Extreme Networks Inc (EXTR) 2006 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to Extreme Networks fiscal second 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. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded today, Tuesday, January 24, 2006.

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

Please go ahead, sir.

Thank you, operator.

Good afternoon, everyone.

Thank you for joining us.

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 Q2, FY 2006, a copy of which is 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 are subject to risks and uncertainties that could cause the actual results to differ materially.

In addition, some 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 and Form 10-K 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 to everyone for joining us this afternoon.

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

First of all, let me say that we're pleased with how we are managing many aspects of our business, as we're able to generate sequential net income, increased margins and increased cash flow.

We executed on our stock buyback program and reduced our operating expenses.

We achieved our earnings goals even though revenue did not meet our expectations.

Net revenue for the quarter was $92.8 million and net income for the quarter was $5.7 million, or $0.05 per diluted share on a GAAP basis.

Excluding stock-based compensation expense of $1.6 million, non-GAAP net income for the quarter was $7.2 million, or $0.06 per diluted share.

This is an increase sequentially from $0.05 per diluted share reported last quarter.

We experienced strong growth internationally this past quarter.

Both our EMEA and Asia-Pac regions increased revenue.

EMEA had revenue increases both year-over-year and sequentially.

And in our Asia-Pac region, we saw a very strong quarter, a year-over-year increase of $7.4 million.

Japan, a region that I discussed in detail last quarter, continued its recovery and enjoyed an increase in revenue.

Our Americas business did not achieve the revenue that we planned.

Our challenges were mostly in the U.S. market, where some large deals that we anticipated were pushed out beyond quarter end.

In addition, I don't believe that we managed our pipeline as well as in previous quarters.

We've already undertaken steps to address the U.S. market.

We've made management changes at a variety of levels and identified actions to better track and increase our sales pipeline.

We will aggressively be hiring additional sales and systems engineering teams in the U.S., and our Vice President of World Wide Sales, Frank Carlucci, will provide direct attention to the U.S. market working closely with our regional directors.

We've also added a seasoned sales executive to drive our U.S. federal business.

As I mentioned earlier, this quarter resulted in sequential improvements in our gross margins, profitability and cash generated from operations.

These results demonstrate our ability to firmly manage our business and enable us now to focus on increasing revenue going forward.

Let me touch on a few more financial details.

Last quarter we announced a $50 million stock repurchase program.

During this recent quarter, we began implementing that plan and repurchased $6.8 million in stock.

We are executing to our internal plan and will continue to do so going forward.

We increased gross margins during this past quarter.

This marked eight consecutive quarters in which gross margins have increased on a year-over-year basis.

Our gross margins for the second quarter on a GAAP basis were $54.7%.

Excluding expense for stock-based compensation, gross margin was 55%.

This is an increase from 53.8% from the same quarter last year.

Again, this was the eighth consecutive quarter of gross margin increases.

We continued our drive toward efficiency and higher profitability by reducing operating expenses during the quarter.

On a GAAP basis, operating expenses were $45.7 million.

Excluding stock-based compensation of $1.3 million in the quarter, operating expenses were $44.4 million, or 47.8% of sales.

This is a reduction of $1.7 million compared to the same quarter a year ago.

We generated cash from operations during the quarter of $12.7 million.

After $6.8 million for the stock repurchase activities, we ended the quarter at $456.3 million, an increase of $6 million from the first quarter of fiscal 2006.

Again, to be clear, we increased cash over and above our stock purchases.

Bill will go into more detail a little later.

At this point I'd like to review our strategy going forward.

As we had previously stated, our focus is on convergence, security and on the Metro Ethernet market.

First convergence.

As many of you are aware, Extreme has been promoting our customer-oriented strategy for handling the convergence of applications occurring on today's networks.

Our architecture and vision of open converged networks places us in a unique position to help enterprises and Metro Ethernet service providers build infrastructure that offer the availability, security, voice quality connections, and ease of management required to run voice and video.

Our approach allows users to build a network foundation that promotes intelligence allowing for collaboration between corresponding network devices throughout the network infrastructure, and our approach permits customers to integrate best in class technology for their own customized technology pass not their vendors.

We believe this open and focused approach to convergence will allow us to capitalize on the underlying market requirements and grow our revenue in the future.

A key piece of technology in our open converged network architecture is our BlackDiamond 8800 switching solution, the first switch to deliver true voice class availability at the edge of the network, the BD 8800 continues to attract new customers.

Its combination of our award winning Extreme XOS operating system, convergence-ready hardware, and excellent price performance makes it an ideal solution for converged networks and the key component of our growth going forward.

We talked in the past about the importance of our software and, specifically, of our modular operating system, XOS.

During the quarter, we completed a major new release of XOS that delivers many new capabilities to the market.

Development was focused on providing network availability and enhanced security for converged networks.

Specifically, with the software release, we delivered what is called hitless failover for our BlackDiamond 8800.

Hitless failover provides for the continuous operation of the network in cases of certain failures.

Our implementation even allows power for devices such as IP phones to be preserved allowing no interruption to voice over IP services.

This is very important to keep business quality voice over IP conversations going.

We also added new security capabilities, including network log on functionality for secure network access control.

We made these enhancements because customers' expectations are that voice over IP calls are not interrupted when a change in a network occurs, even with functionality such as network access control turned on.

Now, our unique open approach was recently recognized by global growth consulting company Frost & Sullivan.

