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Executives

Mark Donohue – Director of IR and Assistant Treasurer

Ashraf Dahod – President and CEO

Paul Milbury – VP of Operations and CFO

Analysts

Brian Modoff – Deutsche Bank

Mike Walkley – Piper Jaffray

Amir Rozwadowski – Barclays Capital

Ehud Gelblum – JP Morgan

Thomas Lee – Goldman Sachs

Blaine Carroll – FTN Midwest Securities

Richard Kramer – Arete Research

Doug Whitman – Whitman Capital

Kevin Giddis – Morgan Keenan

Andy Schopick – Nutmeg Securities

Starent Networks Corporation (STAR-OLD) Q3 2008 Earnings Call Transcript October 28, 2008 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2008 Starent Networks Corporation earnings conference call. My name is Erica, and I'll be your coordinator for today. At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions)

I would now like to turn the presentation over to your host for today's call Mr. Mark Donohue, Director of Investor Relations. Please proceed, sir.

Mark Donohue

Thank you, Erica. Good evening, everyone. With me on the call this evening are Ashraf Dahod, our President and Chief Executive Officer, and Paul Milbury, our Vice President of Operations and Chief Financial Officer.

Today after the market closed, we issued a press release announcing our results for the third quarter of 2008. A copy of the press release along with accompanying income statement, balance sheet and operating statistics as well as a reconciliation of the most directly comparable GAAP financial measures to any non-GAAP financial measures used during this call and for certain prior periods are available on the investor section of our Web site at www.starentnetworks.com.

The format for tonight's call is as follows. Ash will begin with a few summary statements and review business highlights. Paul will then review the details of our financial results and present our outlook for the remainder of 2008 and full year 2009. After that we'll open up the call for Q&A.

Before we begin, I would like to remind you that various remarks that we make about the company's future expectations, plans and prospects constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors including those discussed in our most recent filings with the SEC. In addition, any forward-looking statements represent our views only as of today. It should not be relied upon as representing our views as of any subsequent date.

While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates change, and therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.

During this call, we will be referring to non-GAAP financial measures. These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in our earnings press release issued earlier today, which is posted on the investor section of our Web site.

At this time I'd like to turn the call over to Ash.

Ashraf Dahod

Thank you, Mark. Good evening, everyone, and thank you for joining us for our third quarter of 2008 earnings conference call. We are pleased to report that we had a successful third quarter.

Our revenue for the third quarter was $66.1 million, an increase of 80% from the third quarter of 2007. GAAP net income was $19.6 million or $0.26 per diluted share in the third quarter including stock-based compensation of $4.5 million and a $6.6 million benefit related to the reversal of the valuation allowance recorded against our deferred tax assets. Excluding the stock-based compensation charges, and benefit from the reversal of the deferred tax valuation allowance, non-GAAP net income was $17.5 million or $0.24 per diluted share for the third quarter.

I would now like to address our business in the context of the current uncertain and unpredictable global economic environment. While we believe that there will be some impact on the operators from the economic downturn, recent commentary from some of the largest carriers in the world suggest that a wireless operations continue to do well as mobile communication increasingly becomes an indispensable part of people's daily lives. For instance, Verizon mentioned yesterday that their business have shown remarkable stability and stress. They reported that data revenues grew 42.5% year-over-year driven by mobile broadband access and usage, particularly through PC Cards and Smartphones.

From a capital expenditure perspective, Yankee Group has said recently that areas have continuous wireless investment though there have a clear path to generating increased revenues for operator, such as those that better manage mobile, broadband and 3G technologies.

Additionally, mobile multimedia communication is a market that is still in its early stages, and there are a number of trends that collectively drive demand for intelligent packet core solutions. The spread of Smartphones and a successful introduction of recent touch screen devices further demonstrate the demand for mobile broadband.

Furthermore, supplies like Samsung, Motorola and Hutchinson, ING Mobile are increasingly embracing open-source operating systems to deliver low cost multimedia phones. There also continuous to be growing demand for multimedia applications such as Video Streaming, Social Networking, and Music Downloads. For example, Carriers are offering services like HKT Skyworld [ph], Verizon V CAST, Vodafone Live, and U2 Mobile that increased data traffic.

We continue to see strength in our CDMA business. This quarter we expanded our global footprint with new customer wins in America, China and India. At the end of the third quarter, only about 110 million or 27% of the 410 million worldwide CDMA subscribers were are broadband EVDO network according to Wireless Intelligence.

We expect continued growth in this segment as EVDO subscribers are expected to reach 250 million by 2012. Continuing progress in the UMTS HSPA market is a key business objective. We believe this market has significant growth potential as HSPA subscribers today represent less than 2% of worldwide GSM subscribers. At the end of the third quarter, we had UMTS HSPA mobile operator activity in 12 countries throughout Europe and Asia-Pacific. Additionally, the recently added new UMTS win, in Qatar, and South Africa.

We also continue to see strong traction with our SGSN product and currently have wins in five countries. As we grow our business we recognize that there are some inherent differences among the major markets we serve. Although both the Tier 1 and Tier 2 carriers in CDMA and UMTS market each serve about 90% of the worldwide subscriber respectively. The breakdown of the Tier 1 and Tier 2 carriers are quite different. We estimate that a breakdown of subscriber between Tier 1 and Tier 2 CDMA carriers is about 75% and 15% respectively, while the Tier 1 and Tier 2 carriers in UMTS serve about 50% and 40% on the subscriber respectively. Consequently, our strategy is to grow our market share in UMTS with both Tier 1 and Tier 2 carrier win.

