F5 Inc (FFIV) 2002 Q3 法說會逐字稿

Good afternoon. My name is Ranita, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the F5 Network third quarter conference call. All lines have been place on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you, [Mr. Eldrich], you may begin your conference.

[John Eldrich]: Thank you, Ranita. And welcome to our third, third quarter conference call. The speakers on today's call are John McAdam, President and CEO. Steve Coburn, Senior Vice President of Finance and Chief Financial Officer. Also present are Jeff Pankatine, Senior VP of Marketing and Business Development, Steve Goldman, Senior VP of Sales and Services, [Brett Halstel], Senior VP of Product Development and Chief Technology Officer and [Julian Ame], Senior VP of Business Operations. They will be available to answer questions during the question and answer period following today's discussion. Steve Coburn will begin today's call with a review of the financial results for the third quarter, and our current outlook for Q4.

Next, John McAdam will review the companies operations during the quarter, and provide some additional perspective on the current quarter. We will then open the call up for questions. Before we begin, let me quickly review a few preliminary items. First, if you don't have a copy of our press release, you can find one on our web site at www.f5.com.

Second, an archived version of today's live Webcast will be accessible from the web site, through August 7th, from four PM today, pacific time, until midnight pacific time tomorrow. You can also listen to a telephone replay at 800-642-1687, or 706-645-1991. The conference ID for the replay is 4700256. Except for the historical information presented, our discussion today contains forward looking statements which include words such as believe, anticipate, and expect. These forward statements involve risks and uncertainties that may cause the company's actual results to differ materially from those expressed or implied by these statements.

Factors that may affect F5's results are summarized in our quarterly release, and described in detail in our FCC filings. If after today's call you have follow up questions, please direct them to me at 206-272-6571.

Now I'd like to turn the call over to Steve Coburn.

Thank you, John. As we indicated in our July 8 conference call, the third quarter of fiscal 2002, was characterized by solid top, top line performance and continued operational improvement.

Reported results for the quarter include several on time items related to the discontinuation of our cash business, and the consolidation of operations announced in our July 8th press release. Briefly, those non-reoccurring charges include a return reserve of 243 thousand charged against product revenue. An inventory write down of 338 thousand, added to cost of goods sold. A net reduction of 337 thousand to general and administrative expense. The two components of this item are a 500 thousand dollar reversal of bad debt reserve associated with a partial settlement of past due accounts with Exodus Communications. And a 163 thousand dollar write off of bad debts associated with the restructuring.

In addition, a stand alone restructuring charge of 2.8 million, which includes other asset write offs, and a provision for facility consolidation has been included in operating expenses. We anticipate that a charge of approximately 500 thousand dollars for employee separation costs resulting from the restructuring and consolidation will be taken in the fourth quarter.

The following discussion, in the following discussion, I will make explicit reference to both reported and Proforma results. Proforma revenue of 27.3 million was up slightly from the 27.1 million in the prior quarter, and within the target range of 26 to 28 million we had set at the beginning of the quarter. Proforma net loss for the quarter was 1.3 million dollars, or five cents per share, in line with our July 8 announcement, and slightly above our previously targeted range of minus six cents to minus eight cents per share.

This is an improvement over the last quarter's loss of 1.8 million, or seven cents per share. Including on time items related to the restructuring and consolidation that we announced on July 8th, our reported net loss for the quarter was 4.3 million dollars, or 17 cents per share, on reported revenue of 27.1 million.

During the third quarter, reported revenue reflected a mix of 71 percent systems revenue, 23 percent service revenue, and six percent software licensing revenue. The modest increase in software revenue up from five percent in the second quarter, reflected an increase in LEM license revenue from Nokia. Although not significant to our results, we did have first sales of BIG/IP [INAUDIBLE] controller at the end of the quarter.

John will have more to say about both Nokia and our blade server business, uh, in his remarks. From a geographic perspective, 72 percent of our reported revenue was derived from North America, and 28 percent from international markets. This represents a significant change from Q2. Key factors include strong revenue contribution from North America representing the best results that we've seen in the last six quarters.

Continued improvement in Europe, following our recent investments in that market, offset by a significant decline in revenue in Japan. Sales of our applications switch platform were approximately 46 percent of systems revenue, comparable to the prior quarter.

During the third quarter, we had no ten percent customers. Moving down the income statement, gross margin improved for the fifth consecutive quarter. Proforma gross margin of 73.4 percent was above our 70 to 72 percent target range, and up 230 basis points from the 71.1 percent we reported last quarter. Factors contributing to the improvement included improved manufacturing efficiency as resulting from the first full quarter of operations with Solectron as our contract manufacturer. An increase in the percentage of domestic sales, and a slight increase in systems, in software revenue.

Proforma expenses were 21.5 million, squarely in line with our 21 to 22 million target range. On the balance sheet, we continue to see improvements in several areas during the third quarter. Accounts receivable DSO ended the period at 67 days, below the 69 days we had reported in Q2, and better than our 70 day target. Inventories declined from 960 thousand last quarter to 332 thousand this quarter.

This, this was a result of assumption of inventory by Solectron as part of our new contract manufacturing agreement. Although inventories have been below one million dollars for the past two quarters. We expect higher levels of inventory going forward.