Extreme was the recipient of its 2005 Product Line Strategy Award for the enterprise switch market.

We were singled out for our innovative approach to providing an integrated software and hardware network solution that helps customers implement voice over IP and establish network security, as well as integrate wired and wireless infrastructures.

An integral part of our strategy for being the leader in open converged networks is our global strategic partnership with Avaya.

There are two parts to our relationship.

A strategic re-seller arrangement and a joint technology development program.

We recently extended our technology development agreement for another year after having previously extended our strategic resale agreement earlier last year.

Together, our two Companies continue to attract new enterprise customers seeking to deploy market-leading IP telephony applications and our innovative infrastructure to run them.

While the contribution from Avaya was lower this quarter due to seasonality, as this was the first quarter of their new fiscal year, this partnership continues to open doors for us and we believe will help drive growth for us in large and mid-enterprise market.

Now I liked to take a moment and review some of the many customers that relied on our open approach to converged networks to run their businesses.

Extreme Networks is now working with Nike, the world's leading designer, marketer, and distributor of athletic foot wear.

Nike is implementing the campus extension at its Beaverton, OR headquarters, in conjunction with MCI, a managed service provider, as well as our IP telephony partner, Avaya.

This customer chose Extreme Networks' secure and available switching solutions over our leading competitors based on our degree of innovation and performance.

Nike's new employee facility necessitated network access to their campus LAN.

With our quality of service, bandwidth management, and power over ethernet, the network will easily allow Nike to migrate to voice over IP applications in the near future.

At Cal Tech, Extreme Networks' BlackDiamond switches were part of a record breaking bandwidth challenge as part of the super computing 2005 event in November where a team of leading scientists and engineers collaborated in a demonstration of high performance grid computing.

The result was a new world record for data transfer over a global network.

Using our line rate 10 gig bandwidth and our low latency features to aggregate server traffic, the winning team was able to sustain more than 130 gigabits of traffic over an optical network.

In Mexico, the government's INSP, a national health services institution, selected Extreme Networks as the underlying network technology for its 17-hospital system.

Focus on specialty health areas, such as cancer, nutrition, and cardiology, INSP has in place a master strategy to implement leading edge health technologies throughout its system with network infrastructure being the first stage.

Our network switching technologies are positioned with our IP telephony partner, Avaya, to serve as the most reliable converged voice and data solution.

For the second driver in enterprise networking today beyond convergence is security network.

At Extreme, we offer the customer a solution addressing the entire infrastructure, not just the perimeter.

As we have done in the past, we combine our culture of innovation and different perspective along with customer feed back to develop our solution.

The result is a security solution that makes securing the infrastructure easier to manage and much more robust.

We believe this approach to security will be an important part of our growth going forward.

We base our solution on a technology that we invented called CLEAR-Flow.

CLEAR-Flow is a programmable security rules engine that is built into our ASICs.

Because CLEAR-Flow is ASIC-based it operates at full 10 gigabit per second speeds, making it very high performance and suitable for use even in the largest networks.

This hardware centric approach also allows the switches to keep working even while the network itself is under attack.

The strategy of enhancing customer security by integrating security into the core of the network is complimentary to the current base of perimeter security solutions commonly used.

Our approach to integrating security into the network provides users with a solution that keeps the network up and running.

We frequently hear from IT professionals that this is exactly what they need to secure their networks and focus on their businesses.

This is a strong differentiator for Extreme going forward and will be an ongoing area of investment for us.

The third business driver for Extreme is the Metro Ethernet market.

This market is and always has been a key market to Extreme, generating between 20% and 25% of our revenue.

Metro Ethernet sales contributed much of our strong growth in Asia during this past quarter.

Since early 2000, Extreme has been a pioneer in this market.

From our cries of Sonnet [PH] is dead to Ethernet everywhere, we have helped build this market and both drive and enabled the movement to ethernet-based Metro networks.

We have invented and delivered several technologies, such as our Metro Ring protocol called EAPS.

EAPS, which is an acronym for Ethernet Automatic Protection Switching, delivers high availability and resiliency at carrier cost levels.

The strength of this technology and our experience in building large scale networks with EAPS is a competitive differentiator for us in the expanding market.

Our vMAN technology that helps segment network traffic to increase network efficiency and scalability also demonstrates our ability to differentiate and redefine the market, which should contribute to our growth.

The growing trend of entertainment services over the internet signals a need for networking technology that can meet the availability requirements.

With our history of delivering carrier class technology, our XOS software and some upcoming extensions, Extreme is firmly positioned to leverage the opportunities in this growing market.

In addition, as more and more service providers use ethernet to offer residential services, the fact that Extreme has a solution that provides a platform that delivers both business and residential services greatly strengthens our value in this market.

I'd like to review a few Metro Ethernet customers that are relying on us for emerging triple play applications.

First, Finland's Vaasa Telephone Company is using Extreme Networks for converged triple play services.

Supporting this metro network serving thousands of customers on Finland's west coast, Vasa delivers voice, video and data over a high performance 10-gig network between two cities.

Vaasa is relying on our BlackDiamond 10k switches for the network core and Summit switches at the network edge.

Today, the network aggregates more than 30,000 combined fiber to the home and DSL connections carrying broadband traffic for phone calls, internet connections, and video.

Also during the quarter, Korea Telecom, one of the world's largest telecommunications providers, continued to work with Extreme to build out its NTopia Metro network, providing residential ethernet access.

