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Polycom, Inc. (NASDAQ:PLCM)

Q3 2008 Earnings Call

October 15, 2008 5:00 pm ET

Executives

Michael R. Kourey – Chief Financial Officer, Senior Vice President – Finance & Administration & Director

Robert C. Hagerty – Chairman of the Board, President & Chief Executive Officer

Analysts

Tim Long – Banc of America Securities

Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc.

Troy Jensen – Piper Jaffray & Co.

[Jay Snyder] – William Blair & Company

Scott Coleman – Morgan Stanley

Samuel C. Wilson – JMP Securities LLC

[Elliott Gold – Telespan Publishing Company]

Mark Sue – RBC Capital Markets

Tavis McCourt – Morgan Keegan & Company

Scott Sutherland - Wedbush Morgan Securities, Inc.

Manny Recarey - Kaufman Bros., LP

[Jeff Kiveau] - Barclays Capital

Bill Choi - Jefferies & Company

Operator

Welcome to the Polycom Q3 earnings results conference call. (Operator Instructions) I would now like to turn the conference over to Mike Kourey, Chief Financial Officer.

Michael R. Kourey

Welcome to Polycom’s third quarter earnings call. I’m Mike Kourey, Polycom’s Chief Financial Officer and here with me today is Bob Hagerty, Chairman and CEO. As with previous quarterly calls we’re again augmenting today’s voice conference call with a webcast. If you’d like to receive the webcast please open your web browser at this time and enter Polycom’s home page which is www.Polycom.com and click on Q3 earnings call. Then, follow the instructions provided.

For the analysts participating in the Q&A session leave your call live so that you can use your conference call connection for the Q&A session at the end of our call. Please note that Q&A is for financial and market research analysts. We welcome all others to listen in to the Q&A session. Please also note that this entire webcast including Q&A will be maintained on Polycom’s website for 12 months from today for your convenience and replay.

Most of you participating in this call are aware of the federal legislature regarding forward-looking statements. Accordingly, we would like to note that during the course of this conference call Bob and I will be making forward-looking statements and present forward-looking visual materials regarding future events, anticipated future trends, future product offerings and the future performance of the company including financial guidance.

We wish to caution you that such statements and visual materials are just predictions that involve risks and uncertainties and that actual events or results could differ materially. We discuss a number of these risks in our business in detail in the company’s SEC reports including, most recently in the company’s Form 10Q for the quarter ended June 30, 2008. Any forward-looking statements must be considered in the context of such risks and uncertainties.

Also, please note that Polycom’s application of US generally accepted accounting principles or US GAAP requires disclosure that availability of new products, planned features and upgrades discussed during this call are subject to change or cancellation. At this time, let me turn the call over to Bob Hagerty, Chairman and CEO.

Robert C. Hagerty

To begin I’d like to provide our third quarter financial highlights. Later in the call Mike will go through the operating results in greater detail. Revenues for the third quarter were a record $275.8 million representing a 2% sequential increase from the second quarter and a 15% year-over-year. We exited Q3 with record backlog of $61.8 million, up 1% sequentially and 22% year-over-year.

Polycom’s deferred revenues were at a record $109.6 million in the third quarter, up 4% sequentially and up 37% over the year ago period. In our last call, I highlighted many of the measures that we were undertaking to improve our gross margins. I’m pleased to report that driven by mix, cost reductions and some ASP improvements in Q3 and coupled with sequential reduction in our inventories, we generated gross margins of 60.2%.

That’s an improvement of 170 basis points over Q2. At the bottom line, non-GAAP earnings were $0.37 per diluted share representing a 6% growth in EPS year-over-year. From a product line perspective, our network systems business returned to growth in Q3 on both the sequential and a year-over-year basis. The launch of our new RMX 1000 HD video conference media server contributed to the growth in this product area.

This innovative HD solution is optimized for small and medium enterprises complementing our fast growing RMX 2000 product line. Extending Polycom’s customer solution further we also announced our new converged management CMA solution. It’s an enterprise wide visual communication solution that seamlessly integrates video and network management at a desktop video on to a customer’s unified collaboration environment.

Polycom’s CMA product will begin shipping this month which we expect to further drive adoption in our network systems product line in the fourth quarter. Next, let me discuss the drivers of these solid Q3 results. The first such driver is the rapid ROI that Polycom’s collaborative solutions are delivering to our customers. Every day our customers are identifying new ways to deploy our solutions that streamline their business processes and significantly reduce both travel, cost and time.

We believe this is a critical value proposition for our customers as to manage their profitability more aggressively given the current economic uncertainty. Globalization also continues to be a significant near and long term driver for our business growth. In an environment where enterprises and government agencies are looking for every opportunity to collaborate more easily, swiftly and in a cost effective manner, unified collaboration has emerged as an effective solution that can be profitably deployed.

Applications for supply chain, go-to-market, M&A integration projects and business process outsourcing for example need real time collaboration. However, distance is often a barrier that simply must be overcome. With Polycom’s high definition collaboration solution organizations of all sectors and sizes are enabled for agility cost savings without the impediment of distance.

Let me give you some examples of our recent customer wins that highlight our value propositions to customers. Reliance Communications of India recently introduced Polycom’s HD desktop and room video solutions across its nationwide web world stores network. Tyco International implemented Polycom’s HD video solutions to reduce travel, improve productivity and minimize their carbon footprint.

Defense Acquisition University in Virginia just elected Polycom’s RPX immersive Telepresence solution. The DAU choose Polycom’s HD Telepresence for their senior level management courses because it enables a life like HD experience unlike any in the market today. [Gymwit] Financial, a Fortune 500 financial security company just invested in Polycom’s HD end-to-end solution to conduct internal management and planning meetings as well as interviews.

Trinity Health, a large healthcare system in the US recently expanded their Polycom unified collaboration network with our HDX video systems and our RMX network platform. This roll out includes our spectra link line of wireless phones. Our strategic partnership with a major service provided was essential in driving this important customer relationship with Trinity.

In the mining industry, Newmont Mining selected Polycom for a roll out of video solutions. They plan to use this video for important corporate meetings, project management and training at more than 20 remote sites. As many of the customers have highlighted, Newmont selected Polycom because of a comprehensive nature of our unified collaboration solutions. My final highlight is MIT University’s recent adoption of Polycom’s SoundPoint IP desktop phone solutions.

