Extreme Networks Inc (EXTR) 2006 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen, and thank you for standing by.

Welcome to the Extreme Networks first quarter earnings release conference call.

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

Following today's presentation, instructions will be given for the question-and-answer session.

If anyone needs assistance at any time during the presentation, please press the star, followed by the zero, and a conference coordinator will assist you.

As a reminder, this conference is being recorded Wednesday, October 26 of 2005.

At this time, I would like to turn the presentation over to your Chief Financial Officer of Extreme Networks, Bill Slakey.

Please go ahead, sir.

Thank you, Andrew.

Good afternoon, everyone.

Thank you for joining us.

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

This afternoon, we issued 2 press releases.

One announcing our financial results for Q1 FY2006, and a second press release announcing the authorization of a $50 million share repurchase program.

A copy of both these releases are available on our website at extremenetworks.com.

This call is being broadcast live over the Internet today and it will be posted on our website and available for replay shortly after the conclusion of the call.

Let me note that some of the remarks made during this call may contain forward-looking statements about financial and business guidance, product introductions and customer development.

These reflect the Company's current judgment on those issues.

Because such statements deal with future events, they're 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-Qs and form 10-Ks which are on file with the SEC and are available on our website.

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

Thanks, Bill.

And thanks, everyone, for joining us.

I'll begin the call with a summary of the financial results, review our quarterly highlights, and then turn the call back over to Bill for detailed discussions on our financials.

First of all, let me say that I'm very pleased with our results for the first quarter of 2006.

This quarter marks our seventh consecutive quarter that we have had revenue growth when compared on a year-over-year basis.

It is also the seventh consecutive quarter where we have expanded gross margins when compared on a year-over-year basis.

I believe that these financial achievements demonstrate the market adoption of our innovative networking solutions and our ability to firmly manage the business.

Before discussing numbers, I wanted to bring another item to your attention.

In conjunction with our earnings release, we also announced this afternoon that we're implementing a $50 million stock repurchase program.

As noted in the release, this buyback will be made in compliance with SEC rule 10B18 and we expect to repurchase the stock over the next 12 months.

We currently have over $450 million in cash, and we believe that repurchasing our shares is an excellent way to enhance shareholder value.

Now, I'll continue with the summary of the financials.

We increased revenue to $97.9 million, up 3 percent from the first quarter a year ago and up 2 percent from the previous quarter.

On a GAAP basis, net income was $4.4 million or $0.03 per diluted share.

As many of are you aware, this quarter was the first time we had to account for stock compensation, which was $1.9 million for the quarter.

To m ake comparisons to previous periods consistent, we'll refer to numbers that don't include stock option expense as non-GAAP.

The only difference between the numbers we quote as GAAP and non-GAAP is stock option expense.

Bill and I will both refer to numbers in this fashion during the call.

So, excluding the stock compensation expense, non-GAAP earnings per diluted share were $0.05, an increase from $0.03 in the first quarter of the last fiscal year, and up from zero cents in the previous quarter.

Much of the increase in profit was due to strong improvements in gross margins.

GAAP gross margin was 54.4 percent compared to 53.2 percent a year ago.

On a non-GAAP gross margin basis, it was 54.7 percent compared to 53.2 percent in the previous year.

We've made good progress on gross margins with increases of 1.5 percent or 150 basis points on a non-GAAP basis.

Much of this is due to new product contribution which I will address in a few minutes.

In looking at regional contribution, we saw strong performance across the board.

Revenue in the U.S. was $45.1 million up from the previous quarter and the year ago quarter.

I'm pleased to say that we've turned Asia around with sales up across the region.

That includes Japan being up a quarter on quarter for the first time in 5 quarters.

Now, in Japan, Asia being up and Asia overall as we break it out, being up 47 percent sequentially.

As I mentioned on the call last quarter, we placed new leadership in this region and we're very pleased with progress of the new leadership and the team is making.

The European region typically shows seasonal slowness in the September quarter.

Give than backdrop, we are pleased with the performance of our EMEA team which did $30 million, up 19 percent from the same quarter a year ago.

Again, we're very pleased with the results of the quarter.

At this point, I would like to shift gears and talk about the drivers of our business going forward.

Specifically, I would like to discuss 3 trends.

Convergence, security, and metro ethernet.

First convergence.

Our continued commitment to delivering open converged networks, places us in an ideal situation to leverage the convergence occurring on today's networks.

During the quarter, we saw ongoing adoption of our design for 1 network that can easily accommodate voice, video and data with both wired and wireless access with large commercial enterprise customers.

While other networking companies talk about convergence, only Extreme Networks offers users a truly open platform that enables the customer to determine their technology path.

Convergence is one of the primary drivers of enterprise upgrades, particularly in the large scale networks that we specialize in.

Reliable support of converged applications is even more important than network speed and bandwidth, given the mission critical nature of voice, one of the first applications being deployed on a converged network.

This is an area where we've been investing both in technology and in our distribution channels.

Early this calendar year, we introduced the BlackDiamond 8800 as our chassis system for large enterprise converged edge.

This product continues to gain momentum and share in this important area and it continues our history of being recognized by the industry with numerous awards.

Recent awards include product of the year by the U.K.'s leading publication Tech World, and best in test by Sweden's Network and Communication magazine.

On the channels that go to market side, our partnership with Avaya, now in the second year, continues to bear fruit in large and midsize enterprise.

For the first time, booking through Avaya channels exceeded 10 percent of product bookings, an important milestone for us.

Let me go through a couple of examples of converged wins during the quarter.

Significant win for Extreme's open converge network solution was with Lockheed Martin's Information Systems and Services Division based in Pennsylvania.

Lockheed, as an organization, is embarking on a wide scale project to deploy company wide IP telephony working with Extreme Networks as its infrastructure vendor of choice.