The next step in mobile broadband is clearly being the center of LTE and WiMax 4G technology, which are designed to provide multimegabit bandwidth and handle the expectations for dynamic growth in the air traffic. Although as a move to 4G will occur over a number of years mobile operators don't want to repeat the cost fee been replaced 2G to 4G transition, rather they are exploring strategies that will enhance their existing 3G networks, and allow them to seamlessly migrate to 4G through additional software on the same platform assimilating a forklift upgrade.

While UMTA's operators have a natural evolution to LTE CDMA operators moving to LTE require different migration path. Starent Networks deliver an important solution for disevolution through evolve high rate packet dealer or eHRPD. eHRPD allows CDMA mobile operators to upgrade their current packet core network using elements of the LTE core network architecture. This evolutionary path to LTE provides service mobility such as hander [ph] between 3G and 4G LTE network, allowing a phase transition. Starent solutions are well-positioned for 4G network, as they already incorporate intimated intelligent simplified architecture, high performance, and enhanced mobility.

This quarter, Starent was selected to join the LTE/SAE Trial Initiative or LSTI which is devoted to validating the technology's capability to break high speed wireless broadband to the global market. The LSTI is comprised of such companies Alcatel-Lucent, Ericsson, TransTelecom, Orange, Nokia, Siemens Network, Nortel, T-Mobile and Vodafone.

In addition to our technology leadership our other key advantages have been our flexibility and rapid response to customer wants. Our customers acknowledge eastern [ph] advantages as a mobile phone becomes increasingly strategic and complex. Despite uncertain business climate we feel the Starent Networks is well-positioned for the remainder of 2008 and 2009.

I will now turn the call over to Paul to provide you a review of our third quarter financial results and our financial outlook after which we will be happy to answer questions.

Paul Milbury

Thank you, Ash. Revenues for the quarter were up 80% year-over-year to $66.1 million for the third quarter of 2008 and were $183.5 million for the first nine months of 2008, up 93% from the same period a year ago.

Non-GAAP operating profits were $18.6 million or 28% of revenue for the third quarter, and were $46.6 million or 25% of revenue for the first nine months of the year, up approximately 260% over the 2007 levels.

Non-GAAP operating profits exclude $4.5 million of stock-based compensation for the third quarter of 2008 and $12.4 million for the first nine months of the year.

In Q3, we had two 10% customers, put together made up 79% of our revenue, and our top four customers represented 89% of our total revenue.

I will be referring to non-GAAP figures in this call, unless I specifically state I am referring to a GAAP figure. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is available in our earnings press release issued earlier today, which is posted on the investor relations section of our Web site.

Gross margin were 79% in Q3. Product gross margin was about the same as in Q2. Service margins increased about 3 percentage points in the quarter to approximately 64%. This was due to an 18% quarter-over-quarter increase in service revenue compared with a 10% increase in expenses. We expect our service margins to remain variable as we grow our business.

Operating expenses were $33.6 million, up $3.1 million from the second quarter.

Research and development and sales and market contributed about equally to this sequential increase. In research and development ongoing consulting and interoperability testing expenses for a new SGSN business contributed to most of the sequential increase.

Also, when we discuss our operating expense outlook in the last call, we mentioned that we were ramping up our sales resources in Europe and in Asia-Pacific region to capitalize on significant growth opportunities in these areas and we have done so. Commissions were also higher due to strong Q3 bookings volume.

G&A expenses in Q2 were flat quarter-over-quarter and total headcount at the end of Q3 was 739, up 63 from the end of Q2, and up 129 since the beginning of the year.

Other income was $632,000 for the quarter, down from $1.9 million in Q2. This is primarily the result of an unfavorable currency revaluation impact in Q3, but also yield in our cash portfolio. Given these uncertain economic times our cash is invested conservatively in U.S. government and government related securities.

We recorded a $4.9 million income tax benefit for the quarter as a result of a $6.6 million reversal of the valuation allowance recorded against our deferred tax assets partially offset by tax expenses of $1.7 million in Q3. This $1.7 million expense resulted in a non-GAAP tax rate of approximately 9% compared to approximately 7% in Q2.

Non-GAAP net income for Q3 was $17.5 million or $0.24 per diluted share on $74.2 million fully diluted shares outstanding. Based on our reported results and the strength of the business in the quarter we are increasing our full year revenue outlook to approximately $250 million, a growth rate of approximately 71% over 2007. I currently expect Q4 results to look very similar to Q3.

Full year operating profit is expected to be in the area of $65 million. Other income for the year is expected to be around $7 million, and our tax rate is still expected to be about 7% for the year, putting our non-GAAP net income in the area of $68 million or about $0.90 per share on 74.5 million shares.

We expect full year GAAP EPS in the area of $0.76, considering stock-based compensation expenses of about $17 million and the $6.6 million valuation allowance reversal.

Next, I like to review balance sheet activity in Q3 and talk about some expectations for our 2008 year-end balance sheet. Then I will close with an initial outlook for 2009.

During the quarter, our total cash position increased by more than $35 million to approximately $356 million or $4.80 per diluted share. We expect our cash position to grow to more than $375 million by year-end. Accounts receivable increased by approximately $17 million in the quarter to $56.2 million primarily due to invoicing for shipments expected to be recognized as revenue beyond Q3. And inventory was $42.5 million at the end of Q3, up about $1 million from last quarter.

