony.

Hawaiian Airlines, Hawaii's biggest and longest serving airline has also selected the Aspen family for significant network renewal.

Aspen was chosen for its high resiliency features working in conjunction with Extreme's EEPS(ph) to deliver sub-50 millisecond failover allowing the network to recover instantaneously.

The new Extreme network will support the airline's expansive reservation systems as well as office operations.

Gear Systems, a global leader in Semiconductors has recently selected an Extreme Network featuring our Aspen family along with the BlackDiamond 10K core switches.

The advanced network design will deliver greater bandwidth to Gear outfitting them for bandwidth intensive applications within its demanding environment.

Additionally, HPTI, a specialized government service provider and network integrator has installed the Aspen solution at the National Oceanic and Atmospheric Administration in Colorado where the switch is connecting a high-performance compute cluster with dense gigabit ethernet.

Extreme also continues to assist various government and healthcare organization verticals where we have a high degree of expertise.

These include numinous or build-outs for cities and municipalities, various federal organizations and the military.

Recently, Extreme was tapped to build a data center infrastructure for the American Student Assistance, ASA, one of the most respected federal family education loan program guaranty agencies.

The ASA has helped more than 1.4 million students fund their education.

Extreme Networks was selected as the vendor choice for the ASA new home office location where Extreme's award-winning BlackDiamond 6800 and Summit 400 switches are utilized for their high availability features.

Extreme proved to be the superior solution against our competitors.

City of Ithaca, New York, is a municipal network connecting more than 10 city agencies with high performance connections resulting in the converged network supporting voice and data.

Venues include the police department, fire department, youth and activity centers as well as city hall.

All will benefit from the high bandwidth network preparing them for the future.

In the Pentagon, multi-year wedge renovation program continues to contribute business to Extreme where we deliver a highly reliable and simple-to-manage work.

And in the healthcare segment, the Santa Barbara Regional Health Authority selected Extreme's solution to gain a converged network solution that met its requirements for maximum uptime and performance.

Interestingly, the health authority relies on video surveillance supported by its IP network, which replaced the previous tape-based system that required significant time and resources to manage.

The advanced new system can capture and store significantly more video.

This has just been a sample of the new and repeat customers that we are winning.

Our sales team continues to perform very well under Frank Carlucci, our worldwide Vice President of Sales for six months now.

We're very pleased with the leadership that he has brought to our organization.

So before I hand it over to Bill, I want to say again that we're pleased with this quarter and all of the forward momentum that we built up over the last 12 months.

With the general environment continuing to show signs of ongoing, steady improvement, we believe we're in a really sweet spot.

We believe that it's those suppliers that can deliver true convergence that will be in the best position to win the vast majority of upgrades over the next several years.

I keep saying the days of speeds and feeds are over and those companies that only focus on performance will continue to be relegated to the niche status, and we're already seeing that happening.

As a reminder, our analyst day is coming up in New York City on February 1st, and we look forward to telling you more about our vision for networking and our new solutions.

With that, I would like to turn things over to Bill.

Thank you, Gordon.

Good afternoon.

As always, I'm going to briefly review our financial results for the quarter and, then I will update our expectations for future performance.

As Gordon noted for you, we are very pleased with our results this quarter.

Our results are in line with our expectations entering the quarter and they cap off a calendar year 2004 as one in which we achieved four quarters of sequential revenue growth and expanding profitability.

Revenue for the quarter was $100.3 million, consisting of 85.8 million in product revenue and 14.5 million in service revenue.

Total revenue was up 20% over Q2 a year ago, and up 5% sequentially.

Our book-to-bill ratio was above one for the quarter.

Service revenue was up 4% sequentially, making this the sixth consecutive quarter in which service revenues have been flat to up on a sequential basis.

Service revenues were up 22% compared to the year ago quarter.

Product revenue increased 6% sequentially and 20% year-over-year.

Shipment of modular products represented 51% of sales and stackables represented 49% of sales.

This was a slight shift toward stackable products from last quarter, but it's generally consistent with our typical mix.

The split of enterprise sales and service provider sales was 77% to 23%, a slight shift toward enterprise customers compared to Q1, but generally consistent with our typical mix.

We had no 10% customers during the quarter.