Lockheed's existing network infrastructure consists of our BlackDiamond and Alpine switches at the network core, and now they're revitalizing the network edge.

We are providing innovative solutions including the Summit family of edge switches, that feature critical functionality for delivering voice, including power over ethernet, advanced quality of service functionality, and high availability features.

With the first facility well underway with its voice over IP implementation, we look forward to expanding to more locations in the coming months.

In the higher education segment, this quarter, Extreme Networks is helping another member of California's prestigious university system, UC San Francisco, which in addition to our ongoing work that I mentioned last quarter with the new UC Merced Campus.

UCSF has implemented Extreme solutions for its Epidemiology and Biostatistics departments, where they elected to upgrade the facility to support mission critical medical applications over both wired and wireless technologies.

In doing so, UCSF designed a convergence ready network leveraging Extreme Summit400 and our new Summit WM wireless solution.

Finally, Regional Lombardi, one of the Italy's largest regional local government institutions, selected a complete new communications and network infrastructure from Avaya and Extreme.

This network is based on our innovative and scalable BlackDiamond 10K and BlackDiamond 8800 switches as well as hundreds of Summit 400 switches supporting gigabit PoE connections over network edge.

An impressive 10-gigabit backbone features fully redundant network links, as well as many high availability attributes.

This network spans more than 36 different buildings across a large interconnected campus.

So, convergence is the first driver.

The second area that is driving our business is security.

And clearly this is a key area of concern for network professionals.

You can't pick up a trade publication in our industry without reading about network security.

Whereas there are many providers of traditional security products, that is firewalls, BPNs, intrusion prevention protection systems that protect the perimeter of the network, our approach is focused on the infrastructure of the network itself.

As in the past, we rely on our innovative approach to problem solving and offer an integrated security approach, exactly what IT managers tell us they're seeking.

Innovation is the true integration of security into the network itself, rather than being in line in an external appliance.

Integration of security into the infrastructure makes security much easier to manage and allows it to be implemented at all points in the network, not just at the perimeter.

Our solution is based upon a technology that we invented called CLEAR-Flow.

CLEAR-Flow is a programmable rules engine that is built into our network core products.

CLEAR-Flow provides for line rate processing of security threats within the switch.

It is fully programmable and therefore, upgradable.

The strength of CLEAR-Flow comes from its ability to work with virtual appliances and dramatically accelerate the performance of security.

Earlier this calendar year, we introduced Sentrium, which is our first virtual security appliance.

This product completed successful trials in the last quarter and we will recognize revenue this quarter.

We have received very positive feedback from customers that have used Sentrium and CLEAR-Flow in their networks.

I believe that our approach to security is what the market wants, a simple, integrated solution that can be readily updated when new types of threats are identified.

We see this as an important reason for large enterprise customer to choose Extreme and as an enhanced revenue stream for us.

Though we talked about convergence and security, the third market area that will drive our business is metro ethernet.

We've been in the metro ethernet market since the very earliest days.

This market continues to be an important part of our business, representing roughly 20 percent of revenue over the last several years.

The first generation of networks has been implemented, and now users are demanding advanced services, particularly related to conversions.

In this market, voice is certainly important, but video is a growing factor.

When we talk about convergence in this market, it is convergence of voice, entertainment class video and traditional data.

This convergence requires more sophisticated quality of service and inherently more bandwidth.

The more traction that converged metro networks get, the more bandwidth that's required, which is good news for us.

During the quarter we had a number of new and existing customers upgrade to metro ethernet networks.

A key example of this is Telefonica in Germany.

The carrier is planning a nationwide DSL roll-out based on the local loop unbundling ring technology.

Telefonica's goal is to find an appropriate metro ethernet switching platform as an aggregation point for more than 300 points of presence today in Germany.

Network supports broadband Internet access as well as IP telephony applications.

Extreme Network's Summit X450 switch was selected for our modular software technology, the performance advantages compared to our leading competitors, and our strong partnership with Siemens.

Also France Telecom, the incumbent carrier there, chose to rebuild key portions of its current data network infrastructure with our BlackDiamond 8800 and Summit 450 switches.

These platforms feature our modular Extreme wear XOS software providing high availability from end to end.

France Telecom depends on the scalable and responsive ethernet LAN for message hosting, the foundation for ADSL services as well as related IP service platforms.

Entire network is connected to the core at 10-gigabit speeds.

So, convergence, security and metro ethernet are the 3 key drivers for our business going forward.

In all 3 of these areas, we have strong technology in partners and all 3 of these are forecasted to grow strongly in 2006.

Now, a few brief words about technology and then I'll turn things over to Bill.

The key technology underpinning for these growth areas and the growth of our commercial enterprise business is ExtremeWare XOS, our open modular operating system.

There have been modular operating systems in the carrier space before, but XOS is the first to address the requirements of the large enterprise segment.

We introduced XOS almost 2 years ago now and we continue to invest heavily.

This technology is helping us make gains in the market place.

We currently support XOS across 3 of our newest product lines, BlackDiamond 10K, our enterprise core switch, BlackDiamond 8800, our enterprise edge and aggregation switch, and the Summit X450, our high performance enterprise edge stackable product.

XOS is an acronym for Extensible Open Secure.

It is built in a modular fashion which allows us to deliver high availability.

Extensible nature allows us to integrate technologies from other companies, such as voice over IP enabling technologies from Avaya, and security solutions from a number of partners.

The inherent secure nature of XOS combined with CLEAR-Flow, will enable a broad range of integrated security solutions.

We believe growth will come from the market demand for convergence, security and metro ethernet and our ability to deliver innovative solutions.

In working with new customers, we continue to find how our approach for an intelligent network foundation eclipses the traditional speeds and feeds approach, as our customers realize that their applications have evolved and that they must build an advanced infrastructure to match them.

We believe that our core technology to drive this innovation is XOS.