Capital expenditures primarily for engineering and customer lab equipment were approximately $5.6 million in Q3, making them $16.8 million for the first nine months of the year. Our deferred revenue balance increased $32 million sequentially to $150 million which is up approximately $87 million from the beginning of the year and is a large part of reason that are cash is expected to increase more than $140 million in 2008.

Now, I would like to turn to our initial outlook for 2009, keeping in mind that we have still not completed our internal budgeting process. First of all, we expect to enter 2009 with a very strong backlog of business. However, 2009 outlook we need to assume that we will be unable to convert some of that backlog and some of the 2009 bookings to cap revenue under the revenue recognition requirements of SOP 97-2.

Although we may receive acceptances in cash payments for certain transactions, it is likely we will be unable to recognize some of the revenue because of the contractual terms and conditions. For certain transactions we may be required to recognize revenue ratably over a period of several years rather than an acceptance based on the residual method.

As a result, we are currently guiding to revenue in the area of $315 million which is a growth rate of approximately 26% over 2008. Where we have to recognize revenues on the residual method rather than ratably we would estimate that our revenue growth rate to 2009 would be more than 40% rather than in 26% area. If we were not required to ratably recognize certain revenue transactions under GAAP our revenue operating profits in EPS would be considerably higher in 2009.

Given the expected mix of business in 2009 we believe gross margins will be lower than 2008 but still about the high end of our target operating model range of 72%. For 2009, we are targeting operating expense growth at about 20% compared to well over 40% growth in 2008.

Given these assumptions we would expect our operating profit to be around the target operating model of 25%. With other income in the $5 million to $7 million area depending upon short-term interest rates, and a tax rate in the 37% to 39% area we are anticipating non-GAAP EPS in the area of $0.65 to $0.68 on 76 million shares to 77 million shares.

Finally, before we go to Q&A, I would like to remind you that it is our policy not to disclose bookings or backlog so we will not comment on these topics. Secondly, we are not able to answer questions about revenue or sales activities on specific customers because we are required to maintain the confidentiality of this customer information.

Ash and I would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Brian Modoff with Deutsche Bank. Please proceed.

Brian Modoff – Deutsche Bank

Yes, I am curious couple of things, one on your tax rate for next year, you're talking 36%, 39%, I am not able to generate any relief of benefit from some of the revenues you get from proceeds [ph]?

Paul Milbury

I think the tax rate that we provided – range of tax rate does built into the expected rate, some amount of income in forward restriction but we don't have a lot.

Brian Modoff – Deutsche Bank

Looking at your deferred revenue on the quarter, just quite significantly to $140 million, how was your visibility going into Q4 and can you talk about UMTS percent of revenue? Give us an idea what W-CDMA might have done this percentage of revenue the quarter was greater than 10%.

Paul Milbury

Our deferred revenue balance in total was actually $150 million in the end of the quarter, $143 million I believe a short-term preferred incentive of long-term preferred. So that I am seeing this very good visibility into the source of revenue for the Q4. We had an immaterial amount of UMTS revenue in Q3.

Brian Modoff – Deutsche Bank

Do you expect that to change this quarter? When would we see UMTS over 10% of revenues?

Paul Milbury

I would expect that to be probably in '09.

Brian Modoff – Deutsche Bank

'09. Then you talked about new customers in CDMA in China and in India. Are we looking at – in terms of the types of customers we are talking about Tier 1 or Tier 2 in those markets, obviously in China, it is probably China Telecom, but in India which are you talking about Reliance, or are we talking about (inaudible) someone like that?

Ashraf Dahod

Each of those operating is really would rank us Tier 1 in the market.

Brian Modoff – Deutsche Bank

Okay, I will turn over to someone else.

Operator

Our next question comes from the line of Mike Walkley with Piper Jaffray. Please proceed.

Mike Walkley – Piper Jaffray

Thank you. Building on the new customers in CDMA, for China, can you update us on what you are seeing in China in terms of the (inaudible) for 3G? And also when you kind of new customer in China is that due to the restructuring or do you have new business with the CDMA network over there?

Ashraf Dahod

We clearly believe that in China, the realignment of the operators and it's clearly the operators are now getting ready, the 3G spectrum would be (inaudible) and that they will be moving more aggressively into 3G, so we definitely see an increase activity level in China as far as the new win we have in incremental business from as a result of the realignment.

Mike Walkley – Piper Jaffray

Okay, great. Thank you. Can you just talk a little bit about – I know you gave guidance for 2009, just why was the some carriers slowing some CapEx spending versus the opportunities you see in the market for next year?

Ashraf Dahod

Our prediction obviously we have built-in what we believe the market environment will be for 2009. And this is the best information we have as of today. Clearly as I mentioned and Paul also stated that a macroeconomic condition is somewhat uncertain. This would be a – what we have presented is our best estimate what we expect 2009 to be.

Mike Walkley – Piper Jaffray

Okay. And other way you are seeing any change in decision by carriers in terms of RFPs [ph] out there? And is it fair to assume most of your guidance for '09 comes from your current customer base?

Ashraf Dahod

We really haven't seen any change in the activity level in terms of RFPs and proposal that are in the pipeline.