Korea Telecom supports video on demand applications, as well as VPNs, broadband internet, and voiceover IP services for more than two million subscribers.

Our Alpine switch provides a quality of service, bandwidth, and Layer 3 services that are essential to these converged services.

Again, I would like to emphasize the opportunity we have in the Metro Ethernet space.

Its strong technology base, a number of technology innovations that differentiate us, and the experience to help carriers build up the next generation of ethernet broadband networks.

Our investment in this market, hopefully, will bear fruit this calendar year as we introduce some new purpose built products for this market.

So to quickly summarize the quarter, we're pleased with our ability to manage certain aspects of our business.

We are focused on growing revenue and we're optimistic that we can capitalize on the growth drivers, convergence, security, and, particularly, Metro Ethernet going forward.

Now with that, I'd 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.

This was a good quarter for profitability and improvements in our base operating model, and we did meet or exceed many of our financial goals for the quarter.

Gross margins as a percentage of sales expanded again, operating expenses were down notably in dollar terms, and profitability in earnings per share were improved on the sequential basis despite lower revenues.

Cash generation was very good, as well, with $12.7 million in cash from operations and the repurchase of $6.8 million in stock.

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 it's also a tangible evidence of our commitment to improving shareholder value at Extreme over time.

This was also a good quarter for revenue growth outside the U.S. with international revenues up 15% sequentially and 7% year-over-year.

Our performance in the U.S. was weak, however, and impacted our overall growth rate.

Gordon has taken you through some of the steps we are taking to address this going forward.

Revenue for the quarter was $92.8 million, consisting of $77 million in product revenue and $15.8 million in service revenue.

Our book-to-build was slightly above one.

Service revenues were up 9% compared to the year ago quarter and down 1% sequentially.

Product revenue decreased 6% sequentially and 10% year-over-year.

Shipment of modular products represented 45% of sales with stackable products representing 55%.

The split of enterprise sales and service provider sales was 74% to 26%, similar to Q1 and generally consistent with our typical mix.

XOS-based products continued to help drive revenue growth and gross margin expansion for us.

All told sales of XOS-based products represented more than 25% of total product bookings during the quarter.

We saw solid contributions from the BD 8800 and our XOS-based stackables.

Sales of some of our older chassis products declined, consistent with a shift toward newer products.

New bookings for PoE ports were also up sequentially.

We saw solid increase in the sales of PoE blades for the BD 8800.

New bookings of PoE ports represented more than 10% of our total port bookings.

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, resellers -- excuse me, both direct and Avaya resellers, were down sequentially in what is a seasonally slow December quarter for Avaya sales.

Avaya-related revenues and bookings were up strongly compared to Q2 a year ago.

And Avaya represented between 5% and 10% of total Company revenues in the quarter.

Looking at revenues geographically, in EMEA our European operations, which includes the Mideast and Africa, our revenues were $31.4 million for the quarter, up 5% compared with the same quarter a year ago, and up 4% sequentially.

During the quarter, we saw strong growth in Germany and eastern Europe in particular.

Revenues in Japan were $11 million, up 2% sequentially compared to the September quarter.

This is a good outcome for us.

The second consecutive quarter of flat to up revenues after a period of sequential declines in quarterly revenue in Japan.

Revenues in Japan were helped this quarter by one of our largest wireless wins to date.

Looking at Asia outside of Japan, revenues were 16.6 million, up 45% from the September quarter and up 80% from the second quarter a year ago.

Revenues from Asia can be lump for us as a result of a high contribution from service provider business, but this was a very solid result and our strongest quarter in Asia Pacific in over three years.

Our international revenue growth of 7% versus Q2 a year ago was a good result and in line with our goals for the quarter.

In the U.S., however, revenues were weak.

Revenues in the U.S. were $31.9 million, down 27% compared to the second quarter a year ago, and down 29% sequentially.

Revenues were particularly soft in the month of December.

It is certainly fair to say that we did a poor job of forecasting our pipeline, both deal timing and closure rates.

Gordon has taken you through the steps we are taking to address our revenue growth in the U.S. and as a result of these steps and the number of deals deferred into the current quarter, we do expect that U.S. revenues will be up in March despite typical seasonal trends.

Turning now to cost and expenses.

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

These expenses added $1.6 million to our total cost for the quarter.

For those of you who want to note it in your model, the breakout of these expenses by P&L line item in the quarter was as follows: $196,000 increase to product cost; $92,000 increase to service costs; $594,000 increase to sales and marketing expense; $442,000 increase to R&D expense; and $250,000 increase to G&A expense.

This breakout is all included in Table 4 in our press release.

Looking at gross margins, not including stock-based compensation, total gross margin as a percentage was 55%, up from 54% sequentially, and 53.8% a year in the same quarter a year ago.

Both product and service gross margins were up sequentially in year-over-year.

Excluding stock-based compensation, product gross margins were 56.7% compared to 56.4% in the September quarter, and 55.7% in the year ago quarter.

Service gross margins, excluding stock-based compensation, were 46.8%, compared to 46.3% in September, and 42.3% in the same period a year ago.

Gross margins are up sequentially despite lower volumes, primarily as a result of more favorable product mix, lower overhead rates, and reductions in per unit product costs.

At 55% total gross margin, we are operating in the target range for gross margins that we have previously laid out for investors.

We do believe that gross margins on both product 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 that 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 $44.4 million, not including stock-based compensation.