Next, I’d like to speak about what we’re hearing from customers and the CIO community and how significantly we believe Polycom is differentiated and well positioned in this uncertain economic period. First, CIO’s are essentially screening their providers for two things, one, is the seamless integration CIOs need solutions that are just that, end-to-end platform solutions that are not simply amalgamation of disparity end point products but the solution must work within the company’s own platform and across the eco system without nuance or difficulty.

Through our years of deep strategic relationships with the major call management platforms, present space architectures and global service providers, Polycom is uniquely positioned to provide our customers both large and small with a level of end-to-end simplicity and quality that we believe is unmatched. Of course, we also maintain our lead through our dedication to providing an open platform that complies with the key standards in the unified communications industry.

Two, CIOs are looking for vendor reductions especially in today’s complex environment, companies and government entities alike are looking to develop strong partnerships with providers that can focus on important issues such as unified collaboration and provide them with a full suite of tools necessary to meet their needs. Driven by fast moving technological advances in IT staffing levels that are certainly challenged, CIOs want suppliers that can provide a broad solution that works, train their staff and their user community and assist their organization in employing best practices.

As with the need for seamless integration we believe Polycom is differentiated with both our product and our service capabilities. We also of course, provide customers with a living platform through our software upgradeability providing investment protection for our customers. Next, I’d like to discuss a few of Polycom’s attributes that we believe are key during this economic uncertainty.

First and foremost is Polycom’s strong balance sheet positioning us very well competitively. For instance, we generated over $40 million in positive operating cash flow in Q3, our 43rd consecutive quarter of generating cash. In addition, we exited the third quarter with over $287 million in cash and not one dollar of debt. We also reduced our inventories from Q2 by over $2 million and further, we achieved a DSO of 44 days, the best in the collaboration industry.

These balance sheet metrics are core not only due to the financial strength they indicate but also because the brand value that they enable. In other words, our partners and our customers know that Polycom has a rock solid financial standing you’d expect from a market leader. We believe this fact coupled with our market leadership and unified collaboration and our best in industry solutions makes Polycom an effective partner for customers of any size, sector or geography.

Finally, before I turn the call over to Mike Kourey, I’d like to touch on our progress with Polycom’s operating model. As I discussed earlier, we believe Polycom is well positioned to serve as an important cost savings option for enterprise and government agencies alike. As you can see, this continues to have a positive impact on our top line results. In addition, as we stated last quarter, we were going to improve our gross margins and I’m pleased to say we returned to the over 60% level in Q3.

From our operating cost perspective, as we indicated in our last call, we continue to build our go-to-market footprint particularly with customer facing hirers. Driven primarily by the fast ROI benefits of our solutions, we believe these investments will continue to enable us to capture the fast growth opportunity and unified collaboration and will allow us to make competitive gains in most, if not all our major product categories.

Going forward, we expect revenue growth to outpace sales and marketing spending thereby reducing the expense to revenue ratio as we grow. As we forecasted, we reduced research and development spending in Q3. Of course, we continue to invest at a robust level in order to deliver industry leading innovations to our customers. I want to highlight that R&D is now within our target model range.

Lastly, G&A continued to operate at a level that we believe is in balance with our revenue levels. The net result is that we delivered above forecast operating margins in the third quarter. Importantly I wanted to note that not only do I expect Polycom to deliver market leadership through the best unified collaboration solutions with a world class go-to-market but, I expect tangible progress in our operating model in 2009.

As we navigate through the current environment, we are focusing more intently on our profitability. As such, we intend to take a more conservative stance as it relates to future investments in our go-to-market footprint and our R&D spend. These adjustments will only be incremental and be subject to change given economic climate. That said, we intend to prudently make investments where needed to support our market leadership position.

On that note, let me turn the call back over to Mike Kourey for a discussion of Polycom’s financials.

Michael R. Kourey

Before I get started, please note that for the financial guidance that Bob and I are giving today Polycom is not assuming the responsibility to provide any updates regarding this financial guidance regardless of changes, adverse or otherwise which may occur in the future. Also, during this portion of the call, I want to remind you that we will both be making forward-looking statements including our expectations of future financial performance which are subject to many risks and uncertainties.

Moving to a look at our results, as Bob stated earlier, revenues for the third quarter were a record $275.8 million. This represents a sequential revenue increase of 2% and a 15% increase over Q3 of last year. On a product line basis which includes the service elements of each product line, revenues for video solutions were $178.1 million in Q3 growing sequentially by 5% and 22% year-over-year.

Video solutions is comprised of our video communications and network systems product lines. Of these product lines, video communications generated a record $144.2 million in revenue, growing sequentially by 2% and up 27% year-over-year. On a unit basis, we shipped a record 21,126 group video systems. On the desktop video front, we shipped 12,322 units in the third quarter. Telepresence and HD video comprised over half of Polycom video revenues in Q3.

Importantly, the network systems product line returned to growth in the third quarter generating $33.9 million in revenues, up a significant 21% sequentially and up 4% year-over-year. The voice communications business generated revenues of $97.7 million in Q3 representing a 5% sequential decrease from Q2 and a 4% increase from the year ago period. Linearity improved sequentially in Q3 with 44% of revenues in the last month of the quarter.

Polycom exited Q2 with a record $61.8 million in backlog, up 1% sequentially and 22% year-over-year. Polycom’s deferred revenues were $109.6 million in Q3 increasing 4% sequentially and 37% over the year ago period. Excluding the Codian settlement from Q1, Polycom deferred revenues grew 21% year-over-year.

Moving to revenue by geography, in the third quarter North America revenues were up 2% sequentially and 5% over the year ago period. EMEA revenues decreased 3% sequentially but grew 27% over the year ago period. Asia revenues grew 4% sequentially and a significant 31% year-over-year. Latin America was up 13% sequentially and 46% year-over-year.

From a channel standpoint, the revenue breakout for the third quarter is as follows: 38% through value added resellers; 51% through distributors; 6% through service providers; and 5% direct. Reviewing our revenue drivers in Q3 we are delighted with the strong sequential revenue growth of our network systems business and its return to year-over-year growth. We’re pleased with the acceleration of video growth from 25% in Q2 to 27% in Q3.