Mike Walkley – Piper Jaffray

Okay. Thanks for taking my questions. I will pass it on.

Operator

Our next question comes from the line of Amir Rozwadowski with Barclays Capital. Please proceed.

Amir Rozwadowski – Barclays Capital

Thank you very much. Just building upon that, Ash, in terms of the goods in the pipeline for your business in 2009, do you see an increased number of folks within the W-CDMA community, looking to additional RFPs coming from that, those types of carriers?

Ashraf Dahod

Even this year, we have seen increased level of activities in the UMTS space. We expect to see that continue in 2009. As I mentioned in my presentation UMTS market is a different than the CDMA market, where the tier 1 and tier 2 while comprising 90% of the subscribers, the split between tier 1 and tier 2 is very different. So tier 1 make up only 15% of the market. In CDMA they make up 75% of their market. So our goal is to in the UMS market to target not only tier 1, but also the tier 2 segment which makes up 40% of the overall market.

Amir Rozwadowski – Barclays Capital

And Ash, perhaps you can give us a little bit color on in terms of the competitive landscape. Have there been any shifts in the competitive landscape or how you view yourself vis-à-vis your competitors?

Ashraf Dahod

I believe competitive landscape hasn't changed dramatically. The new developments obviously – again, this is all from public information is that Ericsson has announced that they will not be moving to GGSN to (inaudible) platform. So they will continue with the Juniper platform. The second development obviously as we have entered the SGSN market is we do not see any of incumbent having any plans to come out of a next generation SGSN. Clearly, the advantage we have in SGSN market is although SGSN platform is designed to not only support 2.5 TN [ph] 3G, but it also designed to support MAV functionality for LTE. So we will have a single platform that will be a multi technology for the controlled plane, for 2.5G 3G and LTE. As a result of that we would not require a forklike upgrade by the operator and we can also significantly reduce the end of (inaudible).

Amir Rozwadowski – Barclays Capital

That's very helpful. And then if I may just, Paul, we have seen some of your gross margins pick up pretty steadily for the last couple of quarters. Just wanted to get the quick update as to why you think the returns you got 72% as likely your – what should we view as variable?

Paul Milbury

What we – the long-term model for gross margins is 72, we still think that's the right long-term margin. In the guidance for 2009, we indicated that we expect the gross margins which still stay comfortably above the high end of that 72% range, but be somewhat lower than 2008. And as a result of just sort of the expected mix of business the initial recognition of revenue from some new customers and slight decline in the services margins as well, and then we are in sort of the mid 60s right now.

Amir Rozwadowski – Barclays Capital

Thank you very much, Paul.

Paul Milbury

Sure.

Operator

Our next question comes from the line of Ehud Gelblum with JP Morgan. Please proceed.

Ehud Gelblum – JP Morgan

Hi, thank you very much. Paul, from your comments on (inaudible) revenues goes into your 2009 revenues, I am assuming that it will be a VSOE issue on certain things from the way the contracts are written, but there are certain items that you written to the contracts you do not have the aphelion [ph] if that's the case, can you let us know or help us get our arms around what things you don't have the VSOE on that are different from what you did before, and there is any way breaking to deferred revenue balance out in due, how much of that deferred revenue you will be able to recognize immediately versus how much you have to do ratably?

Paul Milbury

You're right. The issue is – VSOE issue, it's centered in the EMEA region right now, and it is related to maintenance and support for some of the new business that we have entered into there where the customers basically unwilling to sort of agree to the standard, terms and conditions that we had in our contracts to-date. It's not the people are unwilling to pay for maintenance and support, but in a number of cases they seem to want to get it bundled in with the initial purchase price upfront. And so since this now stated renewal for the maintenance and support we can't claim VSOE and therefore carve it out. So that's the issue that we are looking at. I think over time as that becomes more – it will become more – it should become more visible over time in a split of the different revenue between current and longer term.

Ehud Gelblum – JP Morgan

Okay. So you said the term was 7 years in a country?

Paul Milbury

Several. It varies from country to country, every agreement is different so.

Ehud Gelblum – JP Morgan

I mean, often has to ratably recognize it's not just that service and maintenance contract, but the product that are associated with that as well, correct?

Paul Milbury

Exactly.

Ashraf Dahod

If we can't establish VSOE for the maintenance as you know, you can't carve it out therefore take the rest of it upfront. So you may install the solution, get acceptance and get paid upfront, but you still remaining to recognize the whole thing over whatever the initial service period is.

Ehud Gelblum – JP Morgan

Right. Can you give us a sense of preferred revenue balance, how much falls into this ratable category and how much is not?

Ashraf Dahod

It's not significant at this point as I said, when it becomes significant I think it will become clear and if – in the case where it's clear that the revenue needs to be deferred over a period greater than any year, it will have to start showing up as long-term as deferred revenue.

Ehud Gelblum – JP Morgan

Okay, so, entire current balance I should think that, the entire current balance doesn't involve in this category. The entire current balance of deferred revenue does not fall into that ratable category?

Ashraf Dahod

No.

Ehud Gelblum – JP Morgan

Okay. That's actually very, very helpful. Did you have a sense – I know this asked before, but I wonder get almost specific on the shine on the timing of when you could begin the recognized revenues on the time of CDMA next generation build? I know the activities increasing, but would that happen in Q1 or Q2 or is that more of like a Q3 Q4 that when you actually met revenue there?