For the fifth quarter in a row, we generated positive cash flow from operations. Although we had anticipated break even cash flow, with a range of plus, plus or minus one million dollars, reduced inventories and our successful collections efforts, along with other factors, contributed to a positive cash flow from operations of 2.8 million dollars. This contributed to an increase in our cash and investments from 75.5 million in Q2, to 78.9 million in Q3.

Moving on, now, to the outlook. Despite the upturn in North American sales during the third quarter, we are not ready to mark this as the beginning of a trend. As a result of our limited visibility into the North American market, combined with the loss or revenue from our discontinued cash business, and the likelihood of continued weakness in Japan, we do not anticipate significant top line growth in the fourth quarter of fiscal 2002.

For the fourth quarter, ending September 30, we expect revenue from continuing operations to be consistent with the third quarter, within a range of 26 to 26.5 million. We believe that further improvement in gross margin is possible, and have set a target range of 73 to 75 percent. We expect Proforma operating expenses in, excluding the 500 thousand one time charge for employee separation costs, to be between 20.8 million, and 21.2 million. This reflects reduced expense run rate from our restructuring, partially offset, by strategic investment in the blade server initiative, and next generation product development.

Based on these targets, we anticipate a net loss of between one and three cents per share. On the balance sheet, we expect to end Q4 with DSO's between 65 and 70 days, uh, and cash flow from operations within a range of break even to plus one million dollars. With that, I will now turn the call over to John McAdam for additional comments on Q3 and the outlook for Q4.

Thanks Steven, and good afternoon, everyone. I, actually, just before I begin, let me correct something that, that Steve said. I didn't want to interrupt him while he was speaking. But the, the outlook, uh, for this, this coming quarter is actually between 26 and 27.5 million. I think Steve, uh, mistakenly said 26 and 26.5. So it's between 26 and 27.5.

Okay, uh, as I speak to the update call earlier this month, Q3 was a, a pretty solid quarter. Uh, operationally we continued to make significant progress, and the Proforma income statement and the balance sheet. Revenue was above the midpoint of the range we indicated in our Q2 conference call. Growth margins were up for the sixth quarter in a row. Operating expenses were well within our target range, DSO's were down again for the sixth quarter in a row. Inventory, likewise, and we had a positive cash flow from operations for the fifth quarter in a row, with almost 88 million dollars in cash, and no debt.

Uh, from a geography viewpoint, American operations were the stars of the quarter. Business was strong in each of the three months of the quarter, and I will talk about some of the competitive sales wins in a moment.

We also saw a sequential growth again from European operations with [INAUDIBLE] in the investment we have made there over the last few quarters. The only disappointing results were from our Japan organization, who have enjoyed tremendous growth over the last couple of years. We did expect to see a sequential decline in sales in Japan last quarter, but the decline was more than we expected, as the overall economy there continues to suffer.

We had some great sales wins in the quarter, including BMW Financial, Volkswagen America, uh, Alliance Capital, the Defense Intelligence Agency, uh, and Cuban Bank in Taiwan. We also had a significant, had significant repeat business. And by significant, I mean over value greater than 200 thousand dollars. And that was from customers like Fidelity, Sprint, Washington Mutual, eBay, Wells Fargo, Bank Of America, Citigroup, and Microsoft.

And most of these organizations, if not all of them, are implementing F5 solutions, as they deploy mission critical applications across the Internet, or the Intranet. I believe we continue to be very well positioned from a competitive viewpoint. Especially with the BIG/IP Five Thousand and Two Thousand product. As our unique SSL security features, and [INAUDIBLE] applications functionality.

Our customers continue to purchase [INAUDIBLE] leading layer seven functionality, and integration via i-control to application solutions from the likes of Microsoft, Oracle, BEA, [INAUDIBLE], et cetera. The main purchase drives continue to be SSL security requirements, high availability, even at the transaction level, performance, and overall cost reduction of mission critical applications.

Our software business was up modestly this quarter, as sales from the PS started to ramp up. Our [INAUDIBLE] ramp has proved to be slower than we expected at the beginning of this year. I am happy with the progress we made last quarter. We have also closed some initial orders for our [INAUDIBLE] software in the quarter, including sales at Sony and Invesco in the UK. I stated in last quarters conference call that our goal in 2-3 was to start shipping of our [INAUDIBLE] controlled software, and to gain some footprints by the time blade service started to ship in volume at the end of this calendar year.

We continue to make progress at the partnership level, with HP Compaq, HPQ, IRLX, [INAUDIBLE] and Dell, as we are starting to build up [INAUDIBLE] channels to take advantage of the opportunity.

As far as the outlook is concerned, I feel very positive about F5's competitive position, and market opportunity. Our product road map remains very strong. We expect to start beta tests of our layer four performance leading [INAUDIBLE] this quarter, with revenue shipments in fiscal quarter one.

And I believe our current development road map, over the next year, will continue to keep us in that technology leadership position during fiscal 2003. The restructuring program which we announced earlier this month has been completed, and initial reaction to our new content strategy, based on partnering with best of these suppliers, via i-control architecture has been very well received.

Steve has already commented on our financial outlook for the quarter, and clearly the restructuring actions we have taken should accelerate our return to profitability. So with that, now I'm going to hand over the call for questions and answers. Can we have question and answers, please?

Your first question comes from [Sam Wilson] of Merrill Lynch.