It will allow us to integrate new solutions and new capabilities that will enable higher margins.

Now, with that, I would like to turn things back over to Bill for a detailed financial review.

Bill?

Thank you, Gordon.

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

As Gordon noted for you, we are pleased that our financial performance for the quarter, our revenue growth is in line with the expectations we set at the beginning of the quarter, and our profitability is higher.

We met several important financial goals for the quarter.

We saw good year-over-year growth in the U.S. and EMEA, a good contribution from our Avaya partnership worldwide, and revenues in Japan grew sequentially.

In addition, gross margins expanded sequentially, and at 54 percent plus, we are now operating in the target range of 54 to 57 percent that we previously laid out for you.

Operating expenses came down notably during the quarter as well.

And as a result, profitability and cash generation was strong.

These solid results, as well as the strength of our balance sheet has also allowed us to announce a significant share repurchase program, which we expect to begin in Q2 and to complete over the next 12 months.

We believe this use of our cash is both a very direct step to take to increase the value of our shareholders' investment in our Company, and is also tangible the evidence of our commitment to improving shareholder value at Extreme over time.

Now, turning to revenues in more detail, revenue for the quarter was $97.9 million, consisting of $81.9 million in product revenue and $16 million in service revenue.

Service revenue was up 3 percent sequentially, making this the eighth consecutive quarter in which service revenues have been flat to up on a sequential basis.

Service revenues were up 15 percent compared to the year-ago quarter.

Product revenue increased 2 percent sequentially, and 1 percent year over year.

Shipment of modular products represented 49 percent of sales, with stackables representing 51 percent.

This was a shift toward stackable products from last quarter, driven in part by the success of our XOS based stackable product, the Summit 450, and by sales of our wireless and PoE Summit 300 line.

The split of enterprise sales and service provider sales was 78 percent to 22 percent, similar to Q4 and generally consistent with our typical mix.

XOS bases products continue to help drive revenue growth and gross margin expansion for us.

All told, sales of XOS based products represented more than 20 percent of total product bookings during the quarter, up from approximately 5 percent in the first quarter a year ago.

We saw solid contributions from the BD8800 and our XOS based stackables, and we also saw sequential and year-over-year growth from the BlackDiamond 10K.

Sales of some of our older chassis products declined, which is consistent with a shift toward newer products. 10-gig port bookings were up sequentially from the June quarter.

This continuing shift from gig to 10-gig in the network core is contributing to success at the BlackDiamond 8800 BD10K and Summit 400 and 450 stackable products in particular.

New bookings for PoE ports were also up sequentially.

We saw solid increase in the sale of PoE blades for the BD8800.

PoE port sales are now in the high single-digits as a percentage of our total port shipments.

We expect PoE ports to continue on a growth trajectory driven by demand for IP telephony and wireless.

Bookings through our Avaya channels, both direct and resellers, increased again in Q1 following a strong Q4.

As you've heard from Gordon, Avaya related sales represented 10 percent of product bookings during the quarter.

We benefited in Q1 from seasonal strength at Avaya's business.

This is being -- this being their fiscal fourth quarter and typically their strongest quarter.

Avaya channels are now contributing to revenue in the U.S., EMEA and Asia Pacific.

And as Gordon illustrated in his comments, we're getting increased exposure to large deals through the Avaya partnership.

As we expected, our total book-to-bill quarter was below 1.

Looking at sales geographically, revenues in the U.S. were $45.1 million, up 13 percent compared to the first quarter a year ago and up 5 percent sequentially.

In EMEA, our European operations which includes the Middle East and Africa, our revenues were 30.1 million for the quarter, up 19 percent compared to the same quarter a year ago.

While EMEA revenues were down sequentially from the June quarter, this was consistent with seasonal patterns in EMEA and was in line with our projections entering the quarter.

In Japan, revenues were $10.7 million, up sequentially compared to the June quarter.

This is a good outcome for us, and was a solid proof point to our previous projection that after a period of revenue declines, Japan revenues had likely bottomed in the June quarter and could become a source of sequential quarterly revenue growth again in fiscal '06.

Looking at Asia outside of Japan, revenues were $11.4 million, up from $7.8 million in the June quarter, and flat with revenues in the first quarter a year ago.

Revenues in Asia are lumpy for us.

Largely as a result of a high contribution from service provider business, but this was a solid sequential uptick for our business there.

Turning to costs and expenses, as Gordon noted, for the first time, our quarterly GAAP basis financials include stock-based compensation.

The prior period results do not.

The cost of goods and operating expense comparisons I will be discussing do not include stock-based compensation expenses.

These expenses added $1.9 million to our total cost for the quarter.

For those of you who want to note it in your models, the breakout of these expenses by P&L line item in the quarter was as follows: $200,000 increase to product cost, $100,000 increase to service product cost, and $800,000 increase to sales and marketing expense, $500,000 increase to R&D expense, and $300,000 increase to G&A expense.

This breakout is also included in table form in our press release.

So, looking at gross margins now, total gross margin as a percentage of sales was 54.7 percent, not including stock-based compensation.

This was up from 53 percent sequentially and up from 53.2 percent in the first quarter a year ago.

Gross margins improved for both products and services with the total 1.7 percent sequential improvement in gross margins being slightly better than our guidance at the beginning of the quarter.

Product gross margins were 56.4 percent, up 1.8 percent sequentially, and 1.1 percent versus the same quarter a year ago.

Product margins benefited from lower product cost generally, a higher contribution from new products, and changes in the mix of regional sales.

Service gross margins were 46.3 percent for the quarter, up 1.9 percent sequentially and up 5.4 percent versus Q1 last year.

Service growth margins benefited from higher volumes, slightly lower repair cost, and ongoing efforts to improve our pricing and slate of service and maintenance offerings, particularly outside the U.S.