Paul Milbury

Very difficult to project at this time, but we believe that we should be able to recognize some of the China revenue in 2009.

Ehud Gelblum – JP Morgan

But it sounds like more in the back half?

Paul Milbury

It's difficult to predict. I mean it depends on how quickly they move and before they get a better idea, once RFP process concludes, there was a timing in terms of the spectrum.

Ehud Gelblum – JP Morgan

Paul, again, some of the cash flows this quarter clearly – I assume came from prepayments and some of the deferred revenue. Is that all end up in accounts receivable where some of the deferred revenue actually turned into cash. If you were to separate the cash that you received deferred revenue out and just look at the cash flow from operations on revenue do you actually recognize? Is there a sense if you – give us a sense of how much cash the business generated on $66 million in recognized revenue?

Paul Milbury

I am not going to sort of – I think I have something in front of me that I could use to sort of guess it at this point. I think for the year-to-date our cash is up about $120 million or $125 million and our deferred revenue I believe it was up about $87 million. So on a year-to-date basis I can give you that answer. The rest of it obviously would be operational cash.

Ehud Gelblum – JP Morgan

Right, but some of your – we can get more of offline, but some of your deferred revenue didn’t generate cash either – generated account receivable, so maybe I can triangulate around there. That is a good point. And then last thing, with Verizon moving to LTE and so be very aggressive about it, what do you expect CDMA subscribership to look like as you move to – you gave that 220 million subscribers EV-DO number for 2012. Do you expect the CDMA, global CDMA community to say, they are roughly at the same size or do you think by the time we get do that in 2012, the number of subscribers on CDMA will have decline some given Verizon’s move to LTE?

Ashraf Dahod

We do expect that the way the subscribers that migrate would be – some of them will continue to grow in EV-DO. So the EV-DO subscriber base will continue to grow and some of their subscribers may move to LTE or may have LTE plus EV-DO support on the devices. Because we believe that LTE management will get deployed before they get deployed in an island in a CO EV-DO and LTE will be targeted towards the high bandwidth customers. Now, clearly the infrastructure is going to migrate from the current CDMA infrastructure for example for an operator like Verizon to eHRPD infrastructure, and then it will move to LTE between now and whenever LTE goes commercial.

Ehud Gelblum – JP Morgan

Do you think the 410 million subscribers that you have today on CDMA you will not be lower in that number in 2012?

Ashraf Dahod

That is correct.

Ehud Gelblum – JP Morgan

Okay, thanks, I appreciate that.

Operator

Our next question comes from the line of Thomas Lee with Goldman Sachs. Please proceed.

Thomas Lee – Goldman Sachs

Hi, thanks for taking my call. A few questions, first, can you just remind us how many UMTS operators you guys are shipping to? And I don't mean like separate regions but I guess, in terms of parent companies or if you could provide that? Hello?

Ashraf Dahod

I mean you have to go by what we have announced disclosed so far, because we will not disclose all of the UMTS operators we have and separating out the parent company was not a parent company itself is a challenging task.

Thomas Lee – Goldman Sachs

I guess in terms, I mean, if you could just remind us in terms of what you have announced, do you have that readily available, if not, I can serve that back later?

Ashraf Dahod

Yes, we can give it to you.

Paul Milbury

Yes, I think we have intended to announce that on the basis of the number of countries in which we have deployment issue. Now a number of those countries are the same operator. We did announce on our last call that we had signed a deal with another large UMTS carrier in Europe and in the call at least this quarter.

Thomas Lee – Goldman Sachs

Okay, I can serve with that later.

Paul Milbury

There are other countries but I don’t think we are specific about the carrier.

Thomas Lee – Goldman Sachs

And then just in terms of the 10% customers, where they the same customers as last quarter?

Paul Milbury

One of them was the same.

Thomas Lee – Goldman Sachs

One of them was the same, okay. What was the other one that also 10% customer this year?

Paul Milbury

No.

Thomas Lee – Goldman Sachs

Okay, thank you. And then I guess, just lastly in terms of the new CDMA operator wins, how should we think about revenue trajectory of these customers, is it fair to assume that we could see something similar to kind of your current CDMA customer-based or is it more reasonable that perhaps that gets perhaps spread out more so than kind of what you saw in the past? And then, I just have follow up question to that.

Paul Milbury

I’m sorry, we didn’t get the first. Are you talking about how the UMTS revenues were making?

Thomas Lee – Goldman Sachs

No, I’m taking about the – on the CDMA side, the three new CDMA customers that you mentioned earlier.

Ashraf Dahod

Those customers we believe that their pattern is similar to the customers we already have. And as Paul mentioned that this whole issue of revenue recognition currently is more on the India region.

Thomas Lee – Goldman Sachs

Got it. Okay, I guess in terms of the opportunity, is the opportunity on the CDMA side with the new customers, is it similar to kind of your current CDMA customer based?

Ashraf Dahod

I mean that's really – we believe in the long-term, the answer is yes. It is a matter of how quickly they move to deploying broadband services and how extensive they get adopted in those particular countries.

Thomas Lee – Goldman Sachs

Got it and then just lastly, just staying with on the CDMA topic, do these new customers wins that you just announced – are they from multiple vendors? Are these sole source-type opportunities? And then also if you could talk about perhaps the pricing environment as you look into 2009? Do you expect that to change materially versus what you saw this past year?

