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Executives

William J. Leighton III, Ph.D. – Chief Executive Officer, President

William J. Stuart – Chief Financial Officer, Senior VP of Finance and Treasurer

T. S. Ramesh – Principal Accounting Officer and VP of Finance

Inna Vyadro

Analysts

Shao Wang – Lotus

Michael Anari – Amerco Securities

Soapstone Networks,Inc. (OTC:SOAP) Q3 2008 Earnings Call October 16, 2008 8:30 AM ET

Operator

Welcome to the Soapstone third quarter earnings conference call. (Operator Instructions) At this time, I'd like to turn the conference over to Inna Vyadro, please go ahead.

Inna Vyadro

Joining me today are Bill Leighton, Soapstone CEO, Bill Stuart, Soapstone CFO, and T. S. Ramesh, our Vice President of Finance.

This morning Soapstone issued a press release that was distributed by Marketwire. A copy of the announcement and the conference call are available on our website at www.soapstonenetwork.com.

I would like to remind you that during this call, we may be making forward-looking statements including our plans and objectives for future operations as well as our expectation for product delivery, customer activity, and financial performance.

These forward-looking statements are neither promises nor guarantees but are subject to risk for uncertainties that could cause actual results to differ materially from those contained in the forward-looking statement.

Those risks and uncertainties are further described in our press release and presented in detail in our Form 10-K and 10-Q filed with the SEC. Additionally during the call, when we will also discuss various non-GAAP financial measurements. A reconciliation of non-GAAP financial measurements is provided along with the financial tables in our earnings press release which, as previously mentioned is available on our web site.

Our press release was also furnished to the SEC on Form 8-K this morning. At this point I would like to turn the call over to Bill Leighton.

William J. Leighton

This morning we reported third quarter revenue of $2.3 million, which was all for services related to our previous router business.

We reported a GAAP net loss of $5.8 million or $0.39 per share for the third quarter ended September 30, 2008. We ended the quarter with $98.1 million in cash and cash equivalence down from 105.4 million as of June 30th, 2008.

The third quarter is being continued momentum in carrier Ethernet as carriers look to capitalize on the market opportunity for Ethernet services. According to analyst firm, [Overmarage K], the global carrier Ethernet business services market is expected to reap $31 billion by 2012. This is being fueled by demand for high capacity, layer two, virtual private networks, video, business continuity, cloud computing, and other applications.

We have seen a number of announcements from leading vendors introducing new purpose built Carrier Ethernet platforms that addresses scaling limitations of legacy for NAP, provide rich ONMA capabilities, and of course, leverage Ethernet economics.

We are seeing carriers accelerate the migration of their legacy TDM network, Ethernet-based infrastructures for both wireline and wireless back hole application. These developments have secured Ethernet as the de facto transport solution from access to the metro and beyond.

Ethernet services are succeeding because they are overcoming the issues associated with legacy business and transport services including the inability to scale bandwidths as customers need change and the high cost per byte.

As an industry we must help our customers overcome the challenges associated with delivering a global Ethernet service that requires multiple resource providers. Providing a positive and consistent quality of experience to end customers as well as the ease of doing business with a service provider is ultimately what differentiates the service providers' offering.

When service needs to transverse multiple providers providing a consistent quality of experience can be difficult. Moving the bytes between the providers turns out to be a very small part of a problem.

The solution needs and support in drive, intra-provider quality management, and automates the service life cycle to make it easier for the end customer to do business with the carrier. The Soapstone PSE framework is designed to provide quality and capacity management for transport resources.

It is also designed to provide tight coupling between service fulfillment and assurance resulting in a dynamic control plane that creates and maintains resources through active monitoring of network elements and provides uniform reporting of performance, utilization, fault, and resource inventory. This information is then shaped into a form that is meaningful to the OFS services layer.