At 54 percent plus gross margin, we are now operating in the target range for gross margins that we previously laid out for investors.

We do believe that gross margins on both products and services can continue to improve over time through a combination of higher revenue, operational improvements and new product sales.

That said, given the number of pricing, mix ,cost, and volume variables involved, we do not expect a gross margins will improve lock step each and every quarter.

Turning to operating expenses, sales and marketing, R&D and G&A expenses for the quarter were $47.8 million, not including stock-based compensation.

This was down from 51.4 million sequentially, and up from $45.8 million in Q1 a year ago. he sequential reduction in operating expenses was primarily the result of $3 million less spending on the G&A line related to legal and SOX compliance in the June quarter.

As we noted for you last quarter, our Q4 G&A expenses were unusually high, and we believe the run rate on G&A expenses in Q1 is more representative of our ongoing expense level.

Sales and marketing expenses were $25.1 million, down $800,000 sequentially, as we moved past year end commission accelerators and marketing programs.

R&D expenses were essentially flat sequentially at $15.7 million.

Looking forward into Q2, we expect to see operating expenses in the range of $47 million to $48 million, not including stock-based compensation, and this is consistent with our previous expectations.

Looking at net income, in Q1, on a GAAP basis, we recorded operating profits of $3.9 million.

Adding in $900,000 in net other income results in a profit before tax of $4.8 million, and a profit after tax of $4.4 million or $0.03 per share on a diluted EPS basis.

On a non-GAAP basis, excluding $1.9 million in stock-based compensation, operating profitability was $5.8 million, or 5.9 percent of sales, up from 5 percent of sales in Q1 a year ago, and up from a slight operating loss last quarter.

Profit after tax was $6.2 million or $0.05 per share on a diluted basis, up from $0.03 per share in Q1 a year ago.

The tax rate for the quarter was 10 percent.

This is lower than our previous guidance as a result of the continued use of previous tax losses in the calculation.

This 10 percent rate is representative of the rate we now expect for the remainder of the year.

Total shares used to calculate diluted EPS in the current quarter was 124.8 million, total shares outstanding at quarter end were 123.2 million.

Looking at the balance sheet, cash, cash equivalent, short-term investments, and marketable securities on October 2nd totaled $450.3 million, up $9.9 million sequentially.

Cash flow from operations during the quarter was $10.8 million.

Accounts receivables were $30.1 million, down $700,000 sequentially.

DSOs at quarter end stood at 28 days, down 1 day from the end of Q4 as a result of a slightly more linear quarter from a revenue standpoint.

Net inventory at quarter end was 21.4 million, down 4.5 million from the end of Q4.

Inventory turns stood at 8 for the quarter, a nice improvement from the June quarter.

Other items to note, depreciation and amortization for the quarter was $5.1 million and capital expenditure for the quarter was $2 million.

Head count at quarter end stood at 795 regular employees, unchanged from June.

We also have 45 contractors on board at quarter end, up from 39 at the end of June.

Turning now to guidance.

For revenues in the December quarter, we currently anticipate that our revenues will be flat to up 5 percent compared to the $97.9 million we recorded in September.

The opportunity for higher revenues comes from what it is typically a seasonally stronger quarter for us in our industry, and from continued success of our XOS based products particularly in the U.S. and EMEA, and a return to sequential revenue growth in Japan.

On the risk side of the revenue equation, our return to sequential growth in Japan is at its early stages and subject to risks.

Avaya revenues may well be down this quarter as a result of typical seasonality in Avaya's business.

And the overall strength of demand in the economy and for our industry is difficult to gauge at the present time.

On gross margins, our expectation for the December quarter is the gross margin as a percentage of sales will be at a range of 54 to 55 percent of sales, not including expenses for stock-based compensation.

As ever, our gross margins are sensitive to pricing on large, competitive deals and on the precise mix of products and channels.

In addition, we're beginning to incur some costs related to new environmental regulations in Europe in particular.

As a result of these factors, it is possible our margins will be down in December compared to September.

The opportunity to be at the high end of the 54 to 55 point range comes from the expectation of higher volume this quarter versus September, continued success of new products, and ongoing margin improvement after it's in our service business.

Looking at operating expenses, in Q2, we expect our total operating expenses will be in a range of 47 to $48 million, not including expenses for stock-based compensation.

And other items for your models, we expect net interest income of approximately $800,000 a quarter.

We now anticipate a corporate tax rate of 10 percent in fiscal '06, somewhat lower than our previous guidance.

We anticipate that stock-based compensation will continue to run at a quarterly expense rate of approximately $2 million.

As for the impact of our share repurchase program on cash balances, interest income and share count, we will make no particular forecast on this other than to note that it is our expectation to complete the $50 million program over the course of the next 12 months.

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

Investors should note that our quarters are back end loaded with approximately 50 percent of our business done in the last month of the quarter, and so it is fair to say our visibility can be limited.

And it is still a case where 1 or 2 large deals a quarter can make the difference between sequentially up or sequentially down revenue.

Let me summarize my comments this way.

This is a very good quarter for us.

We achieved many important financial goals including revenue growth, gross margin expansion, reduction in operating expenses, a return to sequential revenue growth in Japan, and a strong contribution from our Avaya partnership.

We generated $9.9 million in cash and our cash position has enabled us to move forward with a significant share repurchase program.

As we look out further into FY06, we're committed to continuing to improve our profitability through revenue growth, gross margin expansion and continued tight management of operating expenses.

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

Thank you, Bill.

And thanks to you and your team for the great results.

To summarize, we're pleased with the results of the quarter, particularly the strong increase in gross margins and strong increase in profitability with again non-GAAP results of $0.05 per share.

We're pleased with the turnaround in Asia and Japan with strong results across that region.

And on the product front, we're pleased with the performance of XOS based products, which not only improve margins with a strong software content, but bring important benefits to users.

