Extreme Networks Inc (EXTR) 2005 Q3 法說會逐字稿

[OPERATOR INSTRUCTIONS] I would now like to turn the call over to Mr. Bill Slakey Chief Financial Officer with Extreme Networks.

Please go ahead, sir.

Thank you.

Good afternoon.

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

This afternoon we issued a press release announcing our financial results for Q3 FY 2005.

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

A reminder this call is being broadcast live over the Internet today, April 14, 2005 and it will be posted on our website and available for replay shortly after the conclusion of the call.

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 those issues.

Because such issues deal with future events, they 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-K's 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.

I'm begin this call with a summary of the financial results, review our quarterly business highlights, and then turn the call over to Bill for a detailed discussion on the financials.

Although our results were not as we expected, we did experience year-over-year growth during the quarter, and strong growth in some geographies and in some channels that helped strengthen our position in the network and infrastructure market.

During this fiscal quarter revenues were 91 million, signaling year-over-year growth.

Extreme, like others in the sector, saw softness related to particular geographies.

However, we did see solid demand for new our products and for solutions for emerging applications, such as Voice on the Network.

I'm not passing off this drop as an industry effect, though there was some impact.

I don't believe that we executed as well during the quarter as we should have.

In looking at revenues in more detail, we grew 14% year-over-year outside of Japan.

Japan itself was down 34% year-over-year, or approximately $7 million.

This market which has historically been strong for us has been slow to adopt our newer products.

Further, from an execution perspective, we have been slow to grow our enterprise business in Japan.

Something that we are working to remedy.

As part of a planned transition, our President of Extreme Japan will be retiring at the end of this month, after serving with Extreme for more than 8 years.

We have a new interim leader in place.

We're committed to the Japan market.

We have great partners, great customer base, great brand, and a great team.

Margins during the quarter were 51.4%.

This is lower than we planned due to lower volumes and product startup costs.

We anticipate margins to increase this quarter and going forward.

I'll ask Bill to go into this in some more detail shortly.

Despite the challenging environment we did see positive signs in key areas that Extreme is well-positioned to leverage.

And we are optimistic for several reasons.

These are, our performance in channels, the performance of our new products, and our outperformance against competitors.

I'll address the channel first.

We saw strong traction and growth in our voice or IP telephony channels worldwide.

These channels are different from traditional data networking channels in that they have significant enterprise voice experience, and are in a position to advise our customers on the implementation of IP telephony.

Given the importance of IP telephony as a driver of enterprise decision-making and vendor choice, we feel this is a positive indicator.

With Avaya's integration of Tenovis which they acquired late last year, we now have access to this new channel in EMEA.

Former Tenovis gives us a new footprint in Europe.

We are in the process of training the organization, getting to know the leadership, and preparing that channel to sell our network infrastructure as part of a converged sale.

We are still early in the relationship, but we believe it will bear fruit in the near-term.

In some parts of Asia, we are also expanding our voice channel footprint.

Not going into too much detail, as this is large -- is a large geographically diverse region, we did see early traction and growth over the previous quarter.

In the Americas, our investment over the last year in training, support, and joint marketing is paying off as the Avaya business partners are starting to gain structure selling our infrastructure.

We entered into a relationship with Catalyst Telecom last calendar year and just concluded negotiations and entered into a relationship with Voda One this quarter.

We're pleased with the progress and with the signs that this will be an important channel for us.

I believe the two things that are separating us from our competitors are our ability to access these voice channels, and the strength of our solution that is purpose built for a converged network.

So a few comments about our solution, and in particular our new 8800 series, now called the BlackDiamond 8800.

The new BlackDiamond 8800 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, fewer networking boxes, fewer boxes, and fewer layers is not only simpler but can deliver lower latency and more predictable network performance.

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

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

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

A year ago, we introduced the BlackDiamond 10K as the product for the intelligent core.

Now we are adding the BlackDiamond 8800 as the access product for this two-tier architecture.

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

This new system like our BlackDiamond 10K has voice class availability and a host of features that are best in class for this market segment.

We launched the 8800 in January, and revenue grew rapidly in the quarter exceeding 5% of revenue, one of the fastest adoption cycles in our history.

That's the good news.

The bad news is that more customers moved from our older products to the 8800 than we anticipated.

Thereby causing a decline in some of our oldest products.

And I suspect that the strength of the 8800 caused some reconsideration on the part of customers which may have extended our sales cycles.