In the third quarter, Soapstone successfully executed on delivering a generally available multi-vendor control plane for PBT. We are focused over the next several quarters on introducing a full range of supportive platforms, features, and functions to achieve our vision of a multi-technology, multi-vendor resource and service control plane to help carriers grow and manage their Carrier Ethernet services.

We are working with our partners on our funnel of opportunities and expect by the end of the year we will be deploying our PBT product and customer networks. In parallel we are working to establish additional distribution channels with new partners in hopes that some of those agreements in place in the new term.

We are also seeing a number of carriers direct their vendors to work with Soapstone validating the unique position of the PNC as a multi-vendor solution.

To take advantage of the opportunities for the Soapstone PNC product, I am very excited to announce today the appointment of Don Wadas, a seasoned sales executive who will lead Soapstone's world wide field operations.

In summary, I continue to be excited about the opportunities that lay ahead for Soapstone and our products, the acceptance of the PCN product by partners and customers, and our continued leadership in this new market for a next generation multi-vendor, multi-technology resource and service control framework.

I will now turn the call over to Bill Stuart.

William J. Stuart

Thanks, Bill, and good morning everyone. This morning we reported our results for the third quarter of 2008.

The revenue for the third quarter ended September 30, 2008, all of which was service revenue associated with the Legacy business with $2.3 million compared to $3.9 million in the preceding quarter end of June 30,l 2008, of which $2.7 million was service revenue. The service revenue was $2.4 million in the prior year's third quarter.

The three and nine month ended September 30, 2007 included $26.9 million and $72.3 million in router product revenue from the Legacy Router business. As announced before the company shipped it's last router products in December 2007, and has exited the manufacturing and sale of router products.

Accordingly the company's revenue for the three and nine months ended September 30, 2008 consisted principally of revenue for services relating to the router products which services are scheduled to end on December 31, 2008.

The second quarter ended June 30, 2008. The company also reported as product revenue, revenue deferrals of $1.2 million from prior year's product shipment in connection with the termination of certain customer's terms and conditions.

On a GAAP basis, the company reported a net loss of $5.8 million or $0.39 per share in the third quarter of 2008 as compared to net income of $15 million or $0.97 per share in the prior year's third quarter.

The GAAP net loss for the nine months ended September 30, 2008 was $13.8 million or $0.93 per share compared to GAAP net income of $33.1 million or $2.23 per share for the comparable nine month period of 2007.

In calculating GAAP earnings per share, the number of shares used in the calculation for the 2007 period has been adjusted to include the dilutive effect of stock options, warrants, and restricted stock rams.

Additionally, GAAP net loss and income for the third quarter in nine months ended September 30, 2008, and 2007 includes certain non-cash equity-based charges associated with financial accounting standards Board Opinion 123R, restructuring expenses associated with the 2006 restructuring program, and credits for a certain inventory utilization.

Comparative quarterly GAAP consolidated statements of operations along with comparative non-GAAP consolidated statements of operations excluding these charges and credits and direct consolidation between them accompanies our press release and can also be found in the investor relationship section of our web site.

For the remainder of the call, all references to our results will relate to financial measurements excluding these previously mentioned charges and credits. Such information should be considered superior to, in isolation from, or as a substitute for GAAP results.

Rather we believe this non-GAAP measures provided useful information to investors and analysts in accessing the core operating results of our business. On a non-GAAP basis, the company recorded a net loss of $5 million or $0.34 per share in the third quarter of 2008, as compared to net income of $15.6 million or $1.01 per share in the prior year's third quarter.

On a non-GAAP basis, the company reported a net loss of $11.5 million or $0.77 per share for the nine months end of September 30, 2008, as compared to net income of $34.9 million or $2.35 per share in the comparable nine month period of 2007.

In calculating non-GAAP earnings per share, the number of shares used in the calculation for the 2007 period have been adjusted to include the dilutive effect of stock options, warrants, and restrictive stock rams. Revenue for the quarter was $2.3 million related to the service of the router products with services as scheduled to end on December 31, 2008. Revenue for the prior year's third quarter was $29.3 million and included product revenue of $26.9 million and service revenue of $2.4 million.