We're also pleased with our continued progress in leadership in the open multivendor converged marketplace.

Our message resonates with users and our products fit the bill.

Our channels are working well, including the results of our Avaya partnership, which again had bookings in excess of 10 percent of revenue.

Thanks again for joining us.

Operator, at this point, we would like to open the call up for questions.

Thank you, sir.

Ladies and gentlemen, at this time, we will begin the question-and-answer session. (OPERATOR INSTRUCTIONS) Alex Henderson, Citigroup.

A couple of quick -- just want to make sure I got it right questions.

Did you say that the timing on the share buyback was intending to do it in a fairly short period of 2 months?

Did I hear that right?

No, Alex. 12 months.

12 months.

I was going to say that's pretty unusual.

Okay, thanks, that helps.

Second, I thought I heard you say that the December quarter guidance was 47 to 48 million on operating expense.

Is that 47 to 48 million dollars or 47 to 48 percent?

Excuse me. 47 to $48 million in OpEx in the quarter.

Right.

And then third one along the same lines is, I'm a little surprised to hear you suggest that there is a potential of seeing a sequential flat result into the December quarter.

Considering you've virtually never seen that result happen other than the one quarter where you missed the December quarter.

That is certainly a sharp contrast from normal seasonality.

I realize that 10 percent coming from Avaya, that they're sometimes sequentially weak.

But can you explain the logic for that?

It seems like it ought to be pretty clear that you would be up sequentially, at least something.

Alex, this is Gordon.

I think Bill's guidance was flat to up 5 percent.

That covers a reasonable range that we're comfortable with.

Obviously, Alex, the goal will be up revenues, but given of some the risks we laid out, I think it is prudent to lay out the possibility of flat as well.

So, is it a function of concern about possibility of rollover in Japan again?

Or what -- it doesn't seem like the Avaya numbers are sufficient to be cause of that.

What's the root of that concern?

Alex, this is Gordon again.

You know, I'm not sure that we just expressed concern.

I think we gave you a range from flat to up 5 percent, which is similar guidance that we gave for this quarter.

So, there's no -- there's no particular item of concern for us.

You know, with Avaya being at 10 percent, we're really excited about that and as we noted, it was the end of their fiscal year, and so there was a push for year-end commissions by their sales team.

But that partnership also has been building for 2 years.

And you know, it has been a great, just steady improvement every quarter.

It does bounce around a little bit because there's some big deals.

I mentioned the deal in Italy that we did with them which was a pretty significant revenue for both of us.

So, there can be some lumpiness because of that.

But over the last last 7 quarters that we've had this great partnership going, we've seen steady strength.

So, no, we're not concerned, other than it was the end of their year and there was 1 pretty large deal in there.

Just one last clarification on the guidance.

Would it also be consistent to assume that normally you run a book-to-bill above 1 in the December quarter that that would also be your target given the historical seasonal patterns?

Yes, sir.

Mark Sue, RBC.

This is Jennifer Tenenbaum for Mark.

Just a couple of questions.

One, if you could talk a bit about 10-gig demand, like the types of customers, you're seeing whether it is service providers, etcetera.

And also the pricing on 10-gig, the trends there, if it has gone down significantly or that we've been seeing for the past few years.

Hi, Jennifer.

This is Gordon.

As we mentioned in the examples that I gave, 10 gilling is being utilized in both of our primary markets, that is in enterprise and in service provider.

We've seen this in large campus networks within enterprise.

We certainly see it within data centers within enterprise.

And as service providers start to rebuild their aggregation layer and their core, particularly in the anticipation of Triple Play and video, they're doing upgrades to 10-gig.

So we're seeing nice demand in that area.

In terms of pricing, so, you know, by the nature -- the price of technology declines over time, I think 10-gig is declining as we all anticipated.

For us to give a single number and say a 10-gig port costs this much is difficult.

And we get the question quite a bit.

But if you look at 10-gig in our product line today, we have it across 3 major product lines, that is across our BlackDiamond 10K for the core, across our BlackDiamond 8800 for enterprise aggregation, as well as in our stackable products.

And the price of a 10-gig port on one of our stackable products, like our X450 is frankly substantially less than on the 10K, having to do with the amount of bandwidth.

Kind of a long answer, but 10-gig is showing well in both markets.

We expect it to grow nicely over the next several years.

And we expect to see relatively consistent price declines on a per port basis, particularly in the area of optics extending out over time.

Okay, and do you think the pricing declines have steadied as compared to a few years ago, or -- ?

The overall pricing market?

Yes.

The overall pricing market.

I would say, you know, again, bearing in mind that this market always has declines in price.

It may not be over 12 months, but certainly over a 24, 36 month period.

I would say the pricing environment is very similar to what it's been throughout the year.

Subha Subramena, Sanders Morris.

2 questions.

First on gross margin.

Can you talk about what mix of modular and chassis-based products is doing to gross margin, and you saw chassis-based products dip below 50 percent.

Can you talk about when -- what you see in terms of mix going forward on that?

Subha, as far as a mix going forward of chassis versus modular, we would expect that modular sales do grow as a percentage of revenues and that our once again, 50 percent will eventually, notably above 50 percent of our total sales.

So I think that's the trend going forward.

I think this quarter was a bit unusual.

And in terms of the impact on gross margin, there is some impact on stackable versus modular.

That mix does impact gross margin, but not as much as you might think.

And for instance, we're more -- we benefit more from growth in new products generally, for instance, than a particular mix of chassis versus modular.

Great.

And then can you talk about federal -- what percentage of revenues does it represent for you?

It seems to be a strong vertical for some of your competitors.

Can you talk about whether that had an impact.

As far as the figures go, federal is a small part of our business.

Single-digit percentage of revenue and in terms of competitive trends, I'll let Gordon answer that.

Yes, Subha, we haven't had a lot of specific exposure in our business to fed over the last several years.