[Sam Wilson]: Hi. Good afternoon, gentlemen. Just a, a few questions for you. Uh, John McAdam for you, can you just tell me what your opinion is, or some color, on whether you think Japan was above the seasonal weakness you'd expected, and, you know, kind of just generally what's going on there. Or did you just expect it, it was just normally seasonally weak, and you expect it to be flat to up this quarter? And then Steve, a few questions for you. Um, can you give us what the new, uh, can you give us what the head count was at the end of the quarter, and then what, kind of, you expect the new head count to be with the reduction?

And can you give me CAPEX? And then can you just give us an indication, kind of what's going on with the [Ferg] revenue? I noticed it was up nicely for the quarter. Is that mostly services, or is that the [INAUDIBLE] also?

Okay, regarding Japan, um, it was, it was slightly worse than we expected. So we, we did expect a decline last quarter, because of seasonality, and it was slightly worse. And for that reason, we are assuming that this quarter is going to be flat to down. Um, so we're not expecting a rebound, and that' what's built into the, the 26 to 27 and a half million range that was given.

Regarding, uh, Sam, your three questions. Uh, we ended the, the quarter with around 510 head count with the restructuring, uh, we're at about 465, uh, uh at this time. Uh, capital expenditures for the quarter were about 850 thousand. And deferred revenue did go up 1.1 million for the quarter. And that is almost entirely associated with, with the deferred service contracts, it'll be amortized over the next 12 months.

We did see increased selling activity there. Uh, particularly in the renewal maintenance area.

[Sam Wilson]: Perfect, thank you gentlemen.

Your next question comes from Jeff Lipton of J.P. Morgan.

Um, thank you, good afternoon. John, could you please comment on, uh, your quarterly results in the context of how much of the growth do you think was environmental in North America, and how much do you think was, um, was share? And, uh, then as an add on, could you comment on, uh, how things might have changed competitively during the quarter, and pricing wise? Thank you.

Okay, and this is going to be very much an opinion rather than facts, actually, Jeff. Because we, to, to, to be sure about the sheer numbers, we obviously need to see, uh, the results on our competitors, et cetera. But I, I'll give you the opinion that we're seeing, which is, we get from, from the sales campaigns, and that, that we probably saw a combination of both, but mainly sheer. Uh, the five thousand and the two thousand, um, [INAUDIBLE] have been very well accepted. Um, layer seven, in terms of building in with the solution providers, like Oracle and Microsoft, we think we've got a major, major, uh, uh, differentiation. Yeah, so I, I do believe we, we've gained share but I can't prove that, because we need to wait to see the results.

Um, from an environmental point of view, we did have a very strong, uh, quarter in North America. I think, I, I mentioned it, it was on a monthly basis as well. It wasn't that we had a specific great big deal that, that, uh, was a spike. It, it was pretty strong way throughout, from the beginning to, to the end of the quarter. But we've only got one, one quarter behind us now, and that's what, when Steve said, uh, we're waiting now to see what the trend is. The pipeline of businesses is pretty strong.

And as far as, uh, you know, competition and pricing, any changes on the margin there, John?

No. Not at all. Um, you've seen that our margins have gone up yet again. Um, we're not seeing pressure there, uh, in any way.

Okay great, thank you.

Your next question comes from [Pharon Wong] of First Albany Corporation.

[Pharon Wong]: Just, uh, specifically give us a little more color on your Nokia and, and Dell. Whether or not, um, you're getting any [INAUDIBLE]. Um, and then maybe flush out some of your, uh, server blade revenues if you had any contributions from that?

Okay, we missed a, I suspect we missed the beginning of your question? I, I have it from giving us some more detail on, on Nokia and Dell. Uh, and you mentioned, and the rest of the other, was there anything, the beginning of your question?

[Pharon Wong]: No, I was just, uh, asking about OEM revenues.

Okay, right, right. Um, well as you say, you know, we did go up more, didn't we? Um, mainly because of Nokia starting to ramp up. The Dell Business is, is still looking pretty sound. And so, so the, you know, the intake and, and growth was really from Nokia. Uh, you know, we'll see. It, it, it's a start of the ramp. Um, we do expect to, to see some sequential growth again from Nokia. Uh, we didn't do anything on the OEM side from Intellesis. And in fact, it's very unlikely we will be doing OEM type business with Intellesis in the future, although they are still a partner on the resale side, and we did do some business last quarter with them in the resale side.

Um, from a blade server point of view, I mean the, the, the revenue, the actual revenue was pretty small. It was a handful of customers, it was towards the end of the quarter that we started, uh, shipping the blade controller software. And, frankly, we, we, we've always assumed that it's going to be slow this quarter as well, until the real volume starts shipping. Until companies like Fujitzu, [INAUDIBLE], and Dell, companies start to really ship. Um, but, you know, we got the orders we wanted, and we thought we would get the footprint, we did. Uh, I don't think it's going to have a material effect in this quarter. Uh, hence the, the guidance, but, uh, we should see the ramp up and [INAUDIBLE] in quarter four.

We, we, we don't get specifics on, on the software breakdown by partner.

[Pharon Wong]: Okay, great. Thanks very much.

Your next question comes from [Jason Adder] of [Pumace Wisel Partners].

[Jason Adder]: Yeah, hi guys, um, a couple questions. First, um, could you guys quantify the sequential growth of North America, do you break it out that way?

Uh, we don't. Um...

[Jason Adder]: Could you give us a ball park? I mean, was it up 10 percent, uh, 20 percent?

