Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

3Com Corporation (COMS)

F4Q06 Earnings Conference Call

June 28, 2006 5:00 pm ET

Executives

Scott Murray - CEO

John Vincenzo – Director Investor Relations and PR

Don Halsted - EVP and CFO

Analysts

Matt Shimao - Bear Stearns

Jiong Shao - Lehman Brothers

John Marchetti - Morgan Stanley

William Becklean - Oppenheimer

Manny Recarey - Kaufman Brothers

Long Jiang - UBS

Mark Sue - RBC Capital Markets

Presentation

Operator

Good day, and welcome to this 3Com Q4 2006 quarterly conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Mr. Scott Murray, Chief Executive Officer. Please go ahead, sir.

Scott Murray

Thank you, operator. Good afternoon, everybody. Before we begin today, I want to make a comment about Ciel Caldwell, our Director of Investor Relations, who I know many of you know. She has been expecting her first child and was due in June; and today she's in the process of becoming a new mother, of all days. We at 3Com heartily congratulate her and her family.

As you also may know, over the past few weeks in anticipation of this event, she has been transitioning her Investor Relation responsibilities to John Vincenzo. I would like to welcome John to his new role of Director of Investor Relations and PR within 3Com, working with Don Halsted, our CFO. Now, I would like to ask John to introduce the call for today, please.

John Vincenzo

Thank you, Scott. The remarks being made on this conference call contain forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These include forward-looking statements regarding our goal to reach profitability and reduce costs; and our restructuring plan, including facility closures and expected footprint; workforce reduction; estimated charges, cost savings and efficiencies, and timing for each; decisions on where to invest and add resources; go-to-market plan and partner relationships; strategic direction; the future ownership of H-3C; H-3C product plans and performance; coordination among our businesses; return of capital from H-3C and expected sale of certain non-core assets.

These statements are neither promises nor guarantees, but involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. These risks include, without limitation, the risks detailed in the Company's SEC filings, such as our 2005 Form 10-K.

On this call, we will also discuss several non-GAAP financial measures, including non-GAAP operating loss, several non-GAAP H-3C segment measures, and several pro forma non-GAAP measures for periods not required by GAAP. For each non-GAAP measure, the most directly comparable GAAP measure and a reconciliation of the non-GAAP measure to its most comparable GAAP measure can be found in tables at the back of the press release announcing our results. The press release is available on the Investor Relations section of our website, www.3Com.com. With that, I'll turn the call back to Scott.

Scott Murray

Thank you, John. With me today is our Chief Financial Officer, Don Halsted, who will review our financial results for our fiscal fourth quarter and our fiscal year 2006 with you in just a few minutes.

However, before we get into the specific details regarding our financial performance, I'd like to spend a few minutes sharing my thoughts on the current state of our business. During my remarks today, I will discuss our two operating segments within 3Com.

First our Secure Converged Networking, or SCN segment, which includes our security, data and voice product offerings. Then I'll discuss our Huawei-3Com joint venture in China, which is otherwise referred to as H-3C.

As I mentioned during our last call, we have four key business priorities:

  1. Create a world class go-to-market strategy.
  2. Continue to invest in new technologies.
  3. Leverage and enhance our relationship with H-3C.
  4. Design an appropriate business model and infrastructure to sustain profitability.

While we are making progress in all four areas, today I'm going to spend much of my time focusing on two of these priorities: H-3C, which we began consolidating with this quarter's results, and the business model we have designed to reach our goal of profitability, including details of a cost realignment program.

Before I get into the specific details around our efforts to reach profitability I'll first give you a snapshot of key aspects of our financial performance. Overall, we are pleased with our pro forma results of this business, which were primarily driven by the strong performance of H3-C and cost containment in the SCN. However, we recognize there's still much work to do with respect to our SCN Segment.

Our revenue on a pro forma basis in the fourth quarter was $304 million, a 22% increase over the same period in the prior year. Our non-GAAP operating losses reduced to $8 million in the fourth quarter of fiscal 2006 from a $51 million dollar loss in the fourth quarter of fiscal 2005. This was driven by a combination of cost controls and the inclusion of two months of H3-C results.

We also continue to maintain a strong cash position. 3Com ended the fourth quarter with $864 million in cash and short-term investments, which included $169 million from H3-C.

Don will comment on the results of our business carry ons but I want to mention a factor in our security business performance today. While our security product segment was up year-over-year by over 60% from last fourth quarter '05, we did see a quarterly decline. Some of this decline was due to the seasonal nature of customer buying trends at the end of the calendar year, which was our third quarter; and some of the decline was due to the issues arising from the move of one of our contract manufacturers from the U.S. to Mexico, which we believe have largely been resolved.