We’re also pleased with the acceleration of revenue growth in Asia Pacific, Latin America and US Federal. Of course, with the economic backdrop voice and US enterprise did not perform as well but did generate single digit year-over-year growth in the third quarter. Looking forward in to the fourth quarter, we see several positives including a fast ROI profile for our video collaboration products, a newly invigorated RMX network systems product line, a trained and productive sales force, a solid pricing environment and the best open standards end-to-end integration with strategic partners in the unified communications eco system.

Of course also, Q4 typically exhibits a budget flush for a majority of enterprises around the world. Offsetting these positive drivers of course is a macro environment of tight credit and an uncertain economy. Although we believe Polycom is well positioned to make market gains in this environment and we enter Q4 with record backlog and deferred revenues, we are unsure as to what the spending environment may be in this quarter.

As such, we are taking a conservative stance from a guidance perspective and are guiding to flat sequential revenues in the fourth quarter. Moving on to the statement of operations, non-GAAP gross margins for the third quarter were 60.2% representing a sequential increase of 170 basis points.

This significant improvement was driven by video product cost reductions, increased product mix of higher margin products particularly towards network systems, improved service margins and the partial quarter impact of a small price increase which we instituted in September. Breaking out our gross margin objectives by product family, our network systems product line continues to have targeted gross margins in the high 60s.

Group video and voice communications products have gross margins targeted in the high 50s to mid 60s while desktop voice and service gross margins are targeted in the low 40s. For the third quarter service operated above its target range. Network systems, video and group voice operated within their target ranges and desktop voice operated below its target range. As noted above, gross margins in the future may be higher or lower and are subject to mix variations and other factors.

Switching gears to non-GAAP operating expenses for the third quarter, Polycom’s operating expenses increased sequentially in absolute dollars and as a percent of revenues in Q3. Looking at the specific non-GAAP operating expense line items for the third quarter, sales and marketing represented 28.5% of revenues for the period, up from 26.7% in Q2. R&D closed at 11.5% of revenues down in both a dollars and a percent of revenues basis from Q2. G&A was 4.9% of revenues, up from 4.7% in Q2.

In total, Q3 non-GAAP operating expenses represented 44.9% of net revenues in the third quarter, up as a percent of revenues from 43.8% in the second quarter. Moving to a look at the company’s operating income, Polycom generated third quarter non-GAAP operating income of $42.3 million or 15.3% of net revenues up from 14.8% in Q2. This represents a 3% growth in operating income from $41.2 million of non-GAAP operating income in Q3 of 2007.

As a recap of our performance against our previously stated long term target model, we were within our target gross margin range of 59% to 63%. Sales and marketing operated 2.5 percentage points over the high end of its target range and R&D came in to its target range in Q3. G&A continued to operate within its target range. Our non-GAAP operating margin of 15.3% is 4.7 percentage points below our target range of 20% to 22%.

Looking forward to the fourth quarter, we expect gross margins of approximately 60%. From an operating expense standpoint, we plan to manage our Q4 expenses to roughly Q3 levels. As a result, we anticipate Q4 operating margins to be roughly consistent with the third quarter. Our income and expense for the third quarter was a net expense of $700,000 comprised of $1.6 million in interest income offset by other expense of $2.3 million.

Interest income was impacted by the lower cash balance associated with our stock repurchases in the period and the lower interest rate environment. Our expense was driven by a write down of certain investments in foreign exchange hedging expense in the period. We expect interest income to be offset by hedging and other expense in Q4, yielding approximately zero at the other I&E line in the fourth quarter.

Moving to tax you’ll note that our Q3 effective tax rate was 23.6%. We accomplished this improved rate through our geographic mix of profits, a new lower tax rate in Singapore and Thailand and through various discreet items in the quarter. Looking to the fourth quarter we are forecasting a 25% effective tax rate based on our mix assumptions. Of course, this 25% rate is subject to change based upon changes in geographic mix as well as changes resulting from any new US or international regulations or interpretations.

Q3 non-GAAP net income was $31.7 million representing a 3% decrease from 32.8% non-GAAP net income in the comparable period last year. Non-GAAP diluted EPS in Q3 of $0.37 grew by 6% from $0.35 per diluted share in Q3 of 2007. GAAP profitability for the quarter was $17.9 million or $0.21 per diluted share in Q3 of ’08 versus $19.8 million or $0.21 per diluted share in the comparable period last year.

This represents a 9% decrease in GAAP net income and flat GAAP EPS year-over-year. Moving to DSO the company’s net trade receivables of $133.3 million resulted in a DSO of 44 days consistent with Q2 and a two day improvement year-over-year. Looking forward, we are continuing our best in class DSO guidance of 40 to 50 days.

Inventories decreased $2.2 million sequentially to $92.1 million at the end of Q3 representing turns of 4.8. We expect to maintain inventory at approximately this turns level going forward. Moving to cash, in Q3 Polycom generated $40.4 million in operating cash flow representing Polycom’s 43rd consecutive quarter of positive operating cash flow. These solid operating cash results were driven largely by our strong profitability and working capital management, namely accounts receivable and inventory management.

Cash and investments at the end of the third quarter totaled $287.4 million. Of course, the company continues to be debt free. Regarding expected share count, we expect Polycom’s weighted average shares per diluted EPS to grow by approximately 500,000 shares in Q4 exclusive of further stock repurchases. Note that during the third quarter we repurchased $80 million of our common stock.

Entering in Q4 we have $220 million remaining on our share buyback authorization. In addition of future potential buybacks of our stock our share count will change based upon Polycom’s stock price, any acquisition activity and other factors. Moving to headcount, Polycom had 2,620 employees at the end of Q3 representing a net increase of 22 employees over the prior quarter. This change was driven primarily by additions in customer facing functions.

As a final note on the financials, we have presented both non-GAAP and GAAP financial measures here today. Please refer to our reconciliation of non-GAAP to GAAP financial measures in the tables entitled GAAP to non-GAAP reconciliation in today’s earnings release. At this time let me turn the call back over to Bob Hagerty for closing comments.

Robert C. Hagerty

In summary, our customers are experiencing execution agility and cost savings from the deployments of Polycom collaborative solutions. Every day our customers identify new ways to deploy our solutions that streamline their business processes and significantly reduce both travel costs and time. We believe these are critical long term drivers of our business performance and especially important within the context of the current economic environment.