Yeah, we were up, we, we were up strongly in the quarter. You know, 20 percent plus. So...

[Jason Adder]: Okay great. Um, and then, do you think it's fair, maybe more of a question, uh, for you John. But do you think it's fair to be thinking about, uh, demands for layer four to seven in the same, uh, general way that people think about demands for layer two and three? Or do you think that that layer four to seven is tied into more of the applications?

Absolutely. Uh, it's a [INAUDIBLE]. Um, the, I don't think that the [INAUDIBLE] actually. Uh, what we are finding is that, uh, you know, I'm trying to think of an example. BMW, I mentioned, uh, is a [INAUDIBLE] implementation, and it's transaction integrity and availability. It's linked to the, the actual application. Um, [INAUDIBLE] we are being bought at the moment for mission critical, high availability, obviously performance, and then SSL tends to be a very significant factor. Uh, none of which were with two three switch capability.

[Jason Adder]: So, what I was leading into was, then should we be, uh, really gaging demand or, or, you know, metering demand based upon the health of the application software business to some extent?

No, I, I, I don't think so. And the reason, I think it should be gauged on our customers still deploying applications across the Internet, or intranet. And they could easily have bought, and in fact, most of them have, purchased those ERP, or those CRM applications a year ago, two years ago. But now security's important, high availability is important. As the, the, they deploy them across the Internet. That's the biggest driver for us.

[Jason Adder]: So there's a lag effect from when they bought it to when...

Oh, great.

[Jason Adder]: When typically they would want to buy, uh, an M5 switch.

Yeah, I, well, it, it doesn't have to be a new, no, it's not like that. It, it, for example, a lot of our business is doing high availability of security across main frame applications, that have been bought years and years ago. Um, but because the internet is now used as the, the communications medium within companies, and business to business, and there's a big growth there, that's when our products start to get used. So it's as applications are being pushed out, [INAUDIBLE] applications are being purchased.

[Jason Adder]: Okay, and it's, that's helpful thank you. And then, uh, final question, uh, John, what do you see, you know, really, as the main catalyst on the horizon for F5?

Uh, I think continued deployment, uh, across the Internet of business applications is, is the biggest thing. And then underneath that, is the link, linking of, of our products to save money as that deployment's happening. Uh, increasing the efficiency of the applications, and security. And there, there, there's a, the [INAUDIBLE].

[Jason Adder]: So what can we, what can we really point our finger to there, that's, that's kind of a general statement of, you know, a trend. But is there something in particular that you think...

Probably across the Internet, both business, uh, and, uh, commercials are a very good friend. And that's been growing steadily over the last, in spite of the economy, that's been going steadily over the last few years. That's the biggest factor.

[Jason Adder]: Okay.

Obviously, you know, the, the whole sensitivity towards security.

[Jason Adder]: Okay, thank you very much.

The next question comes from [Paul Verliner] of [Colonial Fine].

[Paul Verliner]: Hi guys, a few quick questions. Just, um, according to my calculation, I'm just sitting here looking at, uh, the debts for accounts receivable went down by over half a million dollars. So that's about two cents. Am I calculating that right? And why did that happen? Also, um, on the Exodus, I know you guys, uh, wrote off those receivables, so, um, does that mean, uh, on an apples apples basis, the [INAUDIBLE] actually went up? And also if you could comment on linearity in Q3. Uh, and finally just on, uh, Nokia. Uh, I know they passed recently on their second opportunity to increase their stake in the company. So do you expect that that relationship is not going to materialize, because the numbers have to come down for, uh, 2003? Next....

Yeah, just to talk about DSO's a little bit. Um, we have, uh, we, we did, as, as we said, on a Proforma basis, reverse about 500 thousand that we'd had reserved on, um, uh, on the Exodus thing. As, as we had settled the receivable trade receivables that, uh, were associated with that reserve. We needed no longer to carry it.

Um, in terms of our absolute collection performance, and DSO's, um, we have, we have improved our collection activity, that is reflected in the DSO's, uh, over time. So we've had our DSO's improving over the last, steadily over the last five quarters. And that really does relate to actual, um, uh, credit activities. We really have two things going there that have...

[Paul Verliner]: But do DSO's actually go up if you strip out the Exodus. I mean, on the apples apples basis?

Uh, no, I don't think that's right. I don't think that's right, DSO's...

[Paul Verliner]: ...zero this quarter, so it wasn't [INAUDIBLE] last quarter was in their DSO.

Yeah, with reversing, with reversing the reserve that we have, that, that actually, that is, that is a net receivable neutral, um, uh, transaction that we haven't had, we reduced the receivable as well as the reserve around that. The, the, the business reality is that we've had steady and, and real improvements and performance on our DSO's over time. And it's really related to three, three factors. One, you know, we've, for the last 12 months we've been selling to a more credit worthy customer, that being a Fortune 100, Fortune 1,000, enterprise class customer.

Two, we've, we've had, um, uh, we really implemented, uh, some, some business controls, both on the front end and the back end. On the front end we're doing credit [vedding] of, um, all our new and existing clients. As orders are placed, that has had an impact, I think, on the credit worthiness of our receivables. And then we have a fairly robust collections activity on the back end. Uh, that has proved over time that we're getting results from as well.

[Paul Verliner]: Okay, [INAUDIBLE] the numbers for 2003?