This was down from $47.8 million sequentially and from $46.1 million in Q2 a year ago.

Sales and marketing expenses declined by $1.7 million sequentially as a result of lower variable cost and less spending on product introduction.

G&A spending decreased $1.1 million, in part, as a result of lower legal expenses in the quarter.

R&D expenses declined $500,000 sequentially to $15.2 million.

Our expenses overall, particularly G&A and R&D, also benefited from holiday shutdowns in some groups.

Of note, head count at quarter end stood at 835, up from 795 at the end of September.

The bulk of the increase in head count was in engineering, primarily in our new facility in Chennai, India.

It actually has resulted in cost savings as a result of bringing in house previously outsourced work.

Sales head count was also up sequentially.

Looking at net income in Q2 on a GAAP basis, we reported operating profits of $5.1 million, adding in $1.4 million in net other income results in profit before tax of $6.5 million and after tax of $5.7 million, or $0.05 per share on a diluted EPS basis.

On a non-GAAP basis, excluding stock-based compensation, operating profitability was $6.7 million or 7.2% of sales, up from 5.9% in September, despite lower revenues.

Profit after tax was $7.2 million, or $0.06 per share on a diluted basis.

Compared to Q2 of last year profitability is down from $10 million, or $0.08 per share.

A reminder, our results last year included $3.9 million, or $0.03 per diluted share, for a consumption tax refund received in Japan.

The tax rate for the quarter was 13%.

Total shares used to calculate EPS in the current quarter was $124.8 million.

Total shares outstanding at quarter end were $122.3 million, down 900,000 shares from the end of September.

Cash and cash equivalents, short term investments, and marketable securities totaled $456.3 million, up $6 million sequentially.

Cash from operations was $12.7.

Net inventory at quarter end was $21.9 million, up slightly from $21.4 at the end of Q1.

Inventory turned stood at eight for the quarter in line with September quarter.

Accounts receivable were $33.6 million, up $3.5 million sequentially.

DSOs at quarter end stood at 33 days, up from 28 days at the end of Q1.

Accounts payable were $22 million, up $4.4 million sequentially.

During the quarter we used $6.8 million to repurchase shares reflecting a pace that was generally in line with our previously stated goal of completing our $50 million share repurchase program within 12 months.

You will note on the balance sheet that our $200 million convertible note has been reclassified to short-term liabilities, reflecting the fact that it is due in the coming December.

Currently our plan is to pay down the debt when due.

Some other items to note, depreciation and amortization for the quarter was $3.7 million and capital expenditure for the quarter was $1.6 million.

Turning now to guidance, the revenue in the March quarter we currently anticipate that our revenues will be in the range of $90 million to $95 million.

We do expect to see seasonally lower revenues outside the U.S., but we expect that revenues in the U.S. will be up from an unusually low result in December.

On gross margins, our expectations for the March quarter is that gross margin as a percentage of sales will likely be flat to down somewhat from this quarter's 55%, not including stock-based compensation.

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

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

On operating expenses in Q3, we expect our total operating expenses will be in a range of $44 million to $46 million, not including stock-based expenses.

This is down notably from our previous guidance of $47 million to $48 million.

In other items for your model, we expect net interest income of approximately $1.2 million to 1.4 million a quarter.

We anticipate a corporate tax rate of 10% to 15% throughout the remainder of fiscal '06.

We anticipate that stock-based compensation will continue to run at a quarterly expense rate of $1.6 million to $2 million, approximately.

As for the impact of our share repurchase program on cash balances, interest income and share count, we will make no particular further forecast on this, other than to note it is our expectation to complete the $50 million program over the course of the next nine 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% of our business done in the last month of the quarter, and so it is fair to say our visibility can be limited.

It is also a case where one or two large deals a quarter can make the difference between sequentially up or sequentially down revenue.

Before I turn the call over to Gordon, I would like to note that Extreme will be holding an analyst meeting in New York on March 2, which is a few weeks later than we have in the past.

Invitations will be going out shortly.

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

Thanks Bill.

To conclude, I just wanted to thank our team here for their hard work in improving our business model and for their focus on increasing margins, for lowering costs, and providing stronger leverage to our business model.

With that, I liked to open the call to questions.

Operator?

Thank you.

Ladies and gentlemen, at this time, we will begin the question-and-answer session. [OPERATOR INSTRUCTIONS] One moment, please, for the first question.

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

Please go ahead.

Hi, Gordon, hi, Bill.

Hi.

I think Extreme has missed three out of the last four December quarters, but you've always managed to grow revenue sequentially in every single June quarter.

Is it a sales force incentive issue or is it something else?

And what component of the miss in the U.S. was end market weakness or was it execution?

And did you see some CapEx slush at the end of the quarter?

There's a number of questions in there, Mark.

And I'll address the last one in terms of was it market weakness or internal execution?

As we stated, I don't think we did a great job of pipeline management, although I can certainly put my finger on a number of large deals that we did anticipate we would ship within the quarter that were delayed beyond the quarter boundary.

Any thoughts just on how you can change your incentives so that you can have sequential growth moving forward in the December quarter versus having very strong June quarters?

Well, I don't have a good answer to that, Mark.

I'm not sure that a sales incentive program is at the root of this problem.

Got it, and what was the book to build?

I don't think I caught that.

Slightly above one, Mark.

Thank you.

Next question, please.

Thank you.

Your next question comes from Alex Henderson with Citigroup.