AT&T accounted for the predominant share of products revenue in all periods. Revenue for the nine month ended September 30, 2008, was $9.8 million, and included $7.7 million of service revenue.

In the second quarter end of June 30, 2008, the company also recorded $1.2 million as product revenue, certain revenue deferrals from prior years, product shipments in connection with the termination of certain customer terms and conditions.

Revenue for the prior year's nine months end of September 30, 2007, was $79.4 million and included product revenue at $72.2 million and service revenue of $7.2 million.

Our gross margin for service for the quarter was 70.1% compared to 85.2% in the prior year's third quarter. Service gross margin for the nine months end of September 30, 2008, was 66.2% whereas service gross margin for the prior year's nine months end of September 30, 2007, was 83.7%.

The client and service gross margin in the current period as compared to comparable prior year period was primarily due to higher labor and labor related costs, facility costs, and depreciation expenses directly associated with support functions.

Total operating expenses for the quarter were $7.4 million compared to $7.8 million in the prior year at third quarter. Total operating expenses for the nine months September 30, 2008, were $20.1 million whereas total operating expenses for the prior year's nine months end of September 30, 2007, were $26.0 million.

The reduction in operating expenses resulted from the elimination of development costs associated with the Legacy Router business offset by an increase in development costs for Soapstone software and increased sales and marketing expenses.

Depreciation expenses recorded in operating expenses during the three and nine month period in 2008 were a $0.3 million and $0.7 million. We expect our operating expenses for the fourth quarter of 2008 excluding depreciation and certain non-cash equity-based charges to be approximately $8 to $9 million as we continue to increase our spending in development, sales, and marketing.

Capital expenditures are projected to be $1.5 to $2 million in the fourth quarter. Total ongoing head count including both on and offshore contract labor in September 30, 2008 was 147 which was an increase of 10 from June 30, 2008 and 39 since the beginning of the year.

Interest income in the quarter was $0.6 million on an average invested cash and investment balance of approximately $101.8 million. Interest income continues to fluctuate in line with average quarterly cash balances and current interest rates.

At September 30, 2008, our cash, cash equivalence, and short-term marketable securities were approximately $98.1 million, a decrease of $7.3 million from the previous quarter. The decrease was primarily due to the current quarter loss and unfavorable change in working capital and capital expenditures.

We expect our cash balance to decline during the balance of this year as we invest in the development and sales and marketing of the PCN product. However, we estimate that our total combined cash position is sufficiently strong to support expected operations for the foreseeable future.

Accounts payable and accrued expenses totaled $4.7 million at September 30th. Deferred revenue at September 30th was $2.2 million; the balance remaining in deferred revenue primarily represents the deferred and unearned portion of customer maintenance and support revenue which will be amortized into service revenue in the fourth quarter of this year.

After 2008, the company does not expect to record any service revenue resulting from the support of its router products. Accordingly is expected to have completely exited all activities associated with these router products.

We continue to have no debt.

In summary, as we have exited the router business and created Soapstone, we have articulated our strategy to develop and market our provider network controller for the service provider market which we believe represents a very attractive investment opportunity and leverages our core technologies and engineering talent.

Importantly, we continue to make good progress in our development and marketing plan for the PNC. In order to continue at this momentum, we will continue to prudently use our cash by investing in the growth opportunity we see in the Carrier Ethernet space.

Again, we believe that this market represents a dynamic opportunity to create value for our shareholders. We also believe the technology is a risky business that should be financed conservatively and that there is no better or more conservative position than having a strong cast position and no debt.

We therefore have no other current plans for our cash but to use that cash to invest in development, sales, and marketing and to build a business that ultimately provides returns and rewards for all of our shareholders.

We acknowledge that this requires a longer term investment horizon which may be unusual in this day and age but it's what we believe is at the heart of the success of every great technology company.