Next question please.

Tim Long, Banc of America Securities.

Just a few little quick ones, then maybe a longer question.

Bill, could you just talk a little bit -- just give us an update on what the FX impacts were in the quarter.

And then the second clarification, when you talked about the 10-gig port and the power over ethernet ports being up sequentially in bookings, could you just clarify, did that mean in dollar terms or number of ports?

And if it was dollars, was it the same complexion in revenues, meaning were revenues up for those products as well?

And then just the third one, maybe just talking a little bit about the XOS-based products, that you said we moved from about 5 to 20 percent over the past year.

Could you just give us a sense as to what impact that might have had on the gross margin line and where you think that could go, over the next year?

Okay.

Let me see if I can get through all of those questions.

In terms of foreign exchange impact on the results, sequentially, it was really very small effect.

Not material in any notable way.

In terms of 10-gig and PoE ports, when we talked about them being up sequentially, we were talking specifically about ports.

It would be true with revenues as well.

And -- but revenues are a little harder to calculate because you get into judgment areas, do you include chassis revenue versus blade revenue, et cetera.

But when we talked about sequential increases, we're talking about ports.

In terms of XOS-based products, yes, as XOS-based become a bigger part of our mix, that does help our gross margin.

It is one of the things that's helping drive the gross margin now.

We fully expect that XOS-based products will continue to grow as a percentage of revenues.

I'm going to stop short of putting a particular number to it.

But it is a strategic imperative for our Company, a strategic goal that we drive XOS in both the enterprise and service provider spaces.

Ok, Bill.

On that front though, is there anything that limits how quickly, from a mixed perspective, how quickly or how high that number could become over the next year?

Overall, of course, this is a -- the strategy that's playing out in our results, moving XOS from what was initially the high end of the product line with the BlackDiamond 10K, introduced 18 months ago, to then the midrange aggregation layer with the 8800, and now the high end of our stackable line with the XOS 450.

So, what one of the things that will be required to grow it is a percentage of revenue is more new products covering a broader part of our product line.

So, that will happen.

You should expect that will happen over the next 12 months.

And then in addition, we will be driving new features and capabilities into XOS as we go to -- in each quarter, I think, make the upgrade attractiveness to our existing install base higher and higher.

Samuel Wilson, JMP Securities.

Just a couple of small questions.

Mostly for Gordon.

I'm sorry, Bill.

First, can you describe a little bit linearity in the quarter?

I know normally August is a slow month.

But just wanted to get a sense for how that rolled thought quarter.

Linearity was pretty typical. 20, 30, 50 is typically what we see.

So, not that unusual.

Great.

Then can you talk a little bit about your national resellers, non-Avaya and just how that relationship building has been going.

I know you've been working on it for a few years and just kind of want to get an update on that.

Sam, there's not a lot to report there other than, we make a little bit of progress every quarter.

We did not have any 10 percent customers in terms of national -- I assume you mean U.S.-based resellers.

Right.

But that's -- again, been very unusual in the past.

So, again, our channels here in the U.S. are a very good mix of what I'll call the national resellers, and we would count Avaya in that group, as well as some very strong regional resellers and some large system integrators.

So, not a lot of shift there I guess I would say.

Ok.

And then lastly, just kind of a big picture question on R&D investment.

So, XOS is 2 years old now.

It is kind of well through.

You've rolled that technology and you're in the midst of the 10-gig upgrade cycle.

As you look forward 1 year, 2 years, can you give some sense as to kind of where you're focusing R&D investment?

Is it on some new services, security, more convergence?

Kind of more speeds and feeds?

Just some sense as to kind of where the Company is looking out a year or 2.

Yes, that's a hard question to answer in 60 or 90 seconds but I'll give it a shot.

You know, as we move forward, as you suggest, XOS is 2 years old now.

We built the basic functionality into the system so from kind of a speed and feeds of basic layer, 2 layer, 3 functionality, we're in very, very good shape.

Our investment in XOS is in adding software functionality in terms of adding the application program interfaces, working with partners in the security area and the void barrier to integrate the functionality.

So I would call it value add software that's being implemented in XOS above and beyond kind of the basic layer two, layer three switch functions.

So, over time, more and more of our engineering investment goes into software and more and more goes into that type of value add which creates differentiation in the market place and ultimately, we hope the margins.

William McLean, Oppenheimer.

Could you elaborate a little bit on what's exactly going on in Japan?

You know, with the strong growth in this quarter and the decline last quarter.

Is it related to developments in the market or related to developments in your channel approach to the market?

This is Gordon.

I think it is primarily due to new leadership team in place.

Kind of a renewed energy we brought into that organization.

In changing how we do business internally, so I would say it is largely extreme, internal factors.

Can I followup with a second question?

In the Avaya business, I understand it could possibly go down slightly in the next quarter but how big could that business eventually be in terms of your planning going forward?

What percentage of revenues?

Well, when we entered into the relationship, we had an internal milestone of getting to 10 percent of revenue and we really didn't think much beyond that.

We got pretty close in shipments, didn't quite make it, but we got there in bookings.

So, I wouldn't want to say that's our goal, that we'll stop working at it when we get to 10.

But that's where we would like to see it be and then work on building it from there.

Our real focus is on the converged marketplace and Avaya is an important channel to get there.

And we would like to have Avaya be an important partner in many parts of the world.

Today we've done some great stuff with them here in the U.S. and in parts of Europe.

I think we have a lot of expansion opportunities in other parts of Europe.

And we haven't really tapped Asia with them yet.

So, they're part of our overall channel plan and we've got a great partnership and some great development that we've done in terms of some common features.

Jiong Shao, Lehman Brothers.

I have 2 questions.

Before that, I missed the book to bill.

Could you repeat that?

Book-to-bill was below 1, as we expected for the quarter.

Okay.

Thanks, Bill.