In summary, as we enter the fourth quarter and move in to 2009 I want to highlight the following: first, the fast ROI of Polycom’s unified collaborative solution makes our offering a must have as customers execute in an uncertain macro environment. Second, we believe Polycom’s diversification across geography, vertical market and enterprise sector provides us with a strong position as we lead the unified collaborations market.

Third, proven by our execution with gross margin, G&A and now R&D spend we expect not only to continue to drive our leadership position but to drive operating leverage in our business as we grow. Fourth, Polycom has a strong balance sheet with nearly $300 million in cash and investments, 43 consecutive quarters of positive operating cash flow and no debt. We believe this positions us as a rock solid partner for adoption of our mission critical solutions.

On that note, we’d like to open the call to the financial and market analysts for questions. For all others we invite you to stay on the call and to listen in. Of course, as we discussed earlier in the call, many of the statements that we have made and will make during the Q&A period are forward-looking statements which are subject to many risks and uncertainties.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Tim Long – Banc of America Securities.

Tim Long – Banc of America Securities

Two questions if I could, maybe Bob I get the conservatism in the guidance despite the good backlog and deferred revenue. Just give us a little bit more color kind of what’s behind that. What are customers saying to you about both the near term and more importantly how long you think there will be some potential sluggishness or lack of visibility?

Then Mike, if you can just give us a little bit of color about impact of the price increases on both top and more importantly gross margin line in the quarter and what we think about pricing heading in to Q4 and in to ’09.

Robert C. Hagerty

What we saw primarily in the third quarter was that we had a very strong pipeline. That pipeline remains, it is a very good pipeline. We are seeing some caution on the part of end user customers about when they’re going to implement programs. At this point we have not seen budgets be reduced. We have seen people have a longer approval cycle, more people involved in that approval cycle.

But, the pipeline looks good, the prospect list looks great and we continue to see enormous amount of people looking at this product line, looking at the ways they can employ these best practices to improve their cost profile. But, we just feel at this point there’s been a lot of gyration, a lot of anxiety in the markets and it hasn’t been just in the US markets so we wanted to take a conservative stance at this stage on the guidance.

Michael R. Kourey

Let me go ahead and respond to your question about price increase impact. In Q3 it was very modest. Why? Because, it didn’t kick in until the beginning of September and obviously bids in process we honored. Plus, to the extent that there were some of the larger transactions off schedule so to speak those continued to be as they always would be and always will be negotiated on a case-by-case basis.

That being said, there will be a full quarter of impact in Q4. You may know that the price increase that we implemented on most, not all, but most of our product lines represents a 3% uplift and based on that we do expect to have some further benefit of that obviously going in to Q4 and 2009. Exactly how that will all shake out will be determined in the future here. But, the prices went up a little bit on September 1st and will be in full impact this quarter.

Tim Long – Banc of America Securities

Then Mike just to follow up, the flat guidance therefore would imply offset by mix or some other factors?

Michael R. Kourey

Indeed. TBD of course Tim. I mean, it may or may not be but that’s the thinking in the guidance, yes sir.

Operator

Our next question comes from Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc.

Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc.

Mike, two question for you, on the credit side of the equation, have some of your customers come back and said it’s difficult to get credit and consequently have put buying decisions on hold? Or, have some of the borrowers have come back and said similar things to you? I’m just curious to see what you are hearing on that front.

Michael R. Kourey

You know, you think you would be and if you look at the macro environment you’d think we should be but at this juncture, no. As a matter of fact, our receivables management has remained very consistent and we’ve put some extra – I mean, we always have great care, we have the best DSO in the industry certainly. But, we have put some extra reviews in to some of that process and what we’re finding thus far is that things are fully intact in that regard.

We are making sure to the extent that some of these issues were to come to pass we’re ready for them and in front of them because we don’t want to be reactive, we’d rather be a bit proactive. But, thus far we’ve seen the credit environment okay for all of our material partners.

Sanjiv Wadhwani – Stifel Nicolaus & Company, Inc.

Then on the European side down sequentially, obviously they always have a weak August month, was that expected for the fourth quarter or was that unexpected? Did things sort of slowdown a bit more than expected in the last 15 days or so of the quarter?

Robert C. Hagerty

Most of the year and we can look back – I think our data goes back about 15 years, most years that third quarter in Europe is slow in the summer and comes back in the September month of the quarter. I would say that this was a fairly traditional profile for what we’ve seen historically. Although, I say that last year was a little more robust than we saw this year.

Operator

Our next question comes from the line of Troy Jensen – Piper Jaffray & Co.

Troy Jensen – Piper Jaffray & Co.

Mike, I just want to follow on the gross margin stuff here. Can you let us know how much of the gross margin boost came from the inventory absorption reversal in Q3? I think I remember three months ago we were going to get a 50 basis point boost in both of Q3 and Q4 which is really consistent with your guidance.

Michael R. Kourey

Well, I mean we had the $2.2 million reduction in inventories during the third quarter so that was definitely a real part of it. If you kind of zoom up and I’ll break it down here a little bit because it was fantastic actually. We went up 170 basis points, way beyond the guidance, we have guided that we’d be up 50 basis points in the third quarter, if I’m not mistaken. We ended up a lot more than that.

About a half a point around the kind of standard margin line which that has been contemplated in that some of that early price increase on some of the materials as well as some cost benefit. We had some other things in the outside area associated with service. Service margins went up, service was a very robust delivery vehicle this quarter on the revenue side as well so that was part of it. It was probably a little over a half a point.

We had some kind of non-standard cost issues, some just outright cost management from a manufacturing overhead standpoint, very effective by the ops team, I have to say. That generated upwards half a point and then there was a bunch of miscellanea to make up the rest of the 170 basis points. It came from a variety of vehicles and if you really look at it, it’s all repeatable stuff.

Now again, mix is in that equation as well and so we want to make sure that as we’re guiding we don’t want to take all the good news and say that’s all repeatable and there wouldn’t be any offset so we’re guiding to about 60% and we’ll see how it shakes out in Q4.

Troy Jensen – Piper Jaffray & Co.

But you are expecting some improvement this quarter from the inventory reversal again, correct?