Please go ahead.

Well, so, June quarter you guys had a major debacle in Japan and we were waiting for that to roll off here in the March quarter so you can get back to a growth trajectory.

Now you're busted in the U.S.

How should we be thinking about this Company's growth prospects over time when you can't seem to put together more than two or three quarters without having a serious debacle in your operations, which looks like from everything we can tell was more Company specific than end market specific.

Yes, Alex.

Like this is Gordon.

Like I said in the last answer, you know, we do accept that there were operational issues in the U.S., but we also, you know, did see some behavior of delays, just delays in terms of business that we have won but that, you know, was not delivered.

And we are very focused on the U.S. operations.

It is our largest market.

But I do want to comment that the other markets, in terms of Europe an Asia, did have very, very strong quarters.

If I could follow-up, certainly the guidance here is below anybody's forecast for the March quarter.

So we're still, even with business being delayed out of the quarter, would still look like you're well off the growth curve that anybody had anticipated coming into this earning's release.

Either the street's missing something or your execution's got some more serious problems to it.

What is it, specifically, in the environment that's causing the periodic miss one geography at a time the way you've been seeing over the last year?

To be blunt about it, you still haven't grandfathered the problem in Japan yet.

Well, you know, again, there's a couple questions in there, Alex.

In looking at Japan, you know, we had Japan used to be a very high percentage of our business, you know, in the high teens and low 20s.

And as the carrier buildouts there have been lumpy, we saw that, you know, drop to a lower level.

But that has grown over the last couple quarters and, although we haven't seen a high level of growth there yet, you know, we've put in place, I believe the right infrastructure to head that direction.

Specifically, on Japan.

Thank you.

Your next question comes from Natarajan Subrahmanyan with Sanders Morris.

Please go ahead.

Thanks.

If I could take another shot at what happened in the U.S.

Are you suggesting that some of the delays and deal closing that you saw were market phenomenons and can you talk about overall activity?

Was it end of the quarter deals didn't close, which, did it affect your linearity?

Yes.

This is Gordon.

The decline came, as Bill mentioned, largely in the month of December, and we did see business delay from both new and existing customers.

So I don't believe this was a situation where we were looking for big budget flushes.

We had a pipeline there and we had expectations for revenue coming in and this deferral came literally during the last several weeks of the quarter.

It did catch us by surprise.

Understood.

Was part of it Avaya related or was this just alone Extreme sales?

It's hard to break out whether it was specifically related to Avaya or to, frankly, a particular channel.

But at these levels of revenue, you know, we do have some very large customers, particularly in the large enterprise space.

And when you look at, you know, a million dollar deal or larger deal that moves across a quarter boundary, that can have a very significant impact on our overall sales level, clearly.

You know, that said, we are proud of the fact that even given that drop and those deferrals that we were able to maintain our profitability at a very high level.

Relatively high level.

Got it.

Thanks.

Thank you.

Next question, please.

Your next question comes from Samuel Wilson with JMP Securities.

Please go ahead.

Good afternoon.

A few small questions, but a number of them.

First, what was linearity for the quarter?

If it's normally 20, 30, 50.

What was it this time around?

Well, Sam, it was slightly better than that.

But that was as a result of coming in with a hole in the revenue the last week or two of the quarter.

Got it.

Okay.

And how about U.S. federal business in particular?

Did you notice anything there?

Was it mainly, you know, U.S. enterprise was the problem?

Our federal business experienced the same issues our enterprise did in the U.S.

Got it.

Then lastly, kind of two other questions.

First, book to bill slightly above one, but you had deals push out at the end of the quarter.

Does that mean the deals, in fact, have not been booked yet?

Yes, that's what we mean by a deal having been pushed out.

It was not signed, not booked, it's not in the backlog.

Got it.

And lastly, why is accounts receivable up quarter-on-quarter if, at the end of the quarter, you had kind of a revenue falloff?

A lot of that stuff should have been through the billing cycle, and usually you would see DSOs go down in those cases.

It was a function of particular channels and mix.

We were doing our business and some of our larger resellers have more favorable terms than others.

Got it.

Thank you.

Thanks, Sam.

Your next question comes from Christin Armacost with SG Cowen.

Please go ahead.

Thank you.

Could you tell us how much exactly Avaya was down sequentially in the quarter, and also on some of the new products can you give us a sense of their contribution and sort of the wireless LAN in the security areas?

Christin, we don't break out Avaya sales directly quarter-to-quarter.

But it was down a few million dollars, enough to impact things.

As it relates to new products, XOS-based products and new product revenues they were up as a percentage of revenue, in some cases up in dollar terms sequentially, but in other cases down in dollar terms sequentially, primarily as a result of what was happening in the U.S.

Thank you.

And then in your OpEx you're making good progress in bringing the OpEx down to the 42, or 44 to 46 million.

How are you driving your OpEx down there in terms of either employee head count or sales and marketing in R&D by the major expense category?

Yes.

In some cases, we have recently opened up our facility in Chennai.

What that has allowed us to do is bring in-house functions we were previously doing outsourced and actually in doing that we've had a very positive effect on R&D, among other things.

On the sales and marketing side, the revenues -- excuse me, operating expenses are coming down with revenues and in some cases a little bit more focus on where we're investing dollars, particularly in the recent quarter as it relates to product intros and such.

And on the G&A side, having worked through some of the previous legal issues that's helping us on those operating expenses there.