We're encouraged by sales of the products that we believe are key to our growth prospects for calendar year 2005.

BlackDiamond 10-K bookings were up sequentially, although, a larger than usual portion of these orders were for multi-quarter projects with delivery scheduled out for the March and June quarters.

As a result, revenues were flat compared with the September quarter with backlog for this product family up sequentially.

Gordon noted for you the activities surrounding our Aspen product launch.

We did book and ship a small amount of Aspen product to customers in the December quarter.

The product is now in production and we anticipate an increased contribution from Aspen bookings and revenues in the March quarter.

We saw a strong quarter for sales of our Summit 300 wireless products in December.

Revenues and bookings were both up sequentially and compared to the year-ago quarter.

Sales in this category benefited from strong demand for our Summit 48 port switch as well as demand for our new 24-port switch, which we began shipping in late September 2004.

Ten gig port bookings grew by more than 50% sequentially in the December quarter on top of a better than 50% sequential growth in the September quarter.

This trend has helped contribute to sales of BlackDiamond 10-K and Summit 400 stackable products, in particular, and we believe will help contribute to the success of Aspen, as well.

Another important trend in our business is an increasing contribution from POE ports.

This is being driven by demand for IP telephony and wireless.

Bookings of POE ports increased by more than 30% sequentially in December helping drive sales of Summit 300s, Alpine products as well as early orders for Aspen products.

Some of our older stackable and chassis products declined during the quarter consistent with the shift in mix towards newer products.

Looking at sales geographically, revenues in the US were 43.4 million, up 9% sequentially and up 54% versus the second quarter a year ago.

The growth in the US was broad-based with growth in sales through resellers, national resellers and direct sales.

In the US, our national resellers, Dell, SBC, Siemens and Verizon, in total, accounted for approximately 26% of our US bookings and increased from approximately 23% in Q2 a year ago.

Revenues in our European operations, which includes the Middle East and Africa, were up $29.9 million, up 19% sequentially and up 21% versus the same quarter a year ago.

Let me say that again.

Revenues for the quarter were 29.9 million, up 19% sequentially and up 21% versus the same quarter a year ago.

This was a very good result on top of the solid result in the September quarter, as well.

The strength in Europe was relatively broad based coming across multiple regions and channels.

We saw sequential bookings increases from both enterprise and service provider customers.

In Japan, revenues were $17 million, down 7% sequentially and down 14% from the second quarter a year ago.

We are gradually growing our enterprise business in Japan.

However, our service provider business in Japan has been lumpy to weak for several quarters.

We are taking steps -- taking several steps to improve our results in Japan, including the opening of additional sales offices.

However, we do expect that we are likely to see weakness in our results here for an additional quarter or more before trends improve.

Looking at Asia outside of Japan, revenues were $9.2 million, down from 11.3 million sequentially and down from 9.8 million in the same quarter a year ago.

Revenues in Asia are lumpy for us as a result of a large contribution from service provider business.

That was the case this quarter as well.

Sales through our Avaya channel worldwide were up significantly versus the same quarter a year ago.

Revenues in Europe and Asia/Pac were up sequentially.

Although revenues in the US through the Avaya direct channel were actually down sequentially.

I think this understates the positive impact we're seeing from the Avaya relationship in the US.

During the quarter, several joint sales projects did close with the customer opting to purchase Avaya product from Avaya and data networking products directly from us.

The strength in our POE port shipments in the quarter are also an indication that our work with Avaya is having a positive impact on our market position and market share, even in cases when the end sale is not directly through the Avaya channel.

We remain pleased with the results of our partnership to date and with the pipeline of opportunities we are working together.

Looking at gross margins now, total gross margin increased to 53.8% in the quarter, up from 53.2% in Q1.

Product gross margins were 55.7%, up slightly from the 55.3% reported in Q1, and up from 52.3% in Q2 a year ago.

On a sequential basis, product gross margin benefited from lower product costs and a slightly beneficial shift in geographic and channel mix.

Service gross margins were 42.3% for the quarter, up from 40.9% in Q1 and up substantially from 25.5% in Q2 a year ago.

Our service gross margins have benefited over the past year from higher revenue as well as progress we've made to reduce repair costs, failure rates and overhead.