This concludes my prepared remarks and we will now open up the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Shao Wang – Lotus

Shao Wang – Lotus

A couple of things. Bill, I didn’t quite hear if you gave a CapEx number for the September quarter. I think you said 1.5 to 2 for the December quarter as your expectation. Is that right?

William J. Stuart

Yes, the capital expenses number for the third quarter was about $1.8 million.

Shao Wang – Lotus

$1.8? Can you tell me what that’s going for? The Cap spending plan?

William J. Stuart

A part of this is for engineering labs and certification labs and in the third quarter, a significant portion has gone to a new facility that we have moved into a couple of days ago.

Shao Wang – Lotus

All right.

William J. Stuart

In development costs and all that.

Shao Wang – Lotus

Totally separate, I'm wondering if you can at least qualitatively talk through how you think the revenue structure might be as the deployments start taking place, either now or say a couple of years from now when you're successful with this project. How do you see the revenue stream coming in, not from the dollars but in terms of structure?

William J. Stuart

Well, we haven't given any guidance yet and won't be in a position to do that –

Shao Wang – Lotus

I'm not interested in the dollar amount.

William J. Stuart

Yes.

Shao Wang – Lotus

I'm interested in what will be – how the contracts will be structure.

William J. Stuart

I understand, I just wanted to clarify that point for all the other listeners. In terms of the structure though we expect it will be an initial term license and that we'll have a potential trained revenue component associated with it.

Shao Wang – Lotus

And the recurring revenue stream would be based on what?

William J. Stuart

Maintenance and support.

Shao Wang – Lotus

It would not be a function of usage or say per byte of information point across or something like that?

William J. Leighton

No, it would be more based on the size of the network. In fact, the whole licensing structure will be based on the size of the network. Then there'll be an initial term component and then ongoing subscription component. Then the other components of it will be what features and functions the customer decides to deploy.

Shao Wang – Lotus

And when you say size of network, are you measuring that by subscribers or –

William J. Leighton

More by size of the network equipment being provided, the number of ports would be a good, a rough surrogate.

Shao Wang – Lotus

Okay. Then finally, any comments on competitive issues or others that you might see that might be pursuing a comparable or similar tasks.

William J. Leighton

We're seeing people take a great deal of interest in the approach we've taken here. So far we haven't seen anybody directly competing with us in this phase. Of course, Juniper last year announced that it was going to move some of its matter control plane functions off to a separate control plane but that’s still a single vendor.

So, a number of folks are doing some single vendor kind of things but we're in a pretty unique position as being multi-vendor, multi-technology control plane.

Operator

Your next question comes from Michael Anari – Amerco Securities

Michael Anari – Amerco Securities

Could you please tell me what's your cash per share right now?

William J. Stuart

$6.50 per share at the end of September quarter.

Michael Anari – Amerco Securities

Well, your stock close at $3.02 yesterday. And pre-market is $2.70. Don't you think that there is a disparity that is incredible here? Don't you think that you should be able to either buy some shares while you are restructuring considering the studies of the market?

William J. Stuart

We have, as I said earlier on the call, the company is continuing to use the cash to invest in what we see as a significant opportunity in the Carrier Ethernet market. While I understand your frustration and it's shared by all of us in terms of the evaluation placed on the company's stock.

The fact is that at the stage that we're in and in the position that we're in with development of the product and the inability to provide revenue guidance at this point, impacts the value of the stock.

As we continue to build the company and begin to get some revenue tracks and I would hope that you'd begin to see some improvement in the stock price.

Michael Anari – Amerco Securities

Well, we wish greatest luck and we hope that you'll succeed in bringing a new product as soon as you can. We hope, we rely on you guys to work hard to get to that result as soon as you can.

William J. Stuart

Thank you. I appreciate that.

Operator

Thank you and at this time then we have no further questions in the queue.

William J. Stuart

Thank you very much.

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