We'll continue to work this and I think the $44 million to $46 million a quarter range is a range you can use for a few quarters yet.

Great.

Thank you, Bill.

Thank you.

Thank you.

Your next question comes from Tim Long with Banc of America Securities.

Please go ahead.

Thank you.

A few questions here.

Back to the margin side.

Having the similar type of operating margins on a lower revenue base, I'm just curious since the miss was very late in the quarter, surprised you were able to swing your OpEx that much or your manufacturing absorption.

Should we assume that had that revenue not missed or pushed out, that you were managing the business for 10% plus operating margins or is there something I'm missing there?

Second question when you talk about the U.S. market being up sequentially, I think Gordon also mentioned some management changes that are occurring.

Could you talk about any potential impact that those management changes may have on your near-term business?

Seems like that could be a risk there.

Then, third, if you could talk about the new sales hire in federal, what's your sense of timing for a little more traction in that business?

Does there need to be more certification to get into some of the larger programs?

Okay.

So lot of questions there.

Let me try and handle the operating margin question.

We previously laid out a goal of getting our operating margins to a 9% to 14% range sometime during this fiscal year.

So you can assume that we are trying to run the business to get into that range.

We're doing so for the current quarter.

Yes, you might infer that had we run at higher revenue rates, certainly operating profits would have been higher.

Some of the ability to turn expenses on short notice included things like holiday shutdowns, et cetera, which could be implemented.

And as far as the federal, new changes in federal, Gordon, I'll turn that one over to you.

Yes, Tim, let me address some of the organizational changes.

I want to be clear that these changes have already happened in terms of the organization.

You know, we are ramping the head count in the U.S. and, you know, given the percentage decline, I do believe that there's upside ahead of us in that market.

In the federal, we did bring on a new leader of that business.

You know, during the December quarter and, you know, as you suggest there is a long tail on some of those deals.

But we do have an installed customer base there and we do expect to see, you know, revenue from that customer base, as well as an aggressive push towards winning some new business there.

You asked about certifications, and the answer -- the short answer is, yes, we do have the certifications.

There's a long list and we'd certainly be happy to go through that with you offline.

Okay.

Thanks.

Next question, please.

Next question comes from Jiong Shao with Lehman Brothers.

Please go ahead.

Thanks.

I'll stick with one follow-up and one question.

The follow-up is for the deals got pushed out to March, I was wondering, could you talk about how many of them, if any of them, half of them have been closed, have been booked?

I will ask a question later.

This is Gordon.

I think that's, you know, given where we are in the quarter, very early on.

I don't have a good answer for that yet.

Okay.

Gordon, I have a little bit longer term question for you.

If we look at the space, the enterprise LAN switching space, it seems like over the last seven, eight years the number of players in the space has been increasing to the -- lot of the process, increasing in somewhat commoditized and the long talked about industry consolidation hasn't happened.

So I was wondering could you talk about what are your views on this space and if the industry starts to consolidate where Extreme stands?

So.

There's, again, a couple questions in there.

Let me address, Jiong, the question of commoditization.

I think one thing that's difficult today is that a lot of the market research firms have bunched a lot of products together.

For example, taking Layer 3 products and Layer 2 products.

The line's blurred and so they've grouped all those products together.

If I look at some segments of that market, and let's say, for example, the small and medium business segment, I would tend to agree that is commoditizing and the functionality is pretty high in a lot of companies' products and certainly sufficient for a small business to build a network.

And we all see that in the networks we've built at home in terms of the cost of products.

I think when you come to the large enterprise market and certainly more particularly to the Metro Ethernet market, which are the two markets in which we participate, that it's far from commoditization.

The skills, both in terms of the support skills, the systems engineering skills, and the products and technology that's necessary to build a 10,000 or 20,000 or 30,000 node network, is significant, and, although I would agree with you that there are more players in the overall switching business than there were eight years ago, there aren't more players in the large enterprise space in that a lot of the new entrants have approached it from the very low cost segment in addressing the small and medium business.

So I hope that answers your question.

Okay.

Thank you.

Next question, please.

Our next question comes from Long Jiang with UBS.

Please go ahead.

Yes, hi, good afternoon.

Couple questions.

Very nice sequential growth in Asia Pac.

Just wondering, was this growth concentrated in one to two carriers or was it more spread out?

And also, you mentioned the growth was driven by some project-related upgrades.

Can you tell me how long were such upgrade projects typically last before the spending trailed down?

Yes, this is Gordon.

The second question, again, in terms of when you look at upgrades it depends very much on the particular customer.

So I hesitate to make any generalizations.

We've seen in some parts of the world a network upgrade where we have one, the next generation network.

We've seen that upgrade be installed over the course of many quarters, six, eight quarters.

There's other cases in some other regions where we see an upgrade go through, you know, pretty quickly and sometimes within a single quarter or bridged over two quarters.

So that's something that's very difficult to predict.

Again, as the carriers operate.

That business does tend to be lumpy.

And, Long, as far as where the revenue came from, it was spread across multiple carriers and, in fact, multiple countries in Asia Pac.

Okay.

Thank you.

My second question has to do with the product mix between module and stackable.

Yes.

For several quarters the mix, the percentage of modular switching continued to decline.

You had said that you expect the mix from modular switching to eventually recover to about 50%.

You still expecting that to happen sometime during the year or do you think it's going to be pushed to next year?

And what will be the catalyst for the module switching to go up?