Turning to operating expenses, total operating expenses for the quarter were 46.2 million, up from 45.8 million in Q1 and flat with 46.2 million in Q2 a year ago.

This is a very good result particularly compared to a year ago.

We have been able to hold expenses generally flat over the past five quarters while increasing quarterly revenue by 20%.

As a result, operating expenses as a percentage of sales have been reduced from 55% to 46% of sales during that period.

Looking forward on operating expenses, we do expect that we will see a sequential increase in expenses of approximately $1 to $2 million.

This increase will be driven by R&D and marketing costs related to the introduction of Aspen, by increased expenses for legal activities and Sarbanes-Oxley related work and increases in expenses as a result of changes in foreign exchange rates over the last several months

Operating profit for the quarter was 7.8 million, or 7.8% of sales, compared to an operating loss of 5.8 million, or a loss of 6.9% of sales in Q2 a year ago.

For the quarter, other income and expense totaled 3.6 million.

Included in this number was a $3.9 million refund for foreign consumption taxes.

This refund is similar to the refund we received in the June quarter and it is the result of a tax holiday, which we qualify for.

That holiday has ended and we will not receive additional refunds in the future.

Profit before tax then on a GAAP basis was 11.4 million.

After tax income was 9.95 million or $0.08 per share.

Excluding the $3.9 million tax rebate, profit before tax would have been 7.5 million and profit after tax 6.6 million or $0.05 per share.

Total shares used to calculate diluted EPS in the quarter was 124.4 million shares.

Total shares outstanding at quarter end were 121.2 million.

Looking at the balance sheet, now, total cash, cash equivalent, short-term investments and marketable securities on December 26 was 446.8 million, up 6.9 million sequentially and up 34.2 million from Q2 a year ago.

This was very solid performance during the quarter.

It was the result of both improved profitability and good working capital management.

Accounts receivable were 30.8 million, up 2 million sequentially.

DSOs at quarter-end stood at 28 days in line with DSOs at the end of Q1.

Net inventory at quarter-end was 22.5 million, down from 23.9 million at the end of Q1.

Inventory turns stood at a very good eight turns for the quarter.

Looking forward, we do expect a modest increase in net inventories during the third quarter as Aspen moves to volume shipment levels and as we build sufficient stocking levels to ensure prompt delivery.

Accounts payable balances at quarter-end were 22.6 million compared with 20.4 million at end of Q1.

Some other items to note, depreciation and amortization for the quarter was $6.2 million, capital expenditures for the quarter were $1.2 million.

Headcount at quarter-end stood at 799 regular employees, which compares to 788 at the end of Q4.

We also had 63 contractors on board at quarter-end.

Turning now to guidance.

For revenues in the March quarter, we currently anticipate that our revenues will be flat to up 5% relative to the December quarter.

Opportunities for revenue growth include an increased contribution from new products including the Aspen product that is in full production and broadly announced.

A modestly improving environment for networking vendors and our own improved sales and marketing execution particularly in the U.S. and Europe.

These opportunities will need to be balanced against seasonal trends, which would typically lead to lower sequential revenue in the March quarter, against weakness in our business in Japan and against the unknown impact in Asia of the recent Tsunami.

On gross margin, our expectation for the March quarter is that gross margin as a percentage of sales will be similar to the 53.8% that we have reported for December.

By similar, we mean slightly up or slightly down depending most importantly on the precise mix of product and channel sales we ultimately record during the quarter.

On operating expenses, we have held quarterly operating expenses generally flat for five quarters while ramping revenues.

Looking forward, we do expect that March quarter operating expenses will increase by approximately $1 to $2 million.

This will be driven by R&D and marketing costs associated with product launch, by costs associated with legal proceedings and Sarbanes-Oxley and by the impact of changing currency rates.

On Currency rates, I'll note for you that 57% of our revenues this quarter came from outside the U.S. and that we do have a large operation in Europe, Japan and Asia and with dollar to euro and dollar to yen exchange rates having weakened by approximately 5% to 8% from where they stood three months ago, the sequential impact on our quarterly expenses in March could approach as much as $1 million.

Looking out over calendar year 2005 as a whole, analyst projections for growth in our market segments vary widely with a consensus perhaps in the high single digit to low double-digit range.