That said, the introduction and the first quarter was a success, the product line has ramped very well.

The strength, I believe, validates our strategy, and is a positive sign for the future.

In addition to voice, two other trends that are important are the move to 10-gigabit Ethernet, which involves two parts, the core and the uplinks moving to 10 gig and being driven by Gigabit to the Desktop.

The 8800, the BlackDiamond 10K, and our summit 400 series form one of the industry's strongest 10-gigabit centric solutions.

All three of these product lines support the trend toward gigabit to the desktop, and provide for a 10-gigabit core that we expect to drive 10-gigabit port installations.

Our 10-gigabit ports grew significantly in the quarter, and with this strong product line in place I expect sales will continue to grow as we move through 2005.

In two weeks, we will be attending a NetWorld+Interops show in Las Vegas, our industry's premier event.

This year Extreme has been selected as the official network hardware and wireless provider for the NetWorld+Interops show called the E-net.

This is the fifth year we have built a network for the Las Vegas show, the industry's key event.

This network showcases our strategy for a converged two-tier network for delivering voice, video, and wireless.

The networks two tiers, the intelligent core and unified access for the edge will utilize our BlackDiamond family, the 10K, and the new 8800.

What is exciting for us is that for the first time we will be providing an integrated wired and wireless network.

In past years, we have been fortunate to have been chosen as the wired infrastructure supplier, but the wireless part has been awarded to startups, but this time is a Extreme, wired and wireless.

This is testimony to the strength and maturity of our unified access architecture, a converged wired and wireless show.

I know that many of you will visit N+I to get a sense of the industry direction and trends, and I encourage you to stop by our booth.

In addition to building the E-net, we'll also be making an important new product announcement, one that opens up a whole new market for us.

So in summary, we help customers build open converged networks that handle emerging applications.

Today IT professionals around the world are focusing on deploying voice, keeping the network secure, and up and running.

These are the drivers for network upgrades, and Extreme has delivered, and will continue to provide innovative networking technologies that enable users to meet these demands.

While we did not reach our expectations, we did experience year-over-year growth.

We are seeing traction in our expanded channels, and we are seeing traction for our new technologies.

This provides us with a good footing to move forward.

During the quarter, and over the last few, we have built leadership products in the key growth areas of IP telephony, wireless, 10 gig, and Gigabit to the Desktop, and we have built the channels to deliver these solutions.

Our strategy for open converged networks has come together, and I believe will allow us to continue to gain share against our competitors as we did this quarter.

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

Thanks, Gordon.

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

Before I do that, I want to acknowledge that we we understand that the timing of our call is unexpected, and inconvenient for many of you.

We are holding our call a week earlier than planned, because we recognize these results are below our previous expectation, but with the results finalized, along with an understanding now of our outlook going forward, we wanted to get this news out sooner rather than later.

As Gordon noted for you, we are disappointed not to have achieved our financial goals for the quarter.

While our 3% year-over-year revenue growth may ultimately turn out to have been share gaining performance in some important markets, it is below the expectations we have for our business overall.

Our business outside of Japan grew 14% compared to the year-ago period, but was down 6% sequentially.

While this sequential decline outside of Japan could be attributed to typical seasonality, we had planned for a slightly up quarter based on the anticipation of strong acceptance of our new BlackDiamond 8800 product, and a return to strength from our Avaya channel.

In fact, both these businesses were strong for us, but it wasn't enough to offset unexpectedly strong seasonal changes in demand from the December quarter.

Our business in Japan, which had been weak over several quarters, was a particular disappointment in Q3, down 22% sequentially in what is typically a seasonally strong quarter, and down 34% compared to Q3 a year ago.

Gordon took you through the changes we are making in Japan to improve our execution.

Revenue for the quarter was $91.9 million, consisting of 76.8 million in product revenue, and 15.1 million in service revenue.

Our book to bill for the quarter was slightly below 1.

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

Service revenues were up 18% compared to the year-ago quarter.

Overall product revenue decreased 10% sequentially and increased 1% year-over-year.

Shipments of modular products represented 54% of sales, and stackables 46%.

This was a shift towards chassis or modular products from last quarter, driven by the early success of BlackDiamond 8800.

The split of enterprise sales and service provider sales was 79% to 21%, a shift towards enterprise customers compared to Q2, but generally consistent with our typical I mix.

We had no 10% customers during the quarter.

Gordon noted for you the early success of the BlackDiamond 8800.

Bookings and revenues were up significantly from our first shipments in December, and the pipeline around this product is strong.