Ashraf Dahod

I think let me address the first question, I mean, in India [ph] so far there is at least one operator with multiple suppliers, India, one of them. And could you repeat the second point that you have?

Thomas Lee – Goldman Sachs

Just on the pricing environment.

Ashraf Dahod

The pricing environment I think would reach our philosophy as in more that we ourselves as investment in R&D have been driving down the cost for megabit and cost for subscriber. And historically that's how we have really delivered greater value to our customers and we expect to continue to do that in 2009.

Thomas Lee – Goldman Sachs

Got it, okay. Thank you.

Operator

Your next question comes from the line of Blaine Carroll with FTN Midwest Securities. Please proceed.

Blaine Carroll – FTN Midwest Securities

Yes, thank you, nice quarter guys. Paul, could you talk about the operating expense guidance that you gave for 2009 and maybe give us an idea of the breakdown between R&D and SG&A and also where some of that incremental spend is going to go into?

Paul Milbury

Yes since we are still budgeting in and doing a lot of sort of putting and taking and trading between the different functions to come up with the budget at this point, we are not going to breakout spending by specific OpEx category at this point. But at a high level, I would expect in 2009 R&D spending to be growing at a rate probably faster than revenue and the SG&A functions growing at a rate slower than revenue and in combination as we said around 20% in total.

Blaine Carroll – FTN Midwest Securities

Okay. Which should be somewhere around $165 million to $170 million?

Paul Milbury

I’m talking about non-GAAP expenses which are roughly $130 million for 2008, so 20% on that would be – up to 20 % of that would be up to $156 million.

Blaine Carroll – FTN Midwest Securities

Okay. And then I guess for you, Ash, if you did start to see sort of some push back from your customers as far as this macroeconomic issue, where do you think you would see that first? Or how would you start to see it? Would it come in order cancellations or push-outs or delays? Could you give us a little idea on how you gauge sort of that end-market demand?

Ashraf Dahod

Clearly, as long as the mobile data continues to grow and we haven't seen any slow down in the growth of mobile data so far, we don't really expect order cancellation or significant push out. What is likely to happen is that some of the operators may delay going to say for example UMTS and HSPA. And they maybe actually delaying projects rather than push-outs of activities that are already underway, but as I have mentioned during the call, we do not see any such delays or push outs so far.

Blaine Carroll – FTN Midwest Securities

Okay. Any idea – if there is a bottleneck occurring in the network and where that is happening right now as these subscribers continue to come on board? When some of this new smartphone devices were originally launched to the market there's a lot of talk about issues within different carriers, networks and so forth, where do you think the real strain is in the network as these data services continue to ramp?

Ashraf Dahod

I think the first point when the strain occurs is obviously in the core because the core is really – they add to the core of the network as they meet demand and the second point usually ends up becoming the back-haul.

Blaine Carroll – FTN Midwest Securities

Okay. Thank you.

Ashraf Dahod

You’re welcome.

Operator

Our next question comes from the line of Richard Cramer with Arete Research. Please proceed.

Richard Kramer – Arete Research

Thanks very much. Several questions please. First of all, with roughly half of the market GAAP and cash right now, can you give us a sense of some of the specific adjacent product areas you might expand into to widen the overall Starent footprint or do you think the environment for 2009 is one where you really need to stick to your net end, and maybe second Ash, if you could comment on whether Starent would seek to bring a large OEM on board as a systems integration partner and try to strike a bit more of an exclusive partnership and maybe try to get one of them to adopt Starent SGSN solution as part of their standard offering and then I have a couple of questions for Paul, thanks.

Ashraf Dahod

First, let me start with the questions you asked me, our goal right now is to focus on what we do well which is the mobile core and at the same time, clearly, we are out looking out for areas that are – that will allow us to build a complete eco-system where if there are functions or a companies out there, that if we combine with what they offer with what we offer and combining those would allow us to deliver greater value to the customer, we obviously are on look out for that. We have been on a look out for it and we will continue to be but our current plans for 2009 does not factor any such activity.

Richard Kramer – Arete Research

Okay.

Ashraf Dahod

We are always in discussions with potential large OEM. There are some properties where even though the customer buy the equipment from us, a large OEM becomes the system integrator and we do believe that if we can sign a large OEM as our system integrator as a partner for us, it would increase our market access but at the same time when we are not contemplating any exclusive deal or any relations that had been set up will clearly be non-exclusive.

Richard Kramer – Arete Research

Okay. And a couple of other questions for Paul or maybe for Ash, Paul can you tell us how many 10% customers you have this quarter and can you maybe talk us through given that there had been some incredibly sharp currency moves of late, what the CapEx impact might have been on either reported sales or deferred income or deferred revenue and how your looking out about taking care of somebody has changes in, how they might affect your international sales profile and whether that stakes into guidance for 2009.

Paul Milbury

Yes the – yes we had two 10% customers in the quarter that together were about 79% of our revenue. From a currency prospective, historically most of our sales have actually been denominated in dollars. We are now making sales in Europe. We have mentioned that we did have an unfavorable translation or revaluation impact on our Euro denominated monetary assets receivable, Euro receivable and some cash that was about a million dollar hit to other income this quarter. So we do now have some exposure there, we currently and historically have not had a hedging program.

Richard Kramer – Arete Research

Okay.