Against that industry backdrop, our current expectations would be to gain share and grow faster than the market and to achieve revenue growth of 10% to 20% for calendar year 2005 versus calendar year 2004.

As revenues increase, we expect to improve operating profitability as a percentage of sales through a combination of modest improvements in gross margin and reductions in operating expenses as a percentage of sales over time.

We may not achieve sequential improvements in gross margin and operating margin each and every quarter of the year.

But on a quarter over year-ago quarter basis, operating profits should be improving consistently both in dollars and as a percentage of sales.

We will have more details to share on our plans for the year at our analyst meeting on February 1st.

As always, I will note that there are risks associated with our expectations.

We are encouraged by the revenue growth we have seen in the U.S. and Europe in the past several quarters and by the early positive reviews and customer acceptance we are seeing for new products including Aspen.

That said, our quarters are back-end loaded with approximately 50% of the business done in the last month of the quarter, so it is fair to say our visibility can be limited and it is still a case where one or two large deals a quarter can make the difference between sequentially up or sequentially down revenue.

Let me summarize my comments this way.

We're very pleased with the revenue growth and improved profitability that we have delivered this quarter and that we have delivered each quarter of calendar year 2004.

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

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

We're looking forward to seeing further improvement in our business during calendar year 2005.

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

Thank you, Bill.

In summary, we're very pleased with the results of this quarter and of the calendar year.

I'm also very pleased with the status of our partnerships and our technology.

Our two-tier architecture, delivered with the BlackDiamond 10-K and Aspen meets the requirements of a new enterprise and allows us to not only participate but to lead in providing the infrastructure for converged voice and wireless.

I look forward to seeing many of you in New York City on February 1st.

And with that, we would like to open the call up for questions.

Thank you, sir. [Operator Instructions].

Our first question comes from Alex Henderson with Smith Barney Citigroup please go ahead.

Where is Mr. Henderson?

Sorry, had the mute on.

Thank you.

First, just a quick clarification on the comment about Japan.

You said on the call that you expect weakness to continue for several quarters.

I assume that you mean year-over-year weakness as opposed to quarter-to-quarter weakness.

I just wonder if you could clarify that.

As for the general question, the question really pertains on the Avaya.

I guess I'm a little confused.

It sounds like your Avaya business was down on as-reported basis based on the most narrow metric, i.e., did it book through Avaya?

On the other hand, it also sounds like your business was up solidly if you add in all of the components of business that would be ascribed to deals that were engaged through Avaya or with Avaya.

Can you be a little bit more explicit on what you mean there?

Because I think it's an important metric of whether that channel is, in fact, progressing.

Yeah, Alex.

This is Gordon.

Let me take a shot at that.

I think you cast it pretty accurately in that the direct business, that is what Avaya bought from us and resold, was down quarter-on-quarter in terms of revenue recognized.

But overall in terms of business through resellers and also business that where we sold it side by side, that is where Extreme took the order, was very strong, and also bookings were very strong in terms of all three of those areas.

So, you know, overall I would say it's very positive although the one metric, which is the single metric that we reported in the past, was down.

And on the Japanese piece?

Yeah.

And Alex this is Bill.

On Japan, the weakness would be on a year-over-year basis certainly but also on a sequential basis, we will be pushing hard to try and improve revenues from where they are right now and may not see the typical seasonal uptick that we would see in March.

I guess I'm a little confused.

Why wouldn't the seasonal uptick happen in Japan?

Is there something structurally eroding sequentially from the December quarter to the March quarter in Japan?

I'm not sure I understand why that would be the case?

Yeah, this is Gordon.

It's just that there's not a lot of certainty around it.

In that you know the fiscal year does end in March and in past years, you know, we have seen sequential increases as a result of that and we're just not sure where we are in the quarter and you know whether that will repeat we just want we want to be a little cautious there.

But there is no specific issue, it's just being cautious.

There is no specific issue.

Great, thanks.

And our next question comes from Jason Ader with Thomas Weisel Partners.

Please go ahead.

Yeah, hi.

Just had a question on the expense side and just overall operating margin, Bill.

I mean I think we are going to see an uptick here, you know, 1 to 2 million and you know going forward, though, I'm just trying to figure out how to model you guys.