We anticipate that the BlackDiamond 8800 could account for more than 10% of revenues as early as next quarter. 10 gig port bookings were up sequentially from the December quarter.

This continuing shift from gig to 10 gig in the network core is contributing to success of the BlackDiamond 8800BD 10k, and Summit 400 stackable products.

New bookings for POE ports were down slightly compared to Q2.

This was driven by the introduction of the Summit 300-24 port switch which has led to a rapid transition from our Summit 300-48 port.

This is a positive outcome in that it has lowered our entry price for both wireless and POE, reduced discounting pressures on that line, and led to an increase in units sold, but for this quarter it has muted the growth in port shipment.

We expect POE ports to return to a growth trajectory in Q4 driven by demand for IP telephony and wireless.

Sales of some our older stackable and chassis products declined during the quarter consistent with the shift in mix towards newer products as Gordon discussed in part.

Looking at sales geographically, revenues in the U.S. were $40.7 million, up 9% compared to the third quarter a year ago, down 6% sequentially.

The sequential decline in revenues was driven by a decline in our federal business and a longer than expected sales cycle throughout the quarter, which made it difficult to increase our enterprise business sequentially.

We believe our overall win/loss rates on competitive deals was good, and has improved over the last years, but the pace at which decisions were made and deals were closed in Q3 was slower than we expected.

Revenues in our European operations, which includes the Mid East and Africa, were up $27.4 million, or 17% up compared to Q3 a year ago, and down 8% sequentially.

As in the U.S., we believe our overall win/loss rates in competitive deals was good, and has improved over the last year, but longer than expected sales cycles made it difficult to grow our business sequentially as we had planned.

Japan revenues were $13.2 million, down sequentially in year-over-year as I have previously noted.

Looking at Asia outside of Japan, revenues were 10.3 million, up from 9.2 million sequentially, and from 6.6 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, but it is fair to say that we are seeing a larger contribution from our enterprise business in Asia.

This included this quarter, our first significant revenue from our Avaya channel in Asia, particularly in India.

Bookings through our Avaya channel worldwide were up significantly both sequentially and versus the same quarter a year ago.

Avaya revenues were more than 5% of worldwide revenues for the quarter, and Avaya channel revenues increased sequentially in the U.S., Europe, and Asia.

These results and the pipeline of business we are currently working make us confident that the relatively low revenue we saw through this channel in December was an anomaly as we discussed on last quarter's call.

Looking at gross margins now.

Total gross margin was 51.4%.

That's up from 51.2 a year ago, but down from 53.8% last quarter, and below our own expectations.

The reduction in gross margin sequentially was driven by several factors, including lower volumes, start-up costs related to the first quarter of volume shipments of the BD 8800, changes in geographic and channel mix, and an increase in discounting on older products.

Looking forward into Q4, we expect to see gross margins increase by at least 1 percentage points as volumes increase as we move to more steady state costs on the BlackDiamond 8800, and we expect continued improvement during the course -- excuse me, we expect continued improvement in gross margins from that level during the course of calendar 2005.

Service gross margins were 40.6% for the quarter, down slightly from 42.3% in Q2.

Service gross margins were impacted by increased freight costs and by incremental investments we are making in infrastructure and service depots in order to improve availability and implement new service offerings.

We expect service margins to improve from these levels during calendar 2005.

Turning to operating expenses.

Sales and marketing, R&D and G&A expenses for the quarter were 46.5 million compared with 46.2 million in Q2, and 46.4 million in Q3 a year ago.

This is 1 to 2 million below the expectations we had entering the quarter.

In addition we have recorded a $2 million one-time expense related to a technology agreement with IBM.

Including this expense, total operating expenses for the quarter were $48.5 million.

Looking forward on operating expenses, we do expect that we will see a sequential increase in sales and marketing, R&D, and G&A expenses of approximately 1 million to $2 million, driven by increases in R&D, legal, and Sarbanes-Oxley related expenses.

Legal expenses remain a risk item and may exceed this forecast for the coming quarter as a result of our ongoing litigation with Lucent.

This litigation is scheduled to come to trial later this month.

For the total, other income and expense totaled $800,000.

Including all costs on a GAAP basis, we reported a loss before taxes of $400,000, and a loss after taxes of 1.3 million, or one $0.01 per share.

The total shares used to calculate diluted EPS in the current quarter was 121.4 million shares.