Uh, 2003, we haven't provided any, any guidance, uh, yet on Nokia, or really, really any of the financial records at this time. And don't intend to, um, you know, we're just entering in to our planning cycle now.

[Paul Verliner]: And [INAUDIBLE] for this quarter, how's it tracking so far? Is it, um, meeting your expectations?

You mean this current quarter?

[Paul Verliner]: Yeah.

Yeah, it's on track. But it's pretty [INAUDIBLE] but it's on track.

[Paul Verliner]: Okay, thanks.

Your next question comes from [Kevin Tiboni] of [Z.A.]. Go ahead, what's your question, sir?

[Kevin Tiboni]: Good afternoon. I was wondering first of all, Steve, if you could, I, I missed the first part. I think I just grabbed the last part of the, uh, the cost breakdown. I was wondering if you could, maybe as opposed to repeating that, if you could just tell us what line items, uh, some of the different, I heard, the bad data, I'm assuming, comes out of G&A, and I thought I caught, uh, but I didn't catch the number coming out of cost of good sold. Yeah, the one time Proforma charges?

Actually if you look at our press release, those are broken out. Um, with, we had, we had a return reserve of 243 thousand that went against revenue. About 340 thousand against [INAUDIBLE] floor inventory. We had an [INAUDIBLE] to G&A of 337, which included this ad, ad back of the Exodus. Uh, reserve reversal. Partially offset by, uh, 163 thousand write off of bad debt associated with the restructuring. And we had a stand alone restructuring charge of 2.8 million, included in outback.

[Kevin Tiboni]: Okay, great. And I think you had somewhat answered it earlier, John, in terms of the, uh, the Dell, it sounds like that was just flat quarter over quarter then?

Yeah. Approximately.

[Kevin Tiboni]: Okay, and then in, just in terms of the blade server and kind of what you're seeing, I realize it's somewhat early. Um, I mean the whole product cycle, but uh, do you have any better feel, I guess, from where you were last conference call of, of, you know, how that will roll out? You know, what the time frame is, you know, before that really starts to get traction in the market.

I, I think it's much the same as we said in the last, uh, conference call. In that, you know, we, we did, uh, we really did set ourself a goal to get some order in Q in Q3, fiscal Q3, and we did. Um, we expect to get more out of this coming quarter, but not having a material effect. And then, the, the, the blade server vendor starts to ship in volume, which we believe will be [INAUDIBLE] is when we should start to see some impact.

[Kevin Tiboni]: Okay. And in terms of distribution, um, how much further, I guess, do you have in terms of, uh, the European market? A lot of that, that is paid off. Do you still feel like you have more penetration into that market, or, or do you feel like you're, you're about to the point where, uh, you know, you want your distribution to be there.

Hi, this is Steve Goldman. I think, um, a lot of it has to do with moving beyond the, uh, major markets of, uh, the UK, Germany, France, into, uh, a lot of the other European markets. And we're still very early in those days. And, uh, we've added a lot of, uh, [INAUDIBLE] to our distribution. Um, so we expect the investments we've made to keep paying off. But, uh, there's still a lot of market that we can, uh, uh, continue to cover and address.

[Kevin Tiboni]: Okay, that's great. Thank you.

Your next question comes from [William Beckline] of [Conners Capital Market].

[William Beckline]: ...the article talking about, uh, Microsoft's dot net initiative, and the whole web services, uh, business. Which, uh, has been around for a couple years but hasn't taken off. Uh, you know, since that is designed to drive, uh, XML traffic over the Internet, does that have any negative implications for you business on a long term basis?

[Jeff Pankatine]: Um, this is [Jeff Pankatine]. No, actually it has a lot of positive implications to our, uh, traffic business. And you can imagine that it will be, um, as XML traffic picks up in the network, that IP traffic itself picks up. Um, and we're also looking forward in the product plans to, uh, uh, implementing further, or taking our XML capabilities further in the network. Today we have an I-control interface, which is so XML, which allows applications to talk to us, uh, through the standard, uh, massaging. And as we go further down the line, we'll be providing, um, real XML switching capabilities going forward.

So, we believe it's anywhere between, uh, every XML transaction will kick off probably another eight to ten on the low end, and, and probably 30 to 35 transactions in the network. So it's actually very positive.

[William Beckline]: Well, but the point of the article was that it hasn't taken off.

[Jeff Pankatine]: Um, it's very early days. People are just now starting to, uh, roll it out and deploy it. I mean, dot net capable, um, tools and applications, and, and by the way, dot net is only one implementation of web services.

[William Beckline]: Right.

[Jeff Pankatine]: The whole job in sight. Um, the tools and the, and the software packages from third parties have really just been rolling out. And most enterprises are, are in, kind of, a discovery phase if you will, or early adoption phase. Like with any other new technology.

[William Beckline]: So you'd say now you're surprised that it's not getting any traction after it's been out there for a couple of years?

[Jeff Pankatine]: Um, first of all I don't think it's been out there a couple years, and...

[William Beckline]: Well that's true, but announced a couple years ago, right.

[Jeff Pankatine]: What, yeah, the architecture was announced. Products from Microsoft for instance, really just started coming out in this past year, in terms of the dot net framework and so forth.