Is there a sense that, you know, that 1 to 2 million is sort of the next step up and then you can kind of keep it flat from there, or should we expect you know if you continue to grow revenue that you will have to continue to grow expenses?

Yeah, Jason, the expectation should be that there's a step up here of $1 million to $2 million a quarter and from that level, we would attempt to manage a very modest increase as revenues grew.

There would not be, I would not expect, sequentially large upticks.

Okay.

But we will manage it tightly as revenues grow from there.

Okay.

But this quarter, it's time to raise our expenses both to support new product intro, support some momentum that we're seeing on the sales side.

Okay, that's fair.

And then you mentioned the potential negative from the weak dollar in terms of your expenses.

Could you give us some sense of any revenue benefits you have been receiving from the weak dollar because you do sell a lot of your products outside of the U.S.?

Yes.

The revenue benefits are indirect.

We sell in dollars essentially everywhere.

Okay.

Worldwide.

So we do not get a direct impact from currency, but obviously, selling in dollars into the reseller channel, the resellers typically then sell out in local currency.

Our products are then a bit cheaper in the market and I think we can see some advantages from that.

Okay, great and then last question, just on the deferred revenues, they were down a bit.

Could you talk to that?

Yeah, there is two things going on deferred revenue.

About a $1 million of the sequential decline was the result of large projects completing, hitting milestones and therefore, the deferred revenue being recognizable.

The other thing that is going on in the deferred revenue has to do with changes we have made to our service programs.

This is something that we have talked about for several quarters.

Our previous service contracts outside of the U.S. often were very inexpensive contracts, which ran for 3 to 5 years and were sold at the time the initial product was sold.

We've altered our service programs now to sell one-year contracts that are priced at more appropriate economics to us.

Over the long term, this will lead to higher revenues, we believe, and higher gross margin, but it has -- the near-term impact of you are booking one year of service into deferred revenue as opposed to the previous 3 to 5 years.

So we will go through a little adjustment period here where deferred revenues will come down a bit, but we anticipate service revenues will continue to grow as they did this quarter.

Thank you very much.

Thank you.

Next question, and we're going to try to limit the questions to one going forward to get everybody on the line.

And our next question comes from Chet White with Merriman, Curhan & Ford Company, please go ahead.

Hi, thank you very much and congratulations on a great quarter, guys.

Thanks Chet.

Sure.

Could you just comment on the wind down of the BlackDiamond 6000 series or even if that's fair to say?

Could you just give us some cope and scale on how that's going, or if that is one of several products that is kind of the old product line versus the new Aspen?

Yeah, Chet this is Gordon.

The BlackDiamond 6800 had a good quarter in December and we don't expect it to wind down per se.

It is an older product, you know, the current version was introduced, I believe, in early 2000, and you know, we have done some switch fabric upgrades so you know it is a workhorse and I expect that customers who are using it, you know, will continue to purchase it.

I see.

And you said that some of the older chassis products declined.

Could you go into some detail on that?

No, I won't go into specific details.

It's products that are gradually being replaced by BlackDiamond 10-K and this quarter by some Aspen products.

It's you know some of the older chassis products.

Okay.

Thank you very much.

Thank you, Chet.

And our next question comes from Mark Sue with RBC Capital Markets, please go ahead.

Thank you.

Hi, Gordon.

Hi, Bill.

Hi, Mark.

Can you just give us a sense what 10 gig was as a percentage of revenues and if you can also comment on 10 gig pricing now?

What you should see, what we should see in terms of 10 gig pricing over the next few quarters, and if you think we're at a point where the price cuts are actually stimulating demand, and can we actually see 10 gig growth accelerate from this point on?

Yeah, Mark.

You know, we don't break it out specifically.

You know, we will report results to IDC and to Deloro (ph) and others, you know, in the next couple of weeks.

You know, as I did note, however, we did see approximately 50% increase in bookings for 10 gig in the December quarter versus September, and we saw, you know, a similar increase in September as opposed to June.

So we are seeing strong growth from Extreme on that.

I think it is driven, as I indicated in my comments, you know, by our new two-tier architecture and using 10 gig links to tie the core to the access and having the products that implement that, you know, pretty cost effectively and with all of the right features.