Well, the catalyst for it to become a more 50/50 mix would be stronger sales in the U.S.

It is just the nature of our business that outside the U.S., we have a higher mix of stackables generally in the revenue stream and inside the U.S. it's a slightly higher mix of modulars.

And so the fact that U.S. revenues were unexpectedly low this quarter also affected the mix of stackable modular.

So as the U.S. recovers and becomes a more traditional part of our total revenue stream, I would expect stackable and modular to shift around.

Okay, one last quick question.

One more.

Okay.

Are you going to pay off the $200 million convertible debt by the year end?

And you're going to continue to carry out this share buyback program?

What kind of net cash level are you comfortable with on the balance sheet?

Yes.

I think that the right sort of net cash balance for a Company like us to carry is something around 50% of revenues.

And at a balance plus or minus that number I think we're at the right balance.

It's certainly more than enough to run the business day-to-day.

Gives you a little flexibility to be opportunistic on things and gives customers comfort.

And thinking on the use of cash to both repurchase shares and pay back the note.

With that let me move on to the next question.

Next question comes from John Mark Duncan with Pacific Growth Equities.

Please go ahead.

Good afternoon.

Can you talk a little bit more about the U.S.

You said you experienced some deal pushout and also some pipeline management issues.

Can you explain if there's -- or talk about if there's any turnover, you know, that's affecting execution here?

So as we said, there have been management changes that have been instituted.

So, you know, certainly there is some turnover, yes.

Okay.

But there's been some -- management changes instituted, I mean there seems to be at least, you know, you do hear regionally that there's certainly some sales turnover in North America beyond kind of, maybe, some forced management changes.

Yes.

You know, again, let me directly address your question and say that, yes, there has been turnover in the sales force and certainly that impacts results.

Okay.

Then on to Japan.

Obviously, it looks like we did have a little sequential improvement here for the quarter.

Can you talk about kind of the expectations that you have as we go into 2006 here?

I think you've laid the ground work in terms of distribution and maybe trying to get into the enterprise.

Do you see some opportunity for carrier upgrades in that region or what are you thinking along the lines of Japan?

Okay.

I want to be clear and say you asked the question about the calendar year, so my comments are about the calendar year and not any particular quarter.

But we do see significant opportunities in Japan during calendar year 2006.

We have a large installed base of Metro Ethernet within the Japan market across many, many customers.

Some of those networks are getting a little long in the tooth, have been installed for three to five years.

We do expect there to be upgrades there.

Given our strong position in that market and in our installed base, we expect that that will contribute to -- contribute significantly to Japan in this calendar year.

Next question comes from Tal Liani with Merrill Lynch.

Please go ahead.

Hi, guys.

I want to focus not on the results but on the bigger picture.

I want to go back to the question Alex asked at the beginning of the conference call.

It seems like you're trying harder and harder and harder in the same area of switching while Cisco has been gaining share, if you look at the market share data, over the last two years.

And you -- would argue you have a better solution, scalable carrier class, whatever.

What are the expected steps you're taking in order to reverse the trends ?

I'm referring here more to your product strategy, long term focus, et cetera.

Thank you.

Tal, first of all, in comparison to Cisco, we participate really in two segments.

That is, call one segment be the mid-size and large enterprise segment in the Metro Ethernet space.

Cisco's market approach is considerably broader than that in that they have been seeing strong growth in their small and medium business segment which is not an area that we participate in at all.

So it's hard, you know -- I mean, I look on a customer by customer basis and we beat Cisco a lot.

It's sometimes tough to capture an account from them, but we've certainly done it during not only this past quarter but in previous quarters.

And I don't know of any good tracking for the -- that breaks out specifically by market segment in terms of looking at large enterprise.

It's really hard to determine what the share changes there are.

I would say, though, that again in looking at this market place that there is a part of the market that not only is open to buying a non-Cisco solution, that is the part of the market that doesn't want to buy from the market share leader.

But I would say that, you know, there's a part that won't buy from them for whatever reason.

Whether it's because of the size of the Company and difficult to get a response or because they want a leading edge solution that's technology based.

So I think you get to a point where, frankly, for them it becomes very difficult to grow market share in a particular segment.

And I think you can see that in terms of looking at their overall corporate strategy and diversifying into new market areas.

I think they're having a tougher time gaining share.

Again, in the particular segments that we play in.

If I use my follow-up question also on the same issue.

Gordon, wouldn't you think that you would need maybe to expand into other areas?

You see your competitor foundry going into routers, going into Layer 4 to 7.

You yourself said Cisco is successful because they are going into SMB and the subsequent question would be, so why wouldn't you try and go into other areas?

So the question is bigger, what is the future direction of the Company?

Are you just going to try and do more of the same or are you going to try and diversify into other sections, other areas?

So I think the answer is pretty clear.

We've made an investment in the security space over the last -- the investment's been over the last 18 months.

We're just starting to see the benefits from a revenue perspective.

We made a significant investment there.

Not only in our core technology, that is the ability to build security within the switch, but also in security appliances, and you can expect to see more from us in that area, both from a software perspective, from products, and from partnerships.

So, we see the security space as an adjacent space.

It's also an opportunity to be best of breed and to have a market beating solution.

I think we have a unique opportunity given our switch architecture to embed that in and to not have a perimeter security solution, but a core security solution.

So that's one area where we've made some visible steps and I think you'll see some future steps from us in that area.