Now turning to H3-C. This business unit continues to perform well, which had a positive impact on our consolidated results for the fourth quarter. H3-C delivered sequential growth despite having a traditionally slow period in the quarter, due to the Chinese New Year. Our joint venture continues to be a strong player in China.

For the calendar quarter ended March 31, 2006 approximately 70% of H3-C's stand-alone revenues were generated in China. Don and I were just in China a little over two weeks ago meeting with H3-C and Huawei as part of our management process that we have established and we were very impressed with the operations, product plans, and the management team.

While I'm commenting on H3-Compression, I want to address a topic that I'm sure is top of minds for many investors. That is the ownership of H3-C post mid-November of this year. As you all likely know, starting in November the governing structure for our joint venture allows either 3Comm or Huawei to consider additional ownership positions through a bidding process.

As I commented last quarter, we expect to continue our discussion with Huawei to determine the outcome for the future ownership positions of H3-C. The ultimate decision is expected to be based upon a number of factors, which include H3-C's continued strong performance, 3Comm's long-term strategic plan, continued involvement and expectations of Huawei.

In this regard, 3Comm Management and its Board of Directors are carefully discussing the strategy. As we are now consolidating H3-C's results, we continue to build a collaborative management process and increase the coordination between the two business segments. We expect to have more information to share with you regarding the joint venture and it's ownership in the coming months; but as I hope you can appreciate, as with any transaction-related event, these discussions must remain confidential during this period.

Clearly H3-C's growth contributed significantly to 3Com's pro forma results, while we continue to work hard to improve the performance of the SCN Segment of our business. We go back to the priorities that I outlined earlier. I stated, we must create the infrastructure and business model to improve the profitability of the business.

To help drive this, today we announced a plan to realign certain aspects of 3Comm's SCN cost structure to a more appropriate size and to enhance the discipline in our business and cost model. The cost savings and efficiencies we expect to achieve from this initiative are aimed at aligning 3Comm's SCN Segment to top line revenue performance. Once we improve the business model we intend to focus on growth. However, our near term priorities will be focused on continuing to drive profitability improvement.

I do want to emphasize today, however, that this cost reduction program does not relate to either our H3-C operations or the TippingPoint security business.

Now the first component of the restructuring focused on rationalizing our site footprint. As any global company, we recognize the importance of having local presence in various countries.

However, after analyzing our global footprint carefully, we determined that we could close or consolidate a number of these offices around the world and still effectively service our customers.

Overall, today we announced we were closing or consolidating 60 of our sites, moving to flexible space arrangements and regionalized sales support models. We still expect to have a presence in many of these countries but we'll increasingly use smaller key suites rather than fixed cost premises.

In addition, we recently decided to close our Santa Clara, California offices. As many of you recall, 3Comm moved its headquarters to Marlborough, Massachusetts several years ago, but we continued to maintain a presence in Santa Clara, with primarily representations from various administrative functions, including IT. Consolidating operations conducted in our Santa Clara with our corporate offices in Marlborough creates efficiencies and allows us also to market for sale the three owned buildings that 3Com has there.

The second phase of the reorganization will result in a head count reduction of approximately 15% of our full time SCN workforce or approximately 250 employees. The head count reductions will occur across all regions, primarily in the sales and marketing organizations, to align these groups to create a more cost-effective go-to-market model. There are also certain other G&A areas of the business that will be impacted by the workforce reduction resulting from various site closures.

The overall goal of our reorganization is not simply to reduce headcount, but also to invest appropriately in resource levels of critical areas of our business, reducing costs in areas where we can be more efficient.

Our current plan is to add employees to H3-C's operations as well as to TippingPoint Sales and Development Teams. Overall, H3-C had approximately 4,000 employees as of the end of March; while the SCN Segment of our business had approximately 1,550 employees as of the end of the fourth quarter in May.

We currently expect the combination of facility and employee reductions will result in a restructuring charge of approximately $10 million to $13 million. While we recognize these are tough decisions that affect many dedicated people, they are necessary to create the right business model for future profitability.

Another key component of our business realignment centers on increased focus on spending in our sales and marketing to drive innovation and to create great customer experience. We're taking a thorough look at how to spend our resources and create programs to provide greater returns on our investments.

For example, we are also looking at the delivery costs of our warranty program and other services support models. We are also working to build the necessary processes and systems throughout the entire Company to make us more cost efficient.