In terms of the overall pricing, again, that's something difficult to describe, a praise on a modular chassis for 10 gig is quite different than the price on a stackable product, so it's really difficult to give an overall conclusion there.

Got it, and then just on the Aspen.

The Aspen, are the chips -- fundamentally different from your other products and is the Aspen largely a replacement product for your install base, or are you also seeing it from new customers for the Aspen products?

Well, first of all, on the second part of the question, you know, it's a little early to tell.

You know, we see Aspen as really carving out a new niche.

You know, its primary target market is at the access layer of a large enterprise network.

We also see significant opportunities for it in high-performance computer clusters, you know, given the price and density and performance capabilities of the product.

So we see a number of markets as well as the mid-size enterprise.

So it's a little bit of overlap with existing product, such as the BlackDiamond 6800 and the Alpine, but Aspen is really a different product and it's targeted differently, so you know, I think there will be a little bit of replacement as people migrate to a newer technology, but there will also be, you know, quite a few new customers that come to Extreme.

That's helpful.

Thank you, Gourd.

Next question comes from Samuel Wilson with JMP Securities.

Good afternoon, gentlemen.

A couple of small questions for you.

First, on the newer products you're launching, such Aspen, are those tiering generally above corporate average gross margins when they ramp into volume production?

Sam, when they ramp in o volume production yes, they will.

The first quarter out of the chute, they're often a little lower than that.

Secondly, a question another one for you, Bill.

What do you expect headcount additions to be over the next calendar year?

Modest.

We were up 11 full-time heads this quarter.

If it were something to similar to that quarter-to-quarter that would be 5% by the end of the year.

I think it's something like that.

And also, Bill, on cash flow, it seems like you had a couple quarters where you were able to bring down your working capital needs, this quarter, free cash generation was in line with net income.

Do you think that is how it will be on a go forward basis where cash flow is in line with net income?

I do.

As we start to grow, we will need to put some money into working capital.

I know that we will be adding to inventories this quarter to get Aspen into the inventory, and so I expect going forward, our cash flow will be nearer net income.

Last question for Gordon, can you talk about the competitive environment?

There's been a lot of grumbling about aggressive price nature and blah, blah, blah, in the back half of '04.

Yet, you made in your prepared remarks steadily improving environment.

I want to get a sense for the competitive environment out there.

Yeah.

I think, as I said, the overall aggregate environment is improving.

I think from a competitive standpoint, you know, we haven't seen any significant changes.

Other than with our new products, I think, we're in a much better competitive position particularly versus, you know, the large competitors, such as Cisco.

I think, you know, Aspen product, you know, really provides a very strong alternative to their 6509 product line.

Not only a much better price point but also a much stronger capabilities, and I also see that versus some of the companies, smaller companies that have focused on high-perform compute clusters.

The Aspen there is roughly a third of the cost of some competitive products there so, you know, I feel that we're in a strong competitive situation, but certainly, you know, we face a lot of competitors and it's a slightly improving environment.

Thank you.

Our next question comes from Gina Sockolow with Buckingham Research.

Please go ahead.

Thank you.

Can you go through the non-operating line and tell us if there are any other factors in there besides the foreign tax refund and also how that impacted your taxes paid, and what your tax rate going forward looks like?

Thank you.

Okay.

Other income and expenses is a collection of things.

The primary items on that line are interest expense for our note which runs $7 million a year offset by interest income on the cash balance we have of north of $400 million.

Typically those items more or less net out and other INE is plus or minus a few 400,000 a quarter depending on precise rates etc.

We also on that line would record costs related to foreign exchange hedging.

Cost were a little higher this quarter.

I mention the exchange rates that are going on and the changes in exchange rates, and then up from time to time, we do have an unusual item or a non-repeatable item such as the tax refund.

Okay.

And your tax rate going forward?

Tax rate going forward, we noted last quarter that as a result of the large amount of tax loss carry-forwards we are carrying from previous years operating results, that our taxes for the remainder of this fiscal year will be in a range of 15%.

They were a little bit below that, in fact, this quarter.

Okay.

Thank you.

Our next question comes from Yan Chow with Lehman Brothers.

Please go ahead.

Thank you very much.

First, a quick follow-up on the tax rate question.