Excluding the one-time cost of the technology agreement, the Company's profit after tax for the quarter was $700,000, or $0.01 per share profit.

Total shares outstanding at quarter end were $121.6 million.

Total cash, cash equivalents, short term investments, and marketable securities on March 26, was $443.3 million, down 3.5 million sequentially, and up 26.4 million from Q3 a year ago.

Accounts receivables were 31.6 million, up $700,000 sequentially, DSOs at quarter end stood at 31 days up 3 days from the end the of Q2 as a result of a more back-end loaded quarter from a return standpoint.

Net inventory quarter end was 22.1 million, down slightly from 22.5 in Q2.

Inventory turns stood at a very good 7 turns for the quarter, down from 8 turns on lower revenues.

Accounts payable balances at quarter end were $24 million, compared with 22.6 million at the end of Q2.

Other assets were up 8.5 million as a result in part an increase in prepaid expenses, and increases for inventory in the channel not yet recognized as revenue.

Some other items to note.

Depreciation and amortization for the quarter was 5.8 million, and capital expenditures for the quarter was 1.2 million.

Headcount at quarter end stood at 784 regular employees, which compares to 799 at the end of Q2.

We also had 53 contractors on board at quarter end.

Turning now to guidance.

For revenues in the June quarter, we currently anticipate that our revenues will be in a range of 93 to $98 million.

We expect to see sequential growth in all geographies except Japan.

We expect to operate with a book-to-bill above one.

Opportunities for revenue growth includes seasonal improvements in demand that we have typically seen in the June quarter during our history, an increase in contribution from new products, including the BD 8800 and additional products introductions scheduled for the quarter.

These opportunities will need to be balanced against the lower than expected revenue trend that we and many of our competitors have seen this quarter, and against weakness in our business in Japan.

On gross margins, our expectation for the March quarter is that gross margins as a percentage of sales will increase by one point or more from this quarters 51.4%.

We expect this improvement to be driven by volume increases, lower costs on the BlackDiamond 8800, and by improvement in service margins.

We have -- on operating expenses, we have held quarterly operating expenses generally flat for six quarters.

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

That's an increase over the $46.5 million of R&D, sales and marketing, and G&A costs for the quarter.

This increase in spending will be driven primarily by R&D spending, legal costs, and Sarbanes-Oxley-related costs.

Again, legal expenses remain a risk item for us, and may rise above this forecast on a short-term basis.

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

I've noted the softer than expected demand that we and many of our competitors have seen during the past three months, and the weakness in our business in Japan.

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

Let me summarize my comments this way.

It's fair to say that we have taken a small step back in the steady progress we have been making in increasing our profitability and predictability, but I think it's important to note that relative to many important competitors of ours, we are growing faster, and in fact now have passed several competitors in terms of quarterly revenue.

We have strong new product and technology cycles and a broad channel footprint, and we are confident that these assets will continue to provide the basis for consistent revenue growth, market share gains, and profitability improvement from the results we have reported today.

And with that, I'll turn the call back over to Gordon.

Thanks, Bill.

While we did not reach our expectations, we are seeing new opportunities in our expanded channels as I've mentioned and we are seeing acceptance for our new technologies.

The 8800 is being accepted very well, and we are very pleased with that, even though it may have replaced more older predict sales than we anticipated.

In any event, I believe this provides us with a strong footing to move forward and to continue to grow faster than our competitors.

Thanks again for joining us on such short notice.

And with that, operator, I would like to open then call for questions.

Thank you, sir. [OPERATOR INSTRUCTIONS] Our first question comes from William Becklean with Oppenheimer & Company.

This is actually Pria Berstrom in for Bill.

I was wondering, last quarter, you had talked about a 10 to 20% revenue growth rate for calendar year '05, and I'm assuming that's something that's not in line at this point in time?

Yes, while we didn't achieve that goal overall this quarter, our guidance indicates that we don't expect to achieve the goal next quarter, as well.

As we get past the first half of the calendar year, we'll reassess our opportunities, we'll look at how much we've been able to improve the business in Japan, and what the industry is growing at the second half of the year, and reassess at that point.

But during the first half, we won't achieve it overall.

Obviously we are achieving it in some geographies, and as the second half gets closer, we'll reassess.

Okay.

And can you also talk a little bit about when you think you might get back on track in Japan itself?

Is it going to be more later part of fiscal year '06?

Could you talk a little bit more on that?

Yes, this is Gordon.

At this point, we're not prepared to forecast our business there.