From a go-to-market perspective, TippingPoint will continue to target large enterprise organizations. In 3Com's SCN operating segments, a great deal of work has been done over the past few months under the leadership of our new head of Sales Marketing, Bob Dechant.

In the mid-market 3Comm will continue to target customers in key verticals such as education, government and health care. We have a strong base of channel partners that are experienced in selling within these verticals. These are areas where we see potential for growth, particularly with this focused approach.

We will also continue to build our relationships with our systems integrated service providers and provide access to many of these accounts to other large enterprises.

In addition to streamlining our core operations, we continue to focus on converting certain non-core assets to cash. For instance, we have agreed to sell a small portfolio of venture capital investments that the company has for approximately $17 million, which will result in a small gain in FY07. In addition, we are currently marketing the three buildings that we own in Santa Clara for sale.

In summary, we have made progress in the business. I'd like to close with the following highlights before I turn it over to Don. We are focusing on our core markets to build a quality global business in our security networking and voice products in specific verticals like education, government, and healthcare, just to name a few.

We've been able to reduce the run rate of our operating costs in the SCN business. We are taking steps, which we've announced today, to reduce the future SCN cost infrastructure in head count and facilities and will continue to invest in new hires in TippingPoint and within H3-C.

We have a strong balance sheet with over $860 million in consolidated cash. And last but not least, our H3-C joint venture with Huawei continues to demonstrate strong growth in China. With that, I'd now like to turn the call over to Don Halsted to provide you a more detailed discussion around our Q4 financial results.

Don Halsted

Thank you, Scott. Before I review our fiscal fourth quarter results, let me set the stage for the discussion by describing the current quarter reporting of the H-3C joint venture, as well as describing the two views of the business we'll be using going forward to review 3Com's consolidated results.

As you may recall, our joint venture operates on a calendar basis, and as such, we include the results of its most recently completed calendar quarter in our fiscal period reporting. Therefore, our fourth fiscal quarter includes the joint venture's performance for the period of January through March of 2006.

You'll further recall that we acquired majority ownership and established effective control at the end of January. Therefore, our reporting of H-3C and 3Com's GAAP results for the quarters reflects the joint venture’s performance for the months of January on an equity basis, consistent with our prior reporting; and reflects the joint venture's performance for the months of February and March on a consolidated basis with an offsetting minority interest charge, reflecting Huawei's 49% interest in the venture.

Now, let me describe how we will discuss the performance of 3Com. First, we will start with reviewing the consolidated measurements of the business. For this quarter, it will include a review of both the GAAP consolidated results reflecting the H-3C joint venture on an equity basis for the month of January, and on a consolidated basis for the months of February and March, and a pro forma view of the consolidated revenue results of 3Com, including the H-3C joint venture as if we had consolidated the results for the entire period and in comparison periods.

Secondly, we will be discussing the performance of our two operating segments, SCN and H-3C, that we adopted with the consolidation of H-3C's results. The performance of these operating segments is included in table H of our press release, along with a corporate non-operating segment, which includes the revenue eliminations and equity ownership positions.

Finally, we will end with a review of the key elements on the consolidated balance sheet and the change in cash.

Before starting the performance review, I want to address guidance. In our last call, we stated that we did not think it was prudent to give forward-looking financial guidance. That is still our position. We have structured this review to give you good visibility into our current operating results in this period of transition. However, we will not be providing forward-looking guidance.

Now, let me start with a consolidated results review. This will include a brief discussion of revenue through operating loss which will be covered in more depth in our discussion of the operating segments. In addition, I will review the results below operating loss line on a consolidated basis.

The fiscal fourth quarter GAAP revenue was $255 million, a 43% sequential and a 44% year-over-year increase, driven primarily by the inclusion of two months of H-3C's results in the current fiscal quarter.

For the 2006 fiscal year, revenue was $795 million, a 22% increase over fiscal 2005, driven by the inclusion of two months of H-3C, as well as increased sales of TippingPoint Security products, and the inclusion of TippingPoint's results in the full current period.

On a pro forma basis, which assumes we consolidate H-3C for the entire quarter and in comparable periods, revenue for the fourth fiscal quarter was $304 million, which is about flat sequentially. For your reference, in table F of our press release we have provided the historical pro forma results for each quarter of fiscal 2006, along with the full year fiscal 2006 and 2005.