But when we announced I-control with the [INAUDIBLE] interfacing a year ago, web services weren't even being discussed. Um, but the thing that's amazing about the web services is that, is that not just Microsoft, but Oracle, IBM, the main players have all agreed a standard. Um, and that's pretty unique in a technology environment. So we, there's every reason to believe that it will be significant. And when you take Jeff's point, and, which is an Internet traffic drive, it can only be good for our, the security aspects of it, that, that will need to go as, as these applications roll out. So it's really early days.

[William Beckline]: Okay, thank you.

Your next question comes from [Dave Pular] of [Wycovia Securities].

[Dave Pular]: How are you.

Go ahead with your question, sir.

[Dave Pular]: Yeah, I had a couple of quick questions. First of all, would you be able to share with us the pricing model for blade server controller software that you have? Secondly, do you still expect your break even revenue point to be 28 to 28 and a half million? And lastly, I missed some of the reasons you expect your DSO's to stay a steady. So could you repeat those, please? I believe there were three of them. Thank you.

Uh, on the pricing model for the blade server software, the way it's priced today is there's a, there's a baseline price for the software running on the blade, which is, uh, four thousand dollars. And then, uh, basically for every blade that it manages, there's a fee for, of about, uh, five hundred dollars. And then if you want to run it in a redundant mode, in other words, run two copies of two different blades, uh, basically you pay the, the four thousand dollar fee again.

[Dave Pular]: Okay, thank you.

With regard to, uh, your two financial questions, um, yes we still believe that the break even point in our business model is between 28 million and 28.5 million on a quarterly revenue run rate. Uh, as we discussed in, um, on July 8th. And with regard to DSO, we were really, we were, uh, just explaining why we had improvements over time on DSO's. Uh, we have provided a range to say that, that implies, of course, that we think incremental improvements are, continue to be possible on DSO, but it's primarily driven by, uh, the credit worthiness of the, of our, uh, enterprise customers that's improved over time. Um, and, and other internal factors including [vedding] up front and collection processes, so, on the back end.

So that's really been the key drivers of our improvement up to this point.

Your next question comes from [Steve DeLuca] of [Stenner Asset Management].

[Steve DeLuca]: Hi guys, um, question on the cashing product. Was there any revenues this quarter, and is there any in your projections next quarter?

Um, yeah, we did have, we did have some revenue this quarter, uh, from cashing, and what we've said is over the last, uh, year or so, that that's been less than three percent of our revenue over time. We did have some revenue this quarter, and we have not included any revenue for cashing going forward, and that's been reflected in the, the guidance we provide in our revenue for the fourth quarter.

[Steve DeLuca]: So is it fair to say on an apples to apples basis you'd be flat next quarter?

Yeah, I think it is, on a, on a continuing operational basis, that is true.

[Steve DeLuca]: Okay great. And then, uh, one for Jeff on I-control, can you give us an update? Is there any, uh, new advancements or adoption there?

[Jeff Pankatine]: Yeah, I mean the big one for the last quarter was [Seaville Systems]. We, uh, certified with, uh, with [Seaville Seven]. Um, the other thing we're doing right now is working with a number of the, uh, partners that we already have like Microsoft and Oracle and others, to, uh, build out solution sets around I-control. So in other words, um, get the applications up and running, get the network in, and, um, really set the parameters and show the solutions that, so that it, uh, reduces the time to implementation, and therefore the cost of implementation for customers.

[Steve DeLuca]: Thanks guys, nice talking.

Thank you.

Your next question comes from [David Escanazie of Cypress.

[David Escanazie]: I agree with you, I thought this was a very solid quarter. Um, I think you guys have done an excellent job of making tough decisions, like reducing costs and head counts, and developing different products while not deteriorating your balance sheet in this environment. And I think you should be commended for that. Um, some time back, it seems like years ago, but I'm sure it wasn't, uh, you guys talked about a stock buy back. And I just, at the time you felt like the company was a good value. And I wonder if you could talk about that again, today.

I don't know if that buy back is still in place. If you ever did anything about, uh, buying any shares back. And if you might have a, a, the same idea at this, in any near, near point in the future?

Yeah, it, it's John here. Um, god, it does seem like years ago, and it was probably a year and a half ago, actually, is when we, we talked about it. I'm not sure exactly. Um, we didn't really, at that time, that was approved by, by the board of directors, but we didn't really do any material, uh, buy back of shares then.

Um, and during that, between then and now we've focused very, very much, in fact, as you pointed out at the beginning of your question, we focused very much on, on improving the, the operational matrix of the company. One of which, of course, is, uh, cash with no debt. Um, so there's no real plans to do anything, uh, on the buy back front at the moment. Besides, an option we'll always look at, uh, but at the moment, uh, we, we really feel that, uh, it's good to have a very, very healthy balance sheet in terms of the, the cash position.

So no real plans there, we haven't given it much thought, quite frankly.

[David Escanazie]: Okay, and then I wonder if you could talk a little bit about your outlook on the blade server from a time frame standpoint. I know that you said you can't really be positively affected too much, until blade server architecture is really adopted. Uh, but can you kind of give, uh, your viewpoint on what kind of time frame that might be, very generally?

Yeah, I, I think it's calendar 2-4. Um, but we're seeing that, this is a really new market, uh, the blade seven market. And we, we don't want to, to set, uh, unrealistic expectations. But we believe calendar 2-4. And the reason for that belief is, because by that time, uh, most of the, the server vendors, if not all, will be shipping systems. And that's clearly where the opportunity lies for us.