As I mentioned, the gentleman who has led that organization for eight years had planned to retire this quarter, and will do so, and we'll be assessing the opportunities there.

We are committed to the market, and we will certainly turn things around.

Okay.

Thank you.

Thank you.

Next question, please.

Our next question comes from Samuel Wilson with JMP Securities.

Please go ahead with your question.

Good afternoon, gentlemen.

I apologize, I have a couple of questions.

So I'll just ask these one at a time.

First, Gordon, can you talk a little bit about U.S.

Federal Government.

I think Bill mentioned in his prepared remarks that it went down sequentially.

Were there -- was that below expectations for the quarter?

It was -- it was down slightly for us -- excuse me, Sam -- yes, Fed was down slightly.

As you know, that's not a huge part of our business.

Right.

And then secondly, you mentioned the 8800 kind of was a little bit stronger than you had expected.

Were there any delivery or supply issues with the 8800 during the quarter?

No, the launch of the product was very smooth.

We had some shipments in the month of December, just prior to the official announcement and had smooth deliveries and shipments throughout the quarter.

As I mentioned, the product was very strong, along the lines that we expected.

On the other hand, I think some customers switched orders from one product family to the 8800, and that caused some of our older products, like the BlackDiamond 6800 to fall off.

Got it.

And then a question for Bill.

Interest and other income jumped noticeably to 800,000.

Can you just describe what's going on there?

Yes.

It was a combination of higher interest rates on our cash, miscellaneous items, various refunds and such that flow into that line, and last quarter we had unusually high hedging expenses which we did not repeat this quarter.

So kind of how much of that is sustainable, and how much of it is one time in nature.

I think that on a sustainable basis with the interest rates moving up as they are, it's probably a 3 to $400,000 line.

Maybe the last question is, just generically for either one of you, but the Company has almost $4 a share in cash, in gross cash, and a couple of dollars in net cash.

What would I it take to potentially recommend a share buyback, or use of some of that cash to start buying back the convertible bond, or call for the convertible bond, or start buying shares in the open market.

Sam, you're going down some obviously paths.

We're not prepared to make announcements today, but there's obvious ways we could be using our cash right now to improve shareholder value.

Our next question comes from Long Jang with UBS.

Please go ahead with your question.

Yes.

I think at the end of March, you mentioned you were going to announce earnings day April 27.

It looks like something changed quite dramatically during the last couple of days.

Is that related to Japan, or is it also related to some other regions?

And, also, related to the 8800, you mentioned bigger than expected cannibalization of your other products.

What kind of confidence do you have for the coming quarter that the same thing wouldn't happen.

And also for the current a very nice revenue ramp for the 8800, and, I mean, how much of that did you ship to your new customers, and is that mostly shipped to your existing customer base, or install base.

Thanks.

This is Bill.

I'll take that first question, and then I'll just -- we're going to need to keep the questions to one going forward in order to give everyone a chance to ask their questions.

In terms of why we are announcing early, or preannouncing, or moving our earnings up a week, as I explained in my notes, once our results were finalized, once we had a good understanding of what had happen in the quarter, a good understanding of how it affected our outlook, we made the decision to announce a week ahead of our previous schedule.

We did that just because we wanted to get this news out sooner rather than later.

And as it relates to 8800 sales and trends, I'll turn it over to Gordon.

Yes.

The first quarter of shipments for any new product line is -- is always challenging in that the best of forecasts can often end up wrong, and you really don't know how customers will react until you launch the product and gain some experience.

And so this first quarter was one of experience-building.

Again, the good news is that the product has sold very well, both to existing and to new customers, has opened up a lot of competitive opportunities for us, given the performance of the product, the value proposition, and it's positioning at the edge of a large-scale network.

What we didn't know going into the quarter is how it would affect customer decision making on existing products, and the effect that we saw was a drop off of some older products, and possibly the extension of the decision making where a customer may be looking at an older product, and then is faced with this new product, and that delays their decision as they make the evaluation.

Typically this is a one quarter phenomenon in that over the period of 10, 12 weeks, that information goes into the market, so looking forward, we do anticipate strong 8800 sales.

Thank you.

Next question, please.

Our next question comes from Alex Henderson with Smith Barney.

Please go ahead.

Mr. Henderson?

Yes.

Please go ahead with your question.

Yes, I'm sorry, I blanked it there for a second.

Can you give us some sense of what you think the reasoning is for this general softness that was seen over the course of February and March?