Table C in our press release provides geographic and product-based supplementary revenue disclosures and is presented on a consolidated basis. On a geographic basis, we had sequential declines in EMEA, North America, and Latin South America of 10%, 6%, and 5% respectively. These declines were more than offset by an increase in our Asia Pacific region, driven by the inclusion of H-3C. With the inclusion of H-3C, APR becomes 3Com's largest region, with $112 million of revenue in the fourth fiscal quarter.

On a product basis, networking grew by 66% sequentially, driven by the consolidation of two months of H-3C, partially offset by declines in our SCN segment.

Security product sales declined 3% sequentially, driven primarily by the seasonality and the transitional manufacturing issues addressed earlier by Scott, offset in part by the addition of H-3C's security sales in China. Security product sales still grew 66% compared to the fourth fiscal quarter of 2005.

Voice products increased 16% sequentially, primarily due to the inclusion of the H-3C voice product sales in China, and to a lesser extent, increases in sales of SCN voice products.

Services increased 10% sequentially, also driven by the inclusion of H-3C, as well as increases in SCN segment performance.

Revenue from connectivity products was $8 million, a 30% sequential decline, resulting primarily from inclusion of a $3 million revenue sharing arrangement related to the sale of certain intellectual property rights in the previous quarter.

Of note within the quarter is that we have made the decision to end-of-life certain connectivity products, as we determine that the cost to ensure EU RoHS compliance was not economic.

Results at the gross margin and certain operating lines will be described in the discussion of the operates segments following this review of the consolidated results. On a consolidated basis, each of these lines was significantly impacted within the quarter by the inclusion of two months of H-3C's results.

The GAAP operating loss for the fourth quarter was $21 million compared to $47 million in the third quarter and $62 million in the same period of fiscal 2005. The $41 million year-on-year improvement can be separated into $26 million due to the reduced operating losses in the SCN segment, and $15 million of operating profit from two months of H-3C.

The SCN operating loss improvement was driven by operating expense reductions, offset in part by lower gross profits on lower revenues. For the fiscal year, operating loss was $157 million, a 23% improvement over the fiscal 2005 operating loss of $203 million.

I will now discuss 3Com's non-GAAP operating loss performance. Management believes that a non-GAAP operating loss measure that excludes unusual expenses along with restructuring, amortization, and the write-down of in-process R&D is the best single measure of the performance of our underlying business operations.

When we adopt FAS 123R in fiscal 2007, we will exclude these costs as well. The reconciliation to GAAP operating loss is provided in table B in the press release.

With this definition consistently applied, the non-GAAP operating loss was $8 million in the fourth quarter of fiscal 2006, a sequential improvement of $22 million compared to the third quarter non-GAAP operating loss of $30 million, and a year-on-year improvement of $43 million, compared to a fourth quarter fiscal 2005 non-GAAP operating loss of $51 million.

The primary drivers of the reduced non-GAAP operating loss are the inclusion of two months of H-3C and continued operating expense controls inside the SCN segment.

For the fiscal year, 3Com's non-GAAP operating loss was $112 million, a 31% improvement over the fiscal 2005 non-GAAP operating loss of $164 million. The net reduction was driven primarily by improved gross profits in the SCN segment, and the inclusion of two months of H-3C.

During the period, we recorded $1 million in unrealized gains on investments for various appreciations in our private equity holdings and interest income for the period of $9 million increased sequentially by $2 million and over the prior year quarter by $3 million. This improvement was driven primarily by the interest income earned on the H-3C cash and cash equivalent balance.

Other income was $8 million in the quarter, compared to approximately zero in the previous quarter. This increase was primarily driven by the inclusion of an H-3C other income resulting from an operating subsidy program by the Chinese VAT authorities in the form of a partial refund to H-3C of VAT taxes collected from purchases of their software products.

The provision for income tax was $5 million for the quarter, versus $1 million in the prior quarter, primarily due to the inclusion of two months of H-3C.

In our fourth fiscal quarter, we recorded equity income of $3 million as our share of the financial performance of the unconsolidated H-3C joint venture for its month of January. We also recorded a minority ownership charge to our results of $11 million, as Huawei's share the financial performance of the consolidated H-3C, for its performance in the months of February and March.

The net loss for the fourth quarter was $15 million or $0.04 per share, of which restructuring and amortization expenses represents about $0.03 per share. This represents a $0.04 per share improvement sequentially, and an $0.11 per share improvement over the prior year quarter.

The weighted average number of shares outstanding during the quarter was 390 million shares. This net increase of 2 million shares from the prior quarter primarily reflects the exercise of stock options and employee stock purchases under our employee stock purchase plan.