My first question is on the guidance.

I know you guided revenue to be flat to up 5 percent.

I was wondering, could you provide additional color on sort of the regional trend, you're expecting?

Yes, On the sequential basis, Jiong, I would expect we could grow revenues in each geography.

It may be that one turns out flat and others grow more than expected, but I think from September to December, there is an opportunity to grow revenues in each of our geographies.

Okay.

Great.

And my second question is on the OpEx , it seems that you're expecting some OpEx reduction for the September quarter.

Is that right?

Because there is a bunch of numbers in the press release.

Well, on a non-GAAP basis, our expenses in the current quarter were at the high end of our range of $47 to $48 million and we expect in the coming quarter to keep them in that range.

Some expenses, some line items will go up and others will go down.

Cobb Sadler, Deutsche Banc.

First question on 10-gig, would you break that out as percentage of revenue, or is it still less than 5 percent?

We don't break that out as a percentage of revenue, Cobb.

Okay.

But it is relatively small still?

At this point, yes.

Okay, great.

And then, metro ethernet, you talked about 2 deals.

Telefonic and France Telecom.

Why would those -- are these kind of 1-time modernizations or would you not see some sort of budget flush in Q4 in Europe with more contribution by those deals?

And then secondly, where -- what's your pipeline look for new metro ethernet deals and where do you expect that to go as a percentage of overall revenue?

This is Gordon.

The term budget flush rarely applies to metro deals.

These networks tend to be very large and very complex.

They tend to be deployed over time.

So that may be over a couple of quarters.

In Japan, we have some networks that have been deployed over a couple of years.

Actually several years.

And they tend to be pretty consistent over that time period.

So, a lot of it depends on the size of the installation and the style of the particular carrier.

If you're starting from scratch, sometimes that actually goes a little quicker than when you're doing an upgrade, because there's no customer traffic and it is easier to plan.

So, if you look back over the last couple of years, our percentage in that business has bounced around the 20 percent range.

Sometimes a little higher.

Sometimes a little bit lower.

It was a little bit above 20 percent this quarter.

I think at the peak of the market in carrier boom, I think we got to around 30 percent.

But we use 20 percent as a planning number.

So, regarding the pipeline,we're working with a lot of existing and new customers as we look out to 2006, and people are planning some pretty good implementations.

Ok, great.

Would you say that the number of deals that you're addressing via RFPs is increasing or decreasing?

Are you seeing a ramp in RFPs or kind of the same that you saw 6 months ago?

I would say there are more new customer opportunities.

John Marc Duncan, Pacific Growth Equities.

In terms of Japan, I think that you had said in the past that it was a majority of service provider business.

And now that you've kind of done some retooling in the region, I'm just wondering, a little bit curious if this quarter, that mix changed at all.

It has been -- John Marc, this is Bill.

It has been bouncing around a little bit quarter to quarter.

This particular quarter, enterprise was up a bit from last quarter.

I do think that going forward for the next quarter or 2, we will see enterprise growing slightly as a percentage of revenues in Japan.

Okay.

And then in terms of your Asia business, it was up nicely for the quarter and I think you had an announcement earlier this quarter in terms of KT Ntopia's Triple Play network over there.

And I was wondering if it was a meaningful contributor this quarter and if it was, can we expect that to continue over the next several quarters here?

KT -- this is Gordon -- KT has been a long-term and pretty significant customer of ours for quite a few years.

So, no major uptick this quarter?

It was a contributor to the growth this quarter and we expect continued contribution to the growth in Asia Pacific over the next year from that account.

Tal Liani, Merrill Lynch.

I have 1 question left.

Stackable margins, the percentage of stackable went up and gross margin went up.

Can I make the assumption that the stackable margin is higher than the modular margin?

Tal, this is Gordon.

That's a difficult assumption to make.

Because during the quarter, we introduced the new stackable product, the X450, which is our first XOS-based stackable.

There was a lot of demand for that product.

It allowed people to basically complete an XOS network end to end.

And certainly the product does -- that particular product does carry very good margins.

So, I think Bill mentioned in his prepared remarks that it really has to do more with the newness of the product than whether it's stackable or modular.

No, I wouldn't come to that conclusion.

So, as you look into '06 and your planned roll-outs of products, do you expect that this family of products will naturally come under margin pressure as you ramp up the volume?

And is this sort of typical for stackable solutions?

Tal, when you say this family of products, do you mean XOS?

XOS-based stackable products.

XOS-based stackable products.

Let me address that.

The XOS-based products provide a platform for other applications to be loaded and to link to them through some APIs.

So, actually, we see the XOS products being higher functionality and most importantly, being used in the network in a different way.

So this is not a low-cost speeds and feeds edge product, just to provide low-cost connectivity.

It is something that new applications and new capabilities will be built upon.

So, although it is very difficult to speculate what the margin of any product is, our strategy as a Company is to increase the software content based upon our XOS platform, and by providing a lot of enhanced capabilities that we're able to command higher margins.

That's independent of whether it is a stackable or a modular system.

And Gordon, last question is about other partnerships.

Avaya proved to be successful as we see in the bookings of this quarter.

What about the next stage?

You see your -- some your competitors going to layer 4 through 7, into routing and into other areas, you said in the past you may not have an interest to go to these areas directly, but you may go there through partnerships.

Can you give us an update on this front?

I'm going to not be specific, but I think I can address the question you're asking in a general sense.

That is if you look at the areas that I outlined, and that is in convergence, security and metro ethernet, those are the areas that we're going to focus our partnership activities.

And I would say again, that a lot of that investment will be -- what I'll call outside the traditional layer two, layer three development.

Manny Recarey, Kaufman Brothers

Question is, looking at the product revenue.

That growth has been in the low single-digits for several quarters now and for the December quarter, it is probably going to be in that range.