We picked it up pretty clearly from the value-added dealers and resellers when we did our survey, but I guess I'm a little confused why it's so soft at this point in time.

Do you think it's Sarbanes-Oxley?

Do you think people have been tightening their budgets?

Virtually everybody that's announced weakness has said it's broader macro.

What's growing on here?

This is Gordon.

I'm not sure I have a clear concise answer to that we did see the slowdown, particularly in the last -- the last couple of weeks, and really in the last week.

I think there were some unusual impacts in the quarter given the timing of the quarter.

That is for us the quarter starting really in December 26, and kind of in a holiday season, and ending on Easter Sunday, I think there was some slowdown there due to just kind of odd positioning of holidays.

I think some people have seen a broad drop.

We did see a drop, you know, a little bit of a drop in the U.S. and I think there was some underlying strength in our competitive position offset by some deterioration, and at this point, I don't have a good answer to that.

What about Sarbanes?

Do you think Sarbanes played into it?

This is Bill.

I'm willing to blame Sarbanes for many things.

But it's hard to say.

In other words we don't have any direct information from customers that they have delayed a network purchase in order to fund their Sarbanes-Oxley requirements.

There's one thing that I wanted to notice, that it is an unusual situation in that the activity going on, the sales calls, the pipelines, et cetera, does actually seem to be fairly robust.

It is just a very -- it's an environment in which decisions are being made much more slowly than we had seen in the second half of last calendar year, or that we expected.

I guess the question on Sarbanes isn't necessarily just to spending, it's whether there's management distraction.

If you're trying to get your K1 out on March 16, I guess you're not signing off a lot of purchasing contracts when you're in a panic getting your filings out.

Alex, I can just speak from personal experience.

That's true enough, that you get very focused on it, and other things go on the back burner, but I would be disingenuous here to tell you, yes, we know specifically four deals slipped out because they were delayed on Sox.

But it could well be a contributing factor.

Thanks guys.

Thank you.

Next question, please.

Our next question comes from Jiang Chow with Lehman Brothers.

Please go ahead with your question.

Thank you very much.

I wanted to ask a follow-up question on Japan.

Could you talk a little bit more in this area?

Do you think where the weakness come from?

Is that because of the economy in Japan, or is that because some larger deals got pushed to other carriers, or you're losing market share in the enterprise business?

Could you talk a lit built more on that?

Yes, Jiang, this is Gordon.

You know, our Japan business has been dropping off for, you know, for a few quarters now.

There's two aspects to our business there, the carrier business and the enterprise business, and as I mentioned in my prepared remarks, I don't think we have executed well on growing our enterprise business.

That is something we have put in place, some programs to remedy, and in changing our sales tactics a bit there.

The carrier side has always been lumpy, and as you know, we have some very large carrier customers there, and as they complete a large scale network build out there is a -- there is a lull, and those two factors have really worked against us there.

So you feel the overall environment in Japan is still okay?

Yes, the -- the economy there does bounce a around a bit, but I think a lot of what we're seeing are things that we can work hard and remedy.

Thanks.

Thank you.

Next question, please.

Our next question comes from Christin Armacost with SG Cowen.

Please go ahead.

Thank you.

Just a general question on guidance with some momentum and obviously you're having some positives in the quarter, momentums with some momentum of new products and channel plus a new product announcement at N+I.

Why not guide -- why wouldn't you -- why wouldn't you think your revenue could be higher than the range, and close to what it was in December, because you're basically running probably about 10 million on a run rate basis, about 10 million below what intuitively or what the street was looking for for June.

Christin, this is BIll.

There's a few reasons for that.

One is the softness in Japan as I discussed.

Two is being cautious a bit about the overall environment based on what's happened to us this quarter, and what appears to have happened to many of our competitors this quarter.

Those are reasons to be cautious.

Third, is I think this is case where we want to get back in the mode of building predictability into our business.

That means inherently you want to be a little bit conservative on the goals you set, you want to be sure you can run with book to bill above one, et cetera, and so we're going to follow through with all those things.

Those were the recipes for success here over the last year, and we intend to get back on that path.

Hence the reasons of maybe being a bit conservative, or hopefully what would turn out be to conservative, but I think it's a very real and a very reasonable range.

And just a quick question.

Tax rate guidance for Q4.

Tax rate guidance is still something around 15%.

The actual taxes are really being driven by the cash taxes we are paying or required to pay outside the U.S.

So it does bounce around a little bit.

Great.

Thank you.

Thank you.