Do you expect the tax rate may get a reverse back to 35% sometime in fiscal '06, or is that going to run through end of fiscal '06, the 15%?

Possibly fiscal '06, but more likely it's further out.

The rules for reversing back our tax losses would be typically would be multiple years of generated profits, so I would expect that we are running at this low tax rate for some time on a reported basis and certainly on a cash basis, we will be running at this rate for quite some time.

Okay.

Great.

My question is on the possible budget flush.

One of the enterprise equipment companies made some comments this evening about some Q4 budget flush.

I was wondering did you see anything in the December quarter at all in the US enterprise particularly?

That's a hard number to put your finger on, but clearly, we benefited this quarter from some seasonal upticks, some Q4 buying in the US and Europe.

I wouldn't want to go out and try and put a number on it for you, but it is one of the things we highlighted in our thoughts on future revenue that we will be fighting some amount of seasonality here as we move into the March quarter.

Okay, great.

Thanks, guys.

Our next question comes from Manny Recarey with Kaufman Brothers.

Please go ahead.

Good afternoon.

Question on the 10 gigabit market.

Are you seeing the growth coming more from the enterprise side of the world or the service providers?

And one question on Japan again.

The issue that you face there, is it more of a competitive or is it just the overall market where it's weak?

Yes.

Let me answer that second part.

This is Gordon.

You know, on the overall market, our business there is you know more than 50% carriers and the carrier business has been lumpy, and although they continue to buy, it's a little unpredictable when.

And we're also coming to a point where some of those, you know, carriers are kind of waiting for demand to catch up so, you know, we do expect it to be lumpy and you know, we will focus more in the future on the enterprise market and make more investments in that area in Japan.

And Manny, as it relates to 10 gig demand in the quarter.

It was more slanted toward enterprise and of course, our business is 70% plus enterprise, so that is consistent.

Okay.

Thanks.

Our next question come from Andrew Schopick with Nutmeg Securities.

Please go ahead.

Thank you very much.

Jean actually asked one of my questions.

Gordon, I would like ask you, if you could comment a little bit more about the 10 gig market share gain that you believe you're achieving and really, which companies you feel you're having the most success with in that particular arena right now.

Yeah.

Andy.

I think in terms of the, you know, the data that I mentioned in terms of 50% growth, really for each of the last two quarters, you know, I'm not sure where that is coming from in terms of whose hide we're taking it out of, but I think a lot of it is due to the introduction of new products.

I think Aspen will help that, as well.

But also giving people a reason to buy 10 gig.

I think a lot of the early installations were in high-performance compute clusters and traditional early adopters and what we're seeing now is more of a mainstream enterprises putting in 10 gig.

So you know, I think with these new products, you know, we will have a very strong solution for high performance compute clusters and we should be able to increase share there.

But also really help large enterprise use this new technology as a way to connect the access to the core.

Bill, with respect to that other income expense line, with cash balances rising, with interest rates rising, net-net, I would have expected to have seen a positive number there excluding, you know, the 3.9 million tax-related refund.

Why wasn't that number on balance positive in this quarter?

Was it something more than just the foreign exchange hedging costs that might have been a one-time, non-recurring nature?

No.

The other INE has bounced around positive to negative for some time.

This quarter, the primary driver of taking it from just over positive to negative was cost related to foreign exchange.

Okay.

Thanks.

Our next question comes from William Beckley with Oppenheimer Company.

This is Priya Parusuraman (ph) for (inaudible).

I was wondering, how much of your revenue comes from new products and even an approximate number will do.

Yes.

That is not a number that we break out quarter-to-quarter.

Can we get the next question please.

Our final question today from comes from Christin Armacost with SG Cowen.

Please go ahead.

This is Lucas Bianchi (ph) for Christin Armacost.

My question relates to the Avaya relationship and the product road map there.

I think you guys had mentioned before that you were going to come out with some joint products in early 2005 and I was wondering if that's still on track and if so, you know, kind of what we should be able to expect to see there.

This is Gordon.

Yeah, we are on track.

You know, you will see those some products in the -- I will say certainly the first half of this year and those will be largely software products.

Okay.

Thank you.

Thank you very much, everyone.

That does conclude the Extreme Networks fiscal Q results conference.