Michael R. Kourey

Yes. I mean, at this juncture we’ll see what we do with builds. As I said in my prepared comments, we expect to be at about this turns level. Does it pop over 5? It might, we’ll see how it all goes but I just want to tie down that much that the net results is we’re very happy with the jump up from 58.5 to 60.2 and we like having a [inaudible] back on our gross margin line.

Troy Jensen – Piper Jaffray & Co.

Two more quick ones, cost reduced HDX platform, is that scheduled to still hit in Q1?

Robert C. Hagerty

We introduced a product called the 7001 with HD on it and so that product is out, it is shipping.

Troy Jensen – Piper Jaffray & Co.

Then just last one and I’ll get out of queue here, the growth in the systems business, can you confirm if that came from video or audio or a combination of both?

Michael R. Kourey

A combination of both.

Operator

Our next question comes from [Jay Snyder – William Blair & Company].

[Jay Snyder – William Blair & Company]

My question for you guys is on the macro sensitivity within the various business segments and I think from what I’m hearing from you guys it is pretty clear that video is less sensitive and voice is more sensitive, is that a fair statement?

Michael R. Kourey

Yes.

Robert C. Hagerty

Absolutely.

[Jay Snyder – William Blair & Company]

What is your feeling on the voice business right now? It was down sequentially in Q3, are you thinking kind of flattish for Q4? I know you don’t normally break it out but we’re not in normal times right now. That’s the first part of the question. The second part of the question is can you give us some color on how SpectraLink is doing primarily because of some of the weakness in the retail sector which I know is their biggest vertical historically.

Robert C. Hagerty

Let me try breaking it down a little bit. I think when you talk about our voice business you need to talk about it in sort of product line. So, you’re right about the SpectraLink, challenging in the retail sector, good in the other areas that we participate in with other verticals like manufacturing and healthcare. But, the retail sector is challenging so that’s dampening growth and dampening the performance in the SpectraLink wireless phone product line.

We have an offsetting kind of business, the analog speaker phones are slower than they have been historically but the IP speaker phones, the IP conference phones are growing nicely as are the install base products. The SoundStructure product line, that is also doing well. Then desktop phones have a bit of a challenge and I’ll say that people have an opportunity to defer because there’s a Greenfield piece in which we’re participating and doing very well, there’s a replacement market which I would say has slowed a bit.

Those are kind of the dynamics of it. I’ll let Mike expand.

Michael R. Kourey

I think that is far. As far as breaking out the guidance, certainly for Q4 or next year for that matter we’re not trying to approach – we only give quarter guidance typically anyway of course but, yes your assessment is correct and we’ll see how Q4 turns out. I mean, we’ve just taken a conservative stance here today even with the other dynamics both Bob and I talked about that really drive at least the video side and the video network side of the business.

Clearly, everything else given equal you would expect video to continue to be a real grower and voice, we’re going to have to take a wait and see.

[Jay Snyder – William Blair & Company]

What I’m hearing is that if I were to model Q4 flat you probably see video up slightly and voice down slightly. Is that close?

Michael R. Kourey

I think if Q4 turns out flat, that would be a very logical assumption.

Operator

Our next question comes from Scott Coleman – Morgan Stanley.

Scott Coleman – Morgan Stanley

Bob, I’m wondering if you can give us a little more color on the verticals this quarter particularly maybe federal versus state, local, education as well as the financial vertical and what your expectations are over the next quarter or so?

Robert C. Hagerty

I would say federal was very strong so it was a good strong quarter in the third quarter for federal. As you know, that’s usually the biggest quarter for the US federal.

Michael R. Kourey

But, it was big up year-over-year as well. I mean, it was a great quarter for federal.

Robert C. Hagerty

Good color on that, yes. It was a very nice quarter. So, up sequentially, up quarter-over-quarter, year-over-year. Now, generally what we’ll see is that the fourth quarter also is a strong quarter for federal and we would expect to see that as well. Let me go through some of the verticals and reiterate what I said to Jason, the wireless phone is primarily participating in the retail as well as some of the IP desktop phones, not quite robust so a little bit challenged because of the retail sector.

Healthcare I would say no real change in what we see as prospects or in performance. The financial vertical as been okay, it was a key driver earlier and I would say it’s surprisingly reasonably strong. But I guess there’s a lot of change in the financial vertical although, we did just close one we mentioned here in the call today. That would be the way I’d approach it.

State and local, we haven’t seen – although states are challenged and if we go state and local or really the way we look at it is the educational sector and that’s a global number and we haven’t seen a big fall off there, it’s been reasonable.

Scott Coleman – Morgan Stanley

From a pipeline perspective and the caution looking at Q4, is that driven by a change in orders? You talked about deals taking longer and projects taking longer to get approval. Given that you just cited strength or not a whole lot of change across most of your verticals I’m just trying to understand where the incremental caution comes from?

Michael R. Kourey

Yes, at a high level every vertical still contributed but financial services was down full stop, it was. So that’s not a positive. That being said, we’re taking a conservative stance because there are some unknowns, there is an uncertainty out there. We’re not seeing deals disappear so that’s important, sometimes it happens either they just go away or to a competitor or whatever. That’s not happening that we can see.

Secondly, we do obviously have tracking of our pipeline and our pipeline is up very nicely versus a quarter ago at this time.

Robert C. Hagerty

And year-over-year. Quarter-over-quarter, year-over-year, the pipeline is bigger.

Michael R. Kourey

Oh yes. So, if you only were looking at that metric in isolation we’d be thinking that there’s no reason to believe we wouldn’t be doing in Q4 off Q3 like we normally do, right. You know, that the last three years if you average it out it’s plus 8.5 sequential. However, I am sure I am preaching to the choir here but there are a lot of uncertainties and so I think it would be the wrong approach to come out with some kind of a normal guidance range so we’re taking a flat guidance at this point. Then, we shall see how it all flows as these weeks click by here over the rest of this quarter.

Operator

Our next question comes from Samuel C. Wilson – JMP Securities LLC.

Samuel C. Wilson – JMP Securities LLC

Just two quick questions, first can you give us some sense of what the US would have looked like without the federal government as part of it? And second, I know you bought back $80 million worth of stock, how many shares did you buy back?