Paul Milbury

Of any kind, we are taking a look at that. beyond that, obviously with a much weaker Euro than where its been, that would have an impact on the translated value of any Euro denominated bookings that were to come in to the – come in to the company just in terms of the translation but since we are not at this point anticipating a very significant contribution from Euro denominated revenues in ’09, at this point I wouldn’t see that as a significant impact from the reported results and on the other side of the equation, obviously the weaker Euro makes our expense structure in – I mean cheaper in the short term..

Richard Kramer – Arete Research

Okay, thanks. And finally you didn’t really answer the previous question on the pricing environment and some of the assumptions you’re making for 2009, maybe Ash you could talk a little bit about – in the consolidating infrastructure market competing against larger OEMs, how do you expect in a market which is maybe the deals would be a little scarcer next year. How do expect your competitors to price against you and what are you baking in to your guidance for 2009 on pricing.

Ashraf Dahod

I think historically we have not seen price pressures because as I’ve mentioned earlier, that our goal is to really dry down the CapEx per megabit of CapEx per subscriber by investing in R&D, and we expect to continue on that path in 2009.

Richard Kramer – Arete Research

Okay, so you don’t see any particular pricing pressure brought to there in 2009 deals?

Ashraf Dahod

Except for whatever the VA accrue [ph] are projecting that is already a factor into our projections for ‘09.

Richard Kramer – Arete Research

Okay, thank you.

Operator

Our next question comes from the line of Brian Modoff with Deutsche Bank. Please proceed.

Brian Modoff – Deutsche Bank

Hi, another question for Paul. I’m looking at your guidance for next year. You talked about $315 million in revenue?

Paul Milbury

Right.

Brian Modoff – Deutsche Bank

And non-GAAP EPS is $0.65 to $0.68?

Paul Milbury

Right.

Brian Modoff – Deutsche Bank

And that is assuming 20% operating expense growth and tax rate of 38% all that. I have a hard time getting to that bottom line number in assuming the gross margin that is between what you did this year and what are you’re long-term target is. I guess I’m trying to understand where the other expense is coming from.

Paul Milbury

Well I think that should [ph] work.

Brian Modoff – Deutsche Bank

What do you have for operating expense is 20%, $156 million?

Paul Milbury

A little higher than that.

Brian Modoff – Deutsche Bank

Well, Paul, why do we talk offline because this not quite getting there, so we will talk offline.

Paul Milbury

It should work out as I said $315 million of revenue. Our goal is to deliver 25% operating profit. Our target operating profit which was in the ballpark of $78 million or $79 million and then other income for the year we said 5 to 7 right?

Brian Modoff – Deutsche Bank

I know that. Okay. All right, we will talk offline then.

Paul Milbury

Okay.

Operator

Our next question comes from the line of Doug Whitman with Whitman Capital. Please proceed.

Doug Whitman – Whitman Capital

I’m trying to figure for next year, if you look at the numbers that you are giving out, just follow through with your expectation, what was the cash flow be for 2009.

Ashraf Dahod

Doug, we can barely hear you.

Doug Whitman – Whitman Capital

I’m sorry, I’m sorry. I’m trying to figure out. I didn’t realize I was still on speaker, I apologize. But I’m trying to figure out if we – given the guidance that you’ve given –if you can give us some range of what you think the cash flow would be for 2009 because the accounting is so complicated obviously with this company. What is the positive cash flow would be?

Paul Milbury

We are not going to provide guidance for cash at this point for ‘09. We are still in the – as I said, in the midst of the budgeting cycle and working on our capital budget as well. As everything else, I would expect cash to increase in 2009 but clearly not at the same rate as in 2008 where cash went up $140 million which was obviously much higher than the income that we are in for the year.

Doug Whitman – Whitman Capital

And falling back on Brian’s earlier question which is a lot the companies are talking about a lower tax rate with the continuation of the R&D tax credit. Could you talk a little bit of why your tax rate would be so high? You seem much higher than the vast majority of companies that we talked to in tech land.

Paul Milbury

Yes, I’m not sure I have to take a look at that myself. I think obviously the federal tax rate of 35% and the Massachusetts tax rate of 10%, so 45% is the statutory rate. And I think the R&D credit does have an impact there but it is not at anymore than what we built in.

Doug Whitman – Whitman Capital

And if you could talk a little about – you had tremendous cash flow this year, you have over $5 a share or roughly $5 a share in cash and you are generating quite a bit of cash going forward, using the higher tax rate when you look at next year, it is well over 10% close to 15% accretive. The current prices to do a buyback you’ve got $350 million to $360 million in cash. Could you talk about a little bit of the reasons why you don’t want that accretions in your earnings? Why you need so much cash?

Paul Milbury

Yes, I think there’s probably two sides of that issue to look at. One side, obviously, is that we along with everybody else are living in extremely uncertain times and having a lot of cash is certainly better than having to go out and look for a lot of cash. I think also another factor in there is that the types of strategic opportunities that we look at and are looking at on a regular basis are getting cheaper. And so the ROIs are becoming more attractive to us and we certainly wouldn’t want to be using our stock as currency for any of those opportunity should one arise that we want to pursue. And then the other side of the equation obviously is, as you said, the cash is earning a low interest rate and the stock is relatively cheap by a number of different measures. We have had a number of discussions on this issue at our board in the past and recently, but at his point, they have decided not to take any action and to stay where we are and to continue to look at things on a regular basis obviously it is a decision of the board not management.

Doug Whitman – Whitman Capital

Well thank you for the great result.