Um, we're doing a lot of work in the background at the moment. Uh, so for example we're signing up, uh, and we have a goal to sign up a number of value added resalers this quarter that are almost incremental to the type of business we do today. So in other words, we're not networking value added resalers that the server value added resalers, and they're showing a lot of interest. Um, and that's what I meant when I made my very brief comment about building up the channels.

Um, but we are, the, we're, the hands of volume shipments of the actual chassis from, from the, the, the server vendors themselves. Um, I think once that happens, uh, in a big way, then, then there's a big opportunity for us. A best guess at the moment, when it has an effect in our business is calendar 2-4. But as I say, we expect to get some more orders this quarter.

[David Escanazie]: Okay, and then one last question, there was a question earlier asked, and I don't think you, you, uh, you got to it, or I just didn't hear it. And it has to do with Nokia and their, their, I guess stock options, or the lack of action on their part. And what, uh, what you could attribute that to, and what your expectations might be going forward on that?

Yeah, I, I actually covered this on, on, a pre-announcement call at the beginning of the month. Um, most people on the call probably know this, but they, they have three milestones where they could purchase our stock. And of which, uh, has just passed. And, and they decided not to do that. They haven't, uh, given us a specific reason, um, for that. What we could do, by the way, and Nokia have agreed to do this, is that we, uh, if, if you want to give us a call we can actually give you a contact name of somebody in Nokia to actually talk to.

They, they, they've offered, uh, that capability. Uh, I'm not going to put it out publicly, because it would rather, you know, we don't want them flooded with calls. But if anybody wants to phone in John Eldridge after this call, we, we can do that. Um, I did say, uh, also at the beginning of the month, that my speculation, and it, and it really is my speculation is, that, what with such an early stage in the relationship, that they're waiting to see, uh, you know, more of a ramp in the revenues.

Um, now, let me just stress, we're very happy with the relationship, uh, our initial expectations were probably too high. Um, that's obvious. Uh, however, uh, we're starting to see the ramp, and we're both connected to, I think, being successful in the market place.

[David Escanazie]: Okay, thanks and, uh, once again, good quarter. Good work.

Your next question comes from [Chris Sessing] of [Prowild Wheadon].

[Chris Sessing]: Yes, thanks for taking my call, guys. Uh, I've got a few questions here. I was wondering, I didn't hear if you mentioned the blade server vendor, uh, that had started shipping already.

Uh, I probably didn't, but, uh, the blade server vendors that have been shipping are ILX, um, uh, the, basically a smaller, a private company that's been shipping, uh, [INAUDIBLE]. Um, Compaq and Hewlett Packard have been, when I say Compaq, of course, I, I mean the, before the, the, uh, the merger. Um, the sales that we've had had involved ILX, and Compaq, I believe. The pro-line, actually.

[Chris Sessing]: And then, uh, on your gross margin, if you look at, uh, you know, you, you guys have had some pretty good gains in here. Uh, you know, obviously, the, the cashing has been somewhat of a drain, but where do you think, you know, what's your goal? What are you, what are you driving for? Where do you think you can top out as far as, uh, gross margin expansion?

Well, you know, we really haven't set a longer term expectation, business model expectation of where we think growth margin is going. What we have said, and this is, our, our belief is there is an opportunity for further expansion, um, going forward. Um, incrementally, based on some of the factors that have been in play up to this point, manufacturing efficiency is being probably the key one, there's still probably some, you know, small incremental gains available there.

I think looking forward, the bigger opportunity for margin expansion comes from [INAUDIBLE] and growth in our, uh, uh, software side of our, of our business. And that's probably where we'd be looking for, uh, further margin expansion as we go forward.

[Chris Sessing]: Okay, so as far as efficiency and manufacturing side, there's, uh, uh, not much outside that.

Well I think there's still some, some incremental, uh, opportunities that lie before us. But I think the key driver going forward for further meaningful, you know, large margin expansion would come from that.

[Chris Sessing]: Okay, and then just lastly, if you guys have any anecdotal evidence as far as, uh, replacements, did you, uh, were you guys kicking out anyone else's systems in the quarter?

You mean in terms of competitive replacement?

[Chris Sessing]: Yeah.

Uh, yeah, I'm not going to name specific names of customers, because they would, uh, find that inappropriate. But we've had a number of examples, uh, and the list I gave you, uh, we've replaced [INAUDIBLE], uh, we've replaced Cisco. Uh, definitely.

[Chris Sessing]: Uh, Cisco on the, on the, uh, on the switch, or Cisco on the whole local director?

Typically local director. But we've also had, uh, also replacements of other points over time. I, I'd need to check of any of them were specifically in the quarter. I suspect they probably were.

[Chris Sessing]: Okay, thanks, guys.

SSL has been, the [INAUDIBLE] integrated SSL has been one of the replacements. Uh, [INAUDIBLE].

[Chris Sessing]: Well since you've mentioned that, what is, what do you think the difficulties would be for them to integrate that on their own product? Similar to what you've done. Is there a great barrier there?

Yeah, I, there's always a barrier. So I think over time that, that's possible we could do that. I think we've made some announcements, future announcements that we are going to do that. However, it, it's not just about having SSL, it's about the functionality and the link between the two, and Brett may want to...