Michael R. Kourey

From a share count standpoint, let me just pull it out, I mean we paid more than where it currently is I will say that right now. We bought just a nose over 3 million shares in the period with the $80 million.

Robert C. Hagerty

So, we don’t really breakout federal. If you look at public sector I think on a quarter-over-quarter basis we would be down a little bit, we wouldn’t have had quite the performance because federal was better than what it normally is. So, stepping up from Q2 to Q3 we have more federal than we had in Q2 and therefore the video in particular would have had lower growth.

Michael R. Kourey

It would have been down sequentially.

Robert C. Hagerty

Yes, but we don’t breakout the specifics of it.

Samuel C. Wilson – JMP Securities LLC

I just wanted to get a sense for how much US enterprise is sort of dealing with economic issues and how much sort of federal was better than expected. I don’t need exact numbers just sort of qualitatively what you’re feeling here?

Michael R. Kourey

Qualitatively the close cycle in US commercial was slowed down especially during those kind of latter couple of days. I mean, bookings were good as you saw, we had backlog go up sequentially, we had deferreds actually have a nice step up sequentially so there was good business flow. But, as far as getting it done, getting it out, as you know all too well there were some issues that really caused people pause there towards the latter part of September and that impacted in particular US commercial and to a lesser degree European commercial.

Operator

Our next question comes from [Elliott Gold – Telespan Publishing Company].

[Elliott Gold – Telespan Publishing Company]

I have a couple of question and one of them may have been answered, I apologize but I got distracted for a second. A real simple one, you did notate that your Telepresence and HD now exceed 50% of your sales in video. In the past you’ve made comments about the growth quarter-to-quarter or even sequential on Telepresence. Do you care to comment on that? Then, I do have another question.

Robert C. Hagerty

HD continues to grow and I don’t have the breakout of HD versus the other but in the last quarter when we commented about HD it was less than half and this quarter it was more than half so it continues to grow faster than the rest of the business.

Michael R. Kourey

Yes, that’s for sure. As far as Telepresence goes, some of those conversions got caught up in what I was just describing with Sam from JMP and that is that Telepresence was off slightly sequentially. It was up big year-over-year, it was up just under 400% year-over-year but sequentially it was off although quite frankly, when we look at the flows of how it goes through backlog in to revenue etc., we actually expect a very nice contribution from Telepresence sequentially and year-over-year in Q4. But, that’s the answer to your question.

[Elliott Gold – Telespan Publishing Company]

Then, on your audio network products, you no longer break them out but last quarter when I asked Bob Q208 Bob said, “It’s been a lumpy business. It wasn’t very good Q2.” Then, the two of you said it was a long sales cycle you expected Q3 and Q4 to see better revenues in the audio network.

Michael R. Kourey

Yes.

Robert C. Hagerty

Q3 was better, Q3 was definitely better and we’ll see about Q4. But, Q3 was definitely better. We did get some good bookings and revenue on the ANG side. Elliott, let me also add though that the video NSD was also good. It wasn’t just ANG that made the network systems grow to the level it grew. The sequential growth was strong, very strong and it was both product lines that drove that and the video product line was strong growth as well sequentially. It was a nice balance win for that product line.

[Elliott Gold – Telespan Publishing Company]

Yes, I saw the sequential jump of 21.1% although I noticed it was flat against last year, it was 33.9% versus 32.6% year-over-year.

Michael R. Kourey

Yes, it was up 4% but that was a very nice recovery.

Operator

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

Mark Sue – RBC Capital Markets

Are you seeing any changes in deal sizes or are customers saying maybe there is a lack of urgency, any qualitative comments there? And, what kind of closure rates are you assuming for the December quarter? Is it similar to maybe what you might see in the first quarter, the March quarter? Or, is it even more conservative than that?

Robert C. Hagerty

Let me try to piece together what we have said already. We’ve said that the pipeline is bigger and we’ve guided the revenue flat so that would imply we’re being conservative in our guidance about closure rate.

Michael R. Kourey

And closure speed.

Robert C. Hagerty

And, closure speed that’s the way to put it. In terms of deal size, if I look at it, I don’t have the numbers I guess anecdotally I haven’t seen a decrease in size of deals. We see in fact, particularly at the high end where there is a mix of Telepresence and the high end video that in fact I haven’t seen any change in that. In fact, we’re seeing repeat business, we’re seeing new business and a very good pipeline, very good pipeline.

Now, closure rate again, I would say in the third quarter, especially after the US kind of blew up a little bit from the banking side and the attention the media was putting on it, we did see people get cautious and we did see people slow down closing deals. But, the pipeline grew and I think that’s a very good sign. We’re trying to be a little bit cautious a little bit conservative given it’s hard to predict with the media and where this will really end up with, with an election and a whole bunch of other things going on.

Mark Sue – RBC Capital Markets

Then Mike maybe lastly just on DSOs, I mean should we start modeling that to kind of expand over time or is this your view that even despite everything that is going on that you should be able to kind of maintain it for at least a couple of quarters.

Michael R. Kourey

I would expect to maintain DSO in the 40 to 50 range. Look, as it has over the past several years it will move around. It happens to be dead steady this quarter and 2% better year-over-year. But, yes, certainly in the 40 to 50 range I’m comfortable with that range.

Operator

Our next question comes from Tavis McCourt – Morgan Keegan & Company.

Tavis McCourt – Morgan Keegan & Company

I’ve got three questions, first the service gross margins were up pretty significantly and I know you talked about in the past some issues with gross margins on Telepresence installations. Was that progress on that front or was that something else that hit service gross margins that allowed such a big expansion in one quarter?

Michael R. Kourey

Well, the bottom line is the revenues were up, some of their costs are fixed and you get some expansion there. We had some very nice margin on some maintenance contract business. Our service model is working great quite frankly. I think it was up almost 15% of revenues, 14.6 % or 14.7%. There was a nice contribution by the team, the value proposition is being adopted by the customers. We provide this very software intensive living platform, customers love that and they’re buying a contract.

They see the value in it and as they buy more of that it frankly not just not only drives revs but it drives the margins as well.