Next question, please?

Our next question comes from Cobb Sadler with Piper Jaffray.

Please go ahead.

Thanks a lot.

My question is on the competitive environment.

I mean, revenue was off pretty significantly, but your product margins held in there fairly well.

Are you walking away from some deals that may be aggressively priced to maintain margin?

That's the first question, and then just quickly what is happening with 10 gig port pricing.

Thanks a lot.

This is Gordon.

The competitive environment, as far as we can see, has not changed in a big way.

We did see some softness in some geographies, and we've talked about some of the things we're doing about that.

Our sense, and this is certainly supported, is that the newer products are doing very, very well on a competitive basis, and particularly on the 10 gig front.

Our newer systems have lower per port 10 gig prices, and as I mentioned, we have strong 10 gig solutions across our Summit 400 now.

Our BlackDiamond 8800 and BlackDiamond 10K.

So I think if you surveyed the industry, you would see a decline in 10 gig prices, and we're certainly part of the leadership of that.

Okay.

Thanks very much.

Thank you.

Next question, please?

Our next question comes from Steven Kamman with CIBC World Markets.

Please go ahead.

I've got two questions.

One's just on the numbers, the inventories, I think you said those were down, but I'm just trying to square that with not recognizing a pretty decent chunk of sales.

Does that mean its out there?

I would have expected, especially given that you announced your earnings date on March 30, that you would have had a spike in inventories, given you thought you had shipped the product.

Do you see what I'm getting at?

So the question there is just why is it inventories are down if we've just had a $9 million miss, why aren't they up by 9 million, and the second question is just on the -- if you could just kind of quantity on the litigation risk around Lucent, or at least give us some color not quantify what exactly the nature of that litigation is, and what if it were to go against you, what would be the nature of the penalties?

Would you see that being ending up a license fee or something more substantial or would it be a one time charge?

And then finally any color on what the IBM deal, exactly what that specifically is this quarter.

Okay.

So, Steve, this is Bill.

I'll try and tick down those.

As far as inventory management, that was just, I think, a good job by our operations folks on responding to changes in demand.

We do have -- we do use Flextronics for quite a bit of our manufacturing, and in many cases take delivery of the inventory literally as it is being drop shipped from their factory, so if we are not shipping it, we are not yet taking delivery of it and putting it on our books, that's one of the things that helps us there.

But I think generally our operations team did a very good job of responding to literally last week changes in demand.

That's on the inventory.

On Lucent, Lucent is a litigation which actually is fairly broadly disclosed in our 10-K's and 10-Qs.

It deals with allegations of IP infringement, it is something that has been going on for a couple of years, and is now scheduled for trial in April, late April, early May, and I should note, as well, that Foundry is involved in this.

I don't know exactly when their trial date is but Lucent has alleged IP infringement and sued them, as well.

So it could go any number of different ways.

We are open to settlement, always have been, alternatively, we think the allegations are false, and we're very willing to take it to trial if that's where it comes out.

So that's why I need to be a little bit open ended on what the expenses would be or what line they might fall on depending on the outcome.

And as far as IBM goes, I can just give you just a very brief description that that is a cross-licensing agreement for IP.

Okay.

Thanks.

Shorter answers than the question.

I appreciate it.

Thank you.

Our next question comes from Erik Suppiger with Pacific Growth.

Please go ahead with your question.

First off, did Avaya meet your goal of growing by 1 to 2 million per quarter?

Erik, on this particular quarter, they more than met that goal.

Now, admittedly some of that was off of December that was a little bit low, but they are back on sort of the track we would have expected even back in June-September now.

So when you said it was 5%, it's really kind of more than 5% you're saying it's kind of in the 5 to 10% range.

Yes.

Can you give us a sense would you expect it to reach 10% of revenue at least this year at some point?

No, Erik, again, I believe that Avaya is a relationship that can ramp 1 to $2 million a quarter for us especially now that we are starting to connect on a worldwide, literally worldwide basis with U.S., EMEA, and Asia.

But beyond that I don't want to make any direct.

Just to be clear Erik, since Bill jumped in there very quickly with a no, that he was saying, no, I'm not going to tell you, not, no it won't happen.

What about the combined Avaya business partners, and Avaya.

Can we assume that that's reached the 10% threshold at this point?

No, Erik, when we discuss Avaya revenues, we are combining sales directly through Avaya, or through Avaya's reseller channel for which Avaya is compensated.

So when we talk about Avaya revenues we are already combining Avaya and their reseller channel.