So I would say we are not just going to build Layer 3 switches, but we will build and emphasize areas that are a key part of the network infrastructure.

And again, just one comment over whether it's a switch or a router.

You know, the line between a Layer 3 switch and a router is, from a product perspective, is blurring.

You know, we tend -- well, we do call our products switches, largely because that's what we've called them in the past.

A Layer 3 switch by definition does routing.

And many of our products are very effective routers and are used in the network as routers.

It just happens as we classify them as Layer 3 switches.

So I think when you look at that, you look at an enterprise router or an enterprise switch, you know, they're really one and the same in today's market.

Thank you.

Next question comes from William Becklean with Oppenheimer & Co.

Thanks, this is actually Pria Basroman [PH] for Bill.

Just going back quickly on that U.S. businesses.

The other pushoffs were they related to XOS-based products or were they more legacy products?

This is Gordon.

Not sure of the answer to that.

It would vary on a deal by deal basis.

I suspect that there was a lot of XOS product in there given those are our newer products and are focused on our largest customers.

The Avaya relationship, where do you see that going by the end of the year?

Well, our partnership with Avaya is a strong one and we see increased success coming from that.

You wouldn't be willing to put a number on it in terms of percent of revenue?

No.

We haven't -- we have not forecast that.

We would expect on a sequential basis from here, Avaya is a grower through the year.

Then we'll get to next December and we'll see where the sequential pattern is there.

But I'd be disappointed if we didn't see a sequential improvement in Avaya revenues here in March.

Thank you.

Thank you.

Next question, please.

Next question comes from Wojtek Uzdelewicz with Bear, Stearns.

Please go ahead.

Yes, hi, it's actually Matt Shama for Wojtek.

I have a question about your A Pac revenues.

Can you clarify for me?

This is the largest revenues in a few years.

So what are you seeing?

Are you seeing a few carriers buy a lot of equipment and now they're going to deploy it over the next two, three quarters, or are you seeing these carriers just buying what they need quarter-by-quarter and you expect this to continue for two or three quarters at this rate?

Hi, Matt, this is Gordon.

So, our business in Asia Pac is a mix of enterprise and carrier, and we won just some terrific enterprise deals in that part of the world.

So I don't want to put too much emphasis on the carrier business.

That said, the carrier business in Asia Pac has been a great one for us.

We have a number of leading customers.

I mentioned on the formal part of the call, Korea Telecom has been a customer of ours for quite a few years.

In terms of buying practices, it's, of course, hard for us to tell but in general, you know, carriers buy and then deploy that equipment fairly quickly.

They don't let it sit around.

The pattern of buying a network expansion is really based upon their demand level and the takeup level they have of new services.

So in some cases, if it's a brand new service, for instance, they will buy a modest amount and then over the next couple quarters as service takeup comes, they'll continue to buy.

If it's an existing service that may be just a standard, you know, order from them every quarter or more or less frequently, depending on the customer.

Very difficult to predict.

That's why we are always care to say that is a lumpy business.

Asia Pac was very strong, as you suggest, the highest level in quite a few years.

Good balance in that market and very good execution by our team.

Are you willing to clarify there how much of the growth was driven by service provider versus enterprise that might be a little more sustainable?

I'm not willing to break it down by market.

You've seen the percentage of the carrier business, if you look at our overall numbers being in the 20% to 25% range.

Been pretty consistent.

This quarter was a little bit above that, toward the high end.

I think you could surmise by the U.S. being down and the U.S., as we said, being largely, large enterprise that there was pretty strong growth in the Metro Ethernet segment.

And I think there's a lot of underlying growth in Metro Ethernet that we hope to capitalize on.

And just quickly, on the [INAUDIBLE] west transition, you mentioned greater than 25% of your revenues this quarter, and last quarter I think you said it was greater than 20.

Actually, it seems a little bit like a slow transition.

Do you have any thoughts on that and how you would expect it to continue to play out?

The mix between carrier and enterprise?

No.

XOS products as a percentage of total product bookings?

We do expect that XOS will continue to increase as a percentage.

All of our new chassis systems are based on XOS.

We do have, you know, some older systems that continue to be used and deployed by customers and continue to be competitive in the market that are ExtremeWare based.

We don't have any plans to convert those systems to XOS.

So it isn't an instantaneous changeover, but you will see XOS revenue, you know, grow as a percentage.

Also, many of our new Summit switches are stackable switches are XOS-based, where today there's only one segment of our product line that is XOS-based.

So you'll see that tick up here during the calendar year.

Okay.

Thank you, Matt.

I understand there's one last question on the line.

Thank you.

Our last question will come from Cobb Sadler with Deutsche Bank.

Please go ahead..

Hey, thanks a lot.

Quick question.

Could you break out 10-gig revenue as a percentage of the total?

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

Okay, and just the weakness in North America, do you think -- are you seeing any product transition from the XOS software versus ExtremeWare?

Is there any sort of hesitation on parts of your customers to wait?

There's -- again, it varies customer by customer.

We have a lot of customers that have a mix of ExtremeWare and XOS.

To be very clear, there's no interoperability issues.

Many people have networks that are mixed XOS and ExtremeWare.

In fact, certainly any customer that's been a customer for several years has a mix on their network.

Okay great.

Just back to the 10-gig, is it more than 5% now or can you -- do you not want to tell us that?

It's more than 5%.

Thanks a lot.

Thank you, everyone.

Thank you, ladies and gentlemen.

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