Robert C. Hagerty

And on specifically to your Telepresence installation question, we are getting more experience, we’re getting faster, better logistics, better prep work done. We do a thing called network analysis to make sure that everything’s ready when we install. And we watch that carefully. I think at first as we started installing these things more and more, we really weren’t sure of everything that you had to have lined up. So you have to have the construction, you have to understand the customer and use your customer’s construction, room readiness, network readiness, and then we have to manage our logistics well. I think our learning curve has been good; real good in that area.

Tavis McCourt - Morgan Keegan & Company

It seems like 1080p is kind of the new product type for HD or videoconferencing now. Which of your units now have had 1080p resolution or when should we expect those in the market place?

Robert C. Hagerty

As you know we demonstrated 1080p at the Infocom Show and I would say we have a very strong pipeline. We ship a lot of product. I think more product than anybody else in the industry. I think we’re at 21,000 units this quarter. We’ve got a strong pipeline, good R&D pipeline of products coming through.

I don’t want to pre-announce anything but there’s a lot of announcement points coming through the fourth quarter and into the first quarter and then actually into the second quarter. So there’s a really robust road map. We have the technology because obviously we’ve demonstrated it and it’s just a matter of when we are ready to package it up and ship it. You’ll expect to see press releases as we go through here now through the fourth quarter and into the first quarter.

Tavis McCourt - Morgan Keegan & Company

Mike, I know individual products have different gross margins but in aggregate does the voice business have lower gross margins or higher gross margins than the corporate average?

Michael R. Kourey

In aggregate typically it is on the product side, they’re not way different but it’s a little less than video typically because remember there’s the desktop mix that comes in there.

Operator

Our next question comes from Scott Sutherland - Wedbush Morgan Securities, Inc.

Scott Sutherland - Wedbush Morgan Securities, Inc.

Talking about verticals, you mentioned the enterprise in the US may be a little bit concerned there. How are you seeing international? In Europe obviously there’s a little bit of weakness there, but the other international markets, how is that all holding up in the enterprise front?

Robert C. Hagerty

Through the quarter I think we’re pretty pleased with the way the flow happened internationally. I think the US was flowing really well and then as the September month started to roll out and we had more and more announcements by the Treasury, by the Fed, by the President, I think people got a little antsy and slowed things down. I didn’t see the same thing internationally at all.

Scott Sutherland - Wedbush Morgan Securities, Inc.

Last month Cisco introduced some more products and moving downstream a little bit, I know you compete with them in some areas, you partner with them in other areas. Can you talk a little bit about has that caused any competitive disruption, what are you seeing from them out there and any other competitive changes you’ve seen out there?

Robert C. Hagerty

We see a strong video market and the market seems to be quite robust. It’s attracted a couple players to start up. Cisco, HP all playing. We’re very happy with our positioning. We’re really happy with our product family, our upgradability of that product family and our road map.

Michael R. Kourey

And it grew 27%.

Robert C. Hagerty

Yes. It’s a good market and growing well, and great markets attract more people, it gets more attention to the market. Everybody says the value of a network goes exponentially by the number of people that add to it. The more people using video, the more attraction that is to other people to use video. There’s over a million systems of a reasonable generation out there in the market place as best we can estimate. The more they get out there, the more people are going to use video. So all the attention this space is getting is helpful to us.

And Cisco, yes, there are some areas which we compete but most areas where we cooperate. They’re certainly doing a lot of marketing which is a positive on us and they certainly build good routers as do others that are more capable now than they were in the past of dealing with video. The better the network infrastructure gets, the more reliable our product line gets.

Operator

Our next question comes from Manny Recarey - Kaufman Bros., LP.

Manny Recarey - Kaufman Bros., LP

On the competitive front thing looking at Camberg’s results on the end points you guys grew substantially faster than they did. Is anything going on from that perspective which kind of drove that during the quarter?

Robert C. Hagerty

I think in the quarter it was actually the other way around. In the second quarter we grew end points; they grew network. This quarter the trend reversed a bit and they grew a little bit faster on end points and we grew a lot faster on network. It’s a jousting back and forth. If you want to look at it from a positive perspective, the more systems that are out there, the more awareness happens, the more network there is. And in the case of most of the vendors, with a couple of exceptions which I won’t go into because we have in the past, everybody’s on standard. So the more systems that are out there, the more inter operability there is and there’s more of a network to operate on.

Michael R. Kourey

The bottom line is it’s a fast growth industry and both of us were in the 20s.

Manny Recarey - Kaufman Bros., LP

One clarification. As Bob said with his prepared remarks, as we look forward because of the economic situation and you’re always kind of bouncing between growing the margins and investing in the business. Looking forward right now to shift a little bit more trying to grow the margins as opposed to investing in the operating infrastructure. Is that kind of a fair summation?

Robert C. Hagerty

I think the way to look at it is we went through two cycles over the last several years. One cycle was to renew our architecture and get onto some silicon that we liked and build a differentiated architecture that allows us a lot of flexibility in engineering. So we’ve done that both in our voice product line and in our video product line. Now there’s always work to do; there’s always new devices out there; there’s always work. That’s a never-ending course that you’re on. There’s always things you can do and improvement. That’s wonderful, right? That’s what gives end users more value for what they buy year after year. We’re kind of up to speed on our architecture so we feel very good about the position we’re in architecturally platform wise on our video solutions and our network solutions and our voice platforms.

If you went to go-to-market, we had a lot of structural work to do as we moved to this direct touch model. Most of that I wouldn’t call it infrastructure but structure is there and we have a good coverage model. Clearly I the market grows faster we will grow the customer facing positions faster but we don’t have to make that initial investment to get the thing up to critical mass where we believe we’re at critical mass both in engineering, and you see that now from an end model R&D spend and sales and marketing go-to-market. The go-to-market aspect of that is coming up to critical mass where it’s more or less should grow at or with market as opposed to having to spend more to catch up with the infrastructure of this model change.

Operator

Our next question comes from Troy Jensen - Piper Jaffray & Co.

Troy Jensen - Piper Jaffray & Co.

Mike, I was wondering if you could talk a little bit about channel inventory. I’m curious if the distributors that stock inventory are getting worried about the economy. Are they holding less inventory currently and how do you manage it around a six-week level?

Michael R. Kourey

As you know we’re very sensitive to that issue with the overhaul we did many, many years ago at this point. Yes, you definitely do not want them to have inventories that would be at a level that would use up their credit line or whatever the case may be or just their cash flow in general. We’re watching that very carefully. We get weekly reporting by many and monthly reporting by the rest.