If you get to your 10 to 20 percent that you hope the Company can grow for, that's going to have to begin to increase.

When do you see that starting and what would you see driving that?

Manny, this is Bill.

So, if you look -- you're correct.

If you do year-over-year comparisons, in the last 2 quarters, our revenue growth has been single-digits.

Revenue growth comparisons have been hurt on a year-over-year basis by our performance in Japan.

Outside of Japan, I think we've been doing pretty well, double-digit growth year over year in places like EMEA and the U.S.

So, our confidence in being able to generate double-digit year-over-year growth later in our fiscal year frankly comes from the change in comparisons to Japan -- for Japan rather, and the expectation that Japan from these levels will now be a sequential grower.

Such that in the second half of the year, we're getting year-over-year growth out of Japan as well.

Okay.

The growth in the U.S. and EMEA that you cited, has that been on the double-digit on the product side, or just the services side?

Or both?

Generally speaking, both, I believe.

I don't have every number in my head here for the last 4 quarters.

I would think you would find it has been both.

Long Jiang, UBS.

Bill, (indiscernible) question on gross margin.

You went up quite above expectation with in-line revenue.

And I mean this quarter, the mix didn't exactly benefit gross margin from a product mix standpoint.

So, do you think you know, the decline in new products that are cause for warranty reserve or increase in XOS, as percent of total product shipment, played a part in the expectation gross margin during the quarter?

Okay, so new product mix had a lot to do with the improved gross margin, sale of new products like the 8800, the X450.

Those certainly helped gross margin.

In addition, I don't want to understate the work being done in our operations group to lower product cost on a per unit basis, to roll out new versions of various components in cards, etcetera, that have helped our per unit cost on all of the products or all of the products we're selling in volume at the moment.

But a big part of the increase here is, as new products become a bigger percentage of our sales, it will be generally a good thing for our gross margins.

Okay.

Just as a follow-up, I mean given this pretty good gross margin here, I mean, do you have outlook for what kind of a long-term operating margin that you're targeting?

And also for this option expense, I mean you provided guidance for next quarter, or for the next few quarters, what about operating expense for next fiscal year?

And also do you have a tax rate guidance?

Thanks.

Okay.

A lot of questions there.

In terms of a longer term model, we've laid out a gross margin target of 54 to 57 percent of sales.

We would like to operate within that range for -- on a quarterly basis for this fiscal year.

And were we to be operating at the high end of that range as we're exiting the year and want to look forward, we'll reconsider the range at that time.

But for right now, 54 to 57 points is our targeted range on gross margin, and I think there is room to expand gross margins over the course of the year from where they are now.

On operating expenses, we would like to operate within this 47 to $48 million envelope per quarter for several quarters now, while we grow revenues and to expand profitability in that fashion.

And I think that was your set of questions.

Also, tax rate guidance.

Excuse me.

Tax rate guidance. 10 percent for the remainder of this fiscal year.

Do you have a rough outlook for next year?

Because I mean, that's a pretty big swing factor for next year.

It can be a large swing factor.

I would expect that as we get into next fiscal year we will be coming off of several years of profitability and therefore, we'll be changing our tax rate calculation to take less consideration of our ongoing tax loss assets.

And so I would expect the tax rate to go up in future -- in the next fiscal year, but I don't have any projection for you right now.

And also for option expense, for next year.

Do you -- given the recent ( indiscernible ) option investing, do you expect option expense to go up meaningfully in fiscal '07?

Option expense at $2 million a quarter, it will up in '07 as we do annual optional grants, etcetera, but I don't have a projection to give you today.

We have time for 1 more question.

Lucas Bianchi, SG Cowen.

I was wondering if you could talk about any products coming out over the next quarter or 2.

In particular, anything related to the video opportunity in the metro ethernet?

I think you at least mentioned video as a big driver there, and I don't know if you have anything specific to that area.

Thanks.

Lucas, this is Gordon.

I don't want to preannounce products other than to say that yes, we will have new products over the next couple of quarters.

Okay.

Is there any particular strategy that you're using for video, like in your current product portfolio?

Yes.

Would you be able to disclose anything like that or talk about it?

Broadly at least?

Broadly, yes.

Sorry you're the last one.

Seriously though, the whole area of entertainment class video does put a lot of strains on networks.

It is something that's quite challenging to deliver in particularly in high volume as you would see on a carrier network, and our products have a lot of capabilities, specifically engineered for very high performance, high density video.

A lot of it has to do with the multicast performance that we support and with very fine grained traffic shaping which allows, for example, in a network, the bulk of the bandwidth to be able to be reserved for video.

In other words, to pack a lot of video on a network and still have bandwidth reservations for voice which requires small amount of bandwidth but very consistent bandwidth.

So, we've really been pioneers in the area of quality of service for the last 10 years.

And have been a leading there.

That's one of the reasons we've done so much metro -- so many metro installations.

A lot of it has to do with quality of service and multicast and the ability to do traffic shaping and recognize certain types of media in realtime.

I guess again, on the metro side, are there any particular upgrades that you're looking for near term?

Upgrades come in 2 categories.

I would say bandwidth upgrades, where people may be on a 100 megabit gigabit and want to go from a gig to a 10-gig.

So, in order of magnitude increase in bandwidth requires you to basically rebuild the aggregation and core.

So that's one aspect of it.

The other aspect of it is to deliver these other services and that's the ability to differentiate between different types of data on the network and give it different treatment.

And again, that's an area where we've deployed a lot of technology.

I guess more specifically, is there any particular reason why you might think Japan is going to increase going forward, just simply because of this build-out of additional capabilities there?

Well, our businesses in Japan is based upon 2 areas.

One is the carrier business, and the other is enterprise.

And we do expect both of those to grow.

And on the carrier front, I should say on the metro ethernet front and video, I would just say stay tuned.

Thanks, everyone.

Thank you, management.

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