Paul Milbury

You're welcome.

Operator

Our next question comes from the line of Kevin Giddis of Morgan Keenan. Please proceed.

Kevin Giddis – Morgan Keenan

Good afternoon gentleman. Can you talk about the pricing environment of these different technologies, UMTS market, larger carriers there, and then the CDMA market, where you might not see so much competition? And maybe what the gross margin impact would be?

Ashraf Dahod

I mean, it is true that the number of our competitors are different in the UMTS market versus the CDMA market and size of the deals are also a bit different, but overall, the gross margin range that we get in CDMA and UMTS is not that significantly different. And what we are projecting for '09 is the result that combines with what we expect in CDMA and in UMTS.

Kevin Giddis – Morgan Keenan

Very good. The two 10% customers you talked about in the third quarter, how much total revenue were they combined?

Paul Milbury

79%.

Kevin Giddis – Morgan Keenan

Very good. And can you offer the same view in the deferred revenue? Of deferred revenue, how is that concentrated by customer?

Paul Milbury

No, we don’t break that out.

Kevin Giddis – Morgan Keenan

When – I am referring to the previous gentleman's question on your cash balance, what do you think the prevalent board thinking is? Would you be inclined perhaps to think they might pursue an acquisition strategy?

Paul Milbury

Well, as I've said and it is one of the earlier callers raised the question about attractive adjacencies for the company in terms of strategic acquisitions of technology or products that they like. Ash mentioned that on a weekly basis we are presented with opportunities in those areas. We have not really done anything significant to-date but we are constantly in discussions obviously the market environment for small companies like that in terms of exit strategies and finding additional capital is not today what it has been and as a result I think there – as I said, there are going to be opportunities for us to consider where the prices will be significantly different once than – than what they had been and I think that's again one of the things that comes in to consideration by the board. And then you go back to just the very initial reasons that we talked about for raising the cash that we've raised as a company and that is in spite of the fact we are looking at $250 million of revenue this year and over $300 million next year, relative to the people that we compete against, we are still viewed as a relatively small company and not as financially strong as some of the people that we compete against and from a customer perspective there is a benefit there.

Kevin Giddis – Morgan Keenan

Okay. Paul regarding the 315 you mentioned for '09, can you give us a ballpark on what you think the product service mix might be?

Paul Milbury

Roughly, 8515 I think is our long-term target next and we have been running about that sometimes 8614 and whatever, but 8515 I think is a rough guess.

Kevin Giddis – Morgan Keenan

And for the fourth quarter in exiting the year, where do you think your deferred balance would be? Is the trajectory up or down from here going to the year-end?

Paul Milbury

We don't project the deferred revenue, there are too many, as we've talked about in the past, too many unpredictable timing elements in the ins and outs of the deferred revenue from shipments to the way we invoice sometimes, generally we – when we ship something we invoice for it, but we have times when we ship product and don't invoice immediately, but invoice with a log and all of those things can lead to variability and are difficult to predict so that we don't project deferred revenue.

Kevin Giddis – Morgan Keenan

Is that something – ?

Paul Milbury

As I said we do expect to enter 2009 with a strong backlog so we made that as a qualitative statement but we are not going to quantify it.

Kevin Giddis – Morgan Keenan

Very good. Is that something that you monitor on a day-to-day basis?

Paul Milbury

The deferred revenue?

Kevin Giddis – Morgan Keenan

Yes or is that something you'll just tabulate it in time that you close the books?

Paul Milbury

For the most – I mean, obviously, we have our own internal forecast that where we look at all of the various business activities from shipments to invoice shipments and non-invoice shipments and that sort of thing, so we do look at it, but we're more focused in the short-term in terms of week-to-week, the new bookings coming into the company and the shipments going out of the plant.

Kevin Giddis – Morgan Keenan

Yes so can – based on that can you give us an indication on how you did in October versus the quarter of September?

Paul Milbury

No. We don't – we don't break things out on the monthly basis.

Kevin Giddis – Morgan Keenan

Very good. Well, thank you so much for taking my questions.

Paul Milbury

Sure.

Operator

Our last question comes from the line of Andy Schopick with Nutmeg Securities. Please proceed.

Andy Schopick – Nutmeg Securities

Thank you and good afternoon. I just want to ask a couple of questions about the new security gateway product. I guess that is being trialed in multiple countries with customers around the world. When do you expect the first customer shift? What's the pricing going to look like on that and can you size that market or the revenue expectation in the year ahead that you may have for it?

Ashraf Dahod

All right. Clearly, the security gateway is designed to support technologies like Wi-Fi and Femto where the traffic will come from an enterprise or a consumer location across the internet. So we expect that we will have the security gateway deployed in multiple countries. We do expect to recognize revenue next year unless we run into some contraction issues in terms of rev reg. As far as the sizes of market, it really depends on how rapidly mobile operators pursue the Wi-Fi market so we can't really give you a prediction at this point.

Andy Schopick – Nutmeg Securities

Alright, thank you.

Ashraf Dahod

You're welcome.

Operator

I would now like to turn the call back over to Ashraf Dahod for closing remarks.

Ashraf Dahod

Thank you very much to all of you who joined us in our quarterly call. And talk to you next quarter. Good night.

Operator

Thank you for your participation in today's conference. This concludes the presentation. Everyone have a great day.

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Source: Starent Networks Corporation Q3 2008 Earnings Call Transcript
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