What we do not include in that number is cases where we may be selling along with Avaya, but the business is done directly with us or through another channel partner.

That would be revenues that Avaya, catalyst, and Voda One?

Correct.

And there are some international aspects to that as well.

Can you comment as to whether the Avaya piece, the direct Avaya was -- did that have good growth?

We don't really break that out, Erik.

Next quarter, do you expect to be cash flow positive?

Yes.

What's that?

Yes, Erik.

Okay.

Then lastly, the prepaid expenses were up.

What was that?

It's just time of year where we make some insurance, buy our annual insurance.

Very good.

Thank you.

Next question please.

Our next question comes from Mark Sue with RBC Capital Markets.

Please go ahead.

This is Brian Muracomi for Mark.

Gordon, you said sales of the 8800 were affecting -- sorry, sales of the 8800 affected sales of Legacy products.

Did that extend to the BlackDiamond 10K, and dit it impact mostly new chassis sales, or were line card sales affected, as well?

I can't answer in detail whether it was chassis or line cards, other than to say that the new system -- the 8800 system increased pretty dramatically from very small sales in the previous quarter, and we did see declines on some older products.

I really don't want to break it out specifically by product lines, just for competitive reasons.

Thank you.

Next question, please in?

Our next question comes from Andy Schopick with Nutmeg Securities.

Please go ahead.

Thank you.

Gordon, I would like to ask you to update us or comment on remarks that you had made earlier in the year at the analysts day in New York where I saw you, and then one Webcast at one of of the brokerage firms concerning expectations of new channel agreements.

You've kind of set the stage for something to happen, but nothing has really occurred on that front just yet.

Is there anything you care to say at this time?

Well, we did enter into an agreement with Voda One, which is a distributor part of WestCon Group.

Was that the only thing you were referencing at that time?

It's the thing that we publicly announced.

Okay.

Gordon, I would also like to ask you how concerned you are right now in terms of what you have seen occur in your business and what we are now seeing among other larger companies including IBM today.

Do you have increased concerns or contingency plans for perhaps the overall economy and market turning out to be weaker this year than what people might have otherwise hoped to see when we turn the corner of the new year?

Yes.

I'm not sure I can comment on particularly on IBM's results, since I haven't read the analysis yet.

Just using it as one example.

No, I appreciate that.

I think at this point we look at these results, and although we certainly did see some softness and some delays, I also believe that some of the shortfall that we saw was -- was due to factors that we can control, and things that we're going to go in and work hard to remedy.

Again, I'm very confident of new channels that we're just firing up, and that we've made investments in.

I'm confident of the technologies and the products that we've introduced.

We've renovated our entire product line literally in the last 18 months.

I also see that looking out over the next year and 24 months as I indicated at the analyst day, that there is an upgrade cycle ahead of us within the enterprise market segment given the age of the existing installed base that was largely put in in anticipation of Y2K.

So it's hard to say what the economic impact is other than from the networking sector, we still see a lot of opportunities.

Okay.

Thanks.

Okay.

I believe we have one last question on the line.

Our final question comes from Rick Church with Unterberg Towbin.

Please go ahead.

Thanks.

Good afternoon.

Question on the service provider side.

It's only about 20% -- 21% of your revenue this quarter.

But I'm just curious if you're seeing -- with carriers moving towards an all IP type of infrastructure, do you see a role for Extreme in that market and do you think the percentage of revenue can grow in that vertical?

I'm sorry, you're saying the service provider in general?

Yes.

Our focus to be clear in the service provider market is in the metro Ethernet space, and that is a phenomenon that has been largely outside the U.S. to date.

We've won a significant number of installations in Japan, in Asia, and in Europe, as well.

Also in South America.

And we're certainly optimistic for that market segment going forward, and we believe that Ethernet technology will, over the course of several years, come to dominate how these types of networks are built.

But you haven't seen anything in particular giving you confidence that growth may resume more quickly in the -- you know, over the next six to nine months, or --?

We see a lot of activity level.

Okay.

Thanks.

Thank you.

Thank you, everyone, for joining us this afternoon.

Ladies and gentlemen, this concludes the Extreme Networks third fiscal quarter earnings conference call.

If you would like to listen to a replay of today's conference, please dial 1-800-405-2236, or 303-590-3000, and enter access code 11028644.

Once again, for a replay of today's conference, please dial 1-800- 405-2236, or 303-590-3000, and enter access code 11028644.

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