So we’re very much on top of that and we keep all that in balance quite frankly. The right way to say it is they keep that in balance. We exited the third quarter with that in balance. You clearly don’t get 44 day DSOs by having a channel with inventory issues. Our inventories were down. Their inventories are in good shape, and we of course would expect them to want to keep an eye on that.

Troy Jensen - Piper Jaffray & Co.

Do you sense that they’re trimming them down?

Michael R. Kourey

The most candid answer I can give is that at the margin, yes, but I would not overstate it because if they go too low then they won’t have availability and part of their value add is the logistics. If you get into distribution in some of these matters, you wouldn’t be able to turn it fast enough and then they’d lose to some of their fellow competitors.

Robert C. Hagerty

I just want to remind everybody who’s been on the company for a while and watching the company for a while, in the past everybody stocked. Now only distributors stock and they only stock what they need to cover the logistics of being able to refresh their inventory when they need it.

Michael R. Kourey

A lot of our business is drop ship as you may know.

Troy Jensen - Piper Jaffray & Co.

Can you give us the units shipped for both group and desktop?

Robert C. Hagerty

126 was the group video and 12,000 something.

Michael R. Kourey

322 is desktop. 12,322. So it was a new record in group video and in desk it was near record at 12,322.

Operator

Our next question comes from [Jeff Kiveau] - Barclays Capital.

[Jeff Kiveau] - Barclays Capital

I was wondering if you folks wouldn’t mind commenting on where the ASP increases are most prevalent for you and then how well are they sticking, how well are customers taking to them?

Michael R. Kourey

Sure. What we saw in the third quarter again was a very strong environment from that perspective and it’s just a market place where it’s very strong. I think that at a higher level than that you could look at it, which probably is intuitive, stronger in video. It’s actually fairly strong in voice but relatively speaking not as much so. It’s more of a video story in that regard.

Robert C. Hagerty

Although I will say now that we’ve heard a little bit of Smartphone interference that all the Polycom speaker phones have Smartphone immunity. So to the extent your organization still has them, it’s a good time to upgrade to Polycom Sound Station 2 or Sound Station W which all are immune.

[Jeff Kiveau] - Barclays Capital

To me it happens so much I didn’t even notice.

Michael R. Kourey

The new phones [inaudible] for just a few hundred bucks you can get out of that problem.

[Jeff Kiveau] - Barclays Capital

Is this something we should monitor going forward if the economic climate deteriorates?

Michael R. Kourey

Monitor ASPs?

[Jeff Kiveau] - Barclays Capital

The ability to keep the ASPs headed north.

Robert C. Hagerty

In video in particular and in voice there’s a range of products. I don’t think we’re seeing significant mix shifts around those products. Because we’re in a constant relatively regular upgrade of the platforms, I think that what we’ve seen over the years is that ASPs tend to stay stable and move up and occasionally rarely move down. It’s because of the value you’re getting.

People have talked about 1080p and other things that we can put into different price points. The price points tend to be relatively stable but what you get for the price points tends to change a lot. So sometimes we’ll accelerate what you get at that price point but we don’t generally change the price points all that much.

Operator

Our last question comes from Bill Choi - Jefferies & Company.

Bill Choi - Jefferies & Company

Bob, I’d like you to clarify your answer to I believe it was Sam Wilson’s question. You said bookings were good in the quarter. Obviously you have the backlog here and then people pause and that’s something that you kind of noted. But what does that mean? What people ordered and then they told you to hold off on shipping that product?

Robert C. Hagerty

No. Bookings were good. We saw the numbers. You can add up the deferred and the backlog and what we had for revenue to figure out approximately where we are in bookings. So bookings were good. We had a strong pipeline coming in and we did see that as the US started to have all these fear factors put into the market place that some buyers held back and did not deliver POs. Others did. We did see people get a little more cautious about delivering a final PO in the last couple weeks, especially as the news got pretty dramatic. I think people reacted to that, and I think as this stabilizes and people understand better, then I think it’s going to flow all right.

Bill Choi - Jefferies & Company

So basically bookings would have been a lot bigger is what you were saying?

Michael R. Kourey

It would have been bigger. I don’t know how that would translate but certainly they would have been bigger.

Robert C. Hagerty

That’s a big what if, so I don’t know what to say. Yes, clearly deals did slip.

Bill Choi - Jefferies & Company

In terms of linearity of those bookings on a month-by-month basis, can you provide that?

Michael R. Kourey

The bookings linearity was good. We don’t quote that. We quote shipment linearity, revenue linearity I should say to be specific. We don’t quote bookings but actually bookings linearity was good.

Bill Choi - Jefferies & Company

Those slipped deals, any update so far into the middle of October?

Robert C. Hagerty

No updates. We don’t really guide that level of detail at all. They’re lost. I’m not going to sit here and report lost deals. Some deals close. Some deals are still in the works.

Bill Choi - Jefferies & Company

One of the things we’re seeing is these products are obviously what people want and yet the cap ex availability is where the stream is and you saw today Cisco trying to lease out time on their Telepresencerooms. Something I heard from someone in the channel is an emergence of potentially leasing of these solutions kind of like the way you do desktop phones of the old smaller or medium business phones are purchased through leasing programs. What’s your thought about these kinds of measures to smooth out these demands? I mean, they want it; it’s the ability to afford it. What can you do to support the market?

Robert C. Hagerty

We’ve had leasing programs in the past. Our channels have leasing programs today. We’re always interested in anything that will make it easier for our channels to deliver products. Mike, maybe you have something more?

Michael R. Kourey

I agree with that. It makes a lot of sense. It’s something that we always take a look at in adding customer value. That is I think a legitimate vehicle to add customer value especially for the Telepresence.

Bill Choi - Jefferies & Company

But it’s not widely in use today?

Michael R. Kourey

It is not widely in use by anyone today.

Operator

There appear to be no further questions at this time.

Robert C. Hagerty

Thank you very much for following Polycom as we deliver solid results through our diversified global footprint. We look forward to continuing to deliver on our market leadership and to driving operating leverage in the quarters and years ahead. We’ll see you next time. Thanks very much everybody.

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Source: Polycom, Inc. Q3 2008 Earnings Call Transcript
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