Yeah, I think one of the keys is that, uh, throughout history we've leveraged the Pentium capabilities. Um, there's hardware, exists, that we use for SSL decryption. But still, most of the real transaction processing is actually done in software. And because of the fact that our architecture not only has, uh, state of the art, or, both state of the art and commodity, um, switching fabric, we also leverage our Pentium platform extensively. And because of that, we're able to get unparalleled SSL performance rates. Now, with the hardware only solution, it doesn't rely upon software assists, or something like a Pentium. There's no way you'll be able to achieve the SSL through put that the big IP 5,000, or the big IP 2,000 is capable of producing.

Therefore the barriered entry to this is, is pretty huge. It, it calls for a re-architecture of something like a Cisco switch to compete with us. So we don't see that happening any time soon. And in the meantime, we continue to, uh, push our performance further and further. As the year goes on, we'll make announcements about, um, significant performance gains in SSL processing. And as John said, when you combine that with layer seven technology that we've developed, we look pretty strong.

Most interestingly, we've received patents for cookie persistence, um, which we pioneered about two years ago. We recently received the patents for that. So the technology that we approach layer seven with, combined with the overall through put of both layer seven and SSL, is quite stellar. And it will be very difficult for competitors to catch up.

[Chris Sessing]: On the cookie persistence, is there a, is that enforceable? Is anyone else doing it the same way? Are we looking at, uh, you know, possible infringements?

Yeah, we wouldn't comment on that in this call.

[Chris Sessing]: Okay, thanks guys.

Your next question comes from [Peter Schubert] of [INAUDIBLE].

[Peter Schubert]: Hi guys, most of my questions have been answered. But, uh, previously you had talked a little bit about customs initiation protocol. Uh, and I'm just curious to know, you know, if you can give us an update on the opportunity there. And, and when you think that might actually become a, uh, a contributor to you guys?

Well, uh, SIP, or session initiation protocol is something that we introduced into our products at, almost nine months ago, and has been responsible for some, uh, significant, huge deals with the telco's. Sprint, for example, I'm sorry? Yeah, in the wireless stage of Sprint, we have, um, begun to implement an infrastructure with them to, um, provide high availability between, behind SIP. And this is also something that we're discussing with a number of other organizations. Uh, this is the key part of, of the connection for the, for wireless. And our, our, our research and development in this, so far, um, has yielded big benefits.

But we've got a lot more features that we intent to implement for high availability and SIP performance. So, yeah, that's been a key factor for us in the telco.

[Peter Schubert]: Great, thanks.

You have a follow up question from [Sam Wilson] of Merrill Lynch.

[Sam Wilson]: Hey Brett, one more question, just on the ASICS, um, I don't know if you can give us some color. Um, I presume they're going in the next generation switch versions of the layer four through seven of the big IP. Can you tell us, are they out of date in that? Have you got them on full tape out? You know, et cetera, et cetera. And just kind of where, where, where, where does that stand.

I'm glad you asked Sam, thanks. Uh, the ASIC went through it's first bin, we got it back and checked it out. The functionality on it was real solid. We've got the final ASIC's coming either Friday or Monday from Okie. We've done all the vector testing, um, prior to the full ramp of the chip, and it's looking real solid. The, uh, board, the, the resting boards that the chips are going to go on are ready and waiting. So, uh, the guys with the soldering irons in Spokane in our hardware facility are just waiting for the final chips to come back on Monday, so we can begin the full check out, the final check out. And we're expecting to hit beta by the end of August, or early on in September, as John mentioned.

Right now we're real confident behind the, uh, technology, and, and everything's looking pretty solid right now.

[Sam Wilson]: And, uh, I presume you already have some beta sites, uh, beta customers arranged?

Absolutely, we've had a number of requests from, uh, customer, well, from people that aren't customers, but from some of our tried and true key customers in the financial states that are, are really excited to give a, a, a kick on the tires, and we'll learn a lot from that. So we hope to do that again, um, within about a month to six weeks.

[Sam Wilson]: Great, thank you gentlemen.

You bet.

Your next question comes from [William Beckline] of [Conners Capital Market].

[William Beckline]: Hi, uh, just a follow up, uh, is my memory correct, and this is addressing the Japanese, uh, issue. That the application you were in over there was related to wireless? And the question that comes out of that is, is the Japanese issue totally one of a weak Japanese economy, or is, does it have something to do with the specific application you ran over there?

Yeah, I think it's more the economy, from what we have seen. Your recollection is correct, in that we've talked many times about [INAUDIBLE] in Japan, and how it's been a, a big driver of our business. Um, 'cause that is a fact. Interestingly enough, I just sent, uh, an e-mail to execs that I'd read in the Wall Street Journal to be [INAUDIBLE] obviously starting to be implemented here by ATT Wireless in the U.S., by Telephonica in Spain. Uh, also in Germany, and, and the matches, I sent an e-mail, is we've got to capitalize on this.

But yeah, you're right. But I think from, to answer the question specifically, uh, [INAUDIBLE] of Japanese management opinion is that, it, it's an economy issue. Um, I don't think it's going to last forever, but uh, you know, we're wary of it at the moment because it was, uh, going more than we expected last quarter.

[William Beckline]: Okay, thanks John.

At this time there are no further questions.

Okay, well thank you, and, uh, we'll talk to you next quarter. Thanks a lot.

Thank you for participating in today's F5 Networks third quarter conference call. You may now all disconnect.