The net loss for the fiscal year 2006 was $101 million, or $0.26 per share, of which restructuring and amortization represent about $0.09 per share. This is a $0.25 per share improvement over fiscal year 2005 net loss per share of $0.51.

Let me now turn to the review of our operating segments. Commencing with the consolidation of H-3C results, we will be reporting two operating segments: SCN and H-3C. The presentation of the results of these segments reflect how we manage these business segment in accordance with FAS 131 and are documented in table H in our press release.

Accordingly, there are certain elements of 3Com's consolidated performance which are not included in the segment operating results. These elements are reflected in the corporate non-operating segment. The segment table presented in our press release is prepared in accordance with GAAP consolidated results, and therefore, reflects two months of H-3C performance on an as-consolidated basis plus one month of equity recording of H-3C. The stand-alone H-3C performance for the month of January continues to be disclosed on the table I attached to our press release, which reviews the performance of H-3C as an unconsolidated subsidiary.

For purposes of quarterly comparisons, we have included a non-GAAP view of H-3C operating segment as if the results for the period from January through March had been consolidated. This view can be seen in table E of our press release.

I will start by reviewing the SCN segment performance, which are comparable to the GAAP 3Com stand-alone prior period results. Revenue for the quarter was $166 million, down 7% sequentially and down 6% compared to the prior year quarter. This sequential decline is primarily explained by two drivers.

First, our EMEA region declined sequentially, driven primarily by reduced network product sales. We saw increased competition in the 10/100, and gigabit markets, as well as in large project deals. We responded with list price reductions in certain gigabit and 10/100 products ranging from 10% to 25%, effective June 1st.

Second, our North America region declined overall, driven by impact of the security business performance discussed earlier, and by lower connectivity products revenue. All other product areas demonstrated sequential growth in North America.

SCN gross margins declined 4 percentage points sequentially, to 36%. About 2 percentage points of the decline are unique to this quarter, resulting from the resolution of cost issues with a service provider and the impact of lower security revenues. About 1 percentage point was due to a change in the classification of certain technical support costs from development to cost of sales. Lastly, there was about a percentage point reduction due to the combination of lower volume and price pressure, offset in part by improved cost.

From an operating loss perspective, this decline was more than offset by a reduction in sales and marketing, research and development, and general and administrative expenses, which totaled $89 million in the quarter, a $23 million sequential decline.

This decline resulted from the absence of a total of $9 million in unusual items for executive severance and impairment charges taken in the third quarter, termination of our branding campaign, other lower operating expenses due to the revenue performance, and a continuation of the reduction in our basic expense run rates.

On a net basis, this resulted in a sequential reduction in the SCN segment operating loss of $11 million. SCN net loss for the quarter of $36 million is a $21 million improvement over the prior year's quarter stand-alone 3Com loss of $57 million.

As Scott discussed in his comments, we are announcing a restructuring plan in our SCN segment to reduce certain head count and office locations. This program is expected to reduce head count by approximately 250 employees and 21 facility locations. The charge for this restructuring is expected to be between $10 million and $13 million and will be recorded over the first two quarters, primarily, of fiscal 2007.

Turning now to the H-3C operating segment, in our GAAP financial statements, we consolidated two months of H-3C results covering February and March. During this two month period, H-3C generated $108 million in revenue, $15 million in operating profit, and $22 million in net income before the Huawei minority interest charge.

In order to give a meaningful comparison, I need to use full quarter results. So I'm going to reference the non-GAAP quarterly performance numbers for H-3C for the fourth quarter set forth in table 8.

On this basis, revenue for the fourth quarter was $156 million, an 8% sequential and a 90% year-over-year improvement. The sequential increase in sales inside of China was driven by continued growth in the sale of high-end enterprise switches and routers. Sales outside of China are primarily OEM sales to 3Com and to Huawei.

From a product perspective, over 95% of H-3C's revenue is categorized in our network product category, with the balance in voice, security, and services. H-3C's gross margin for the complete quarter was 49%, up about 1 percentage point compared to the prior quarter, and up 5 percentage points compared to the same period a year ago.

The gross margin performance in the calendar first quarter continues to reflect the benefit of a strong mix of higher end switching sales directly into the Chinese market.

H-3C's direct operating expenses for the full quarter were $46 million, and amortization expense for the quarter was $8 million. Overall, H-3C had $21 million in operating income for the quarter, including the $8 million in amortization expenses.

Returning to 3Com's consolidated results, I'll now review selected aspects of 3Com's balance sheet. Cash, cash equivalents, and short-term investments totaled $864 million, representing a net increase of $158 million from the balance at the end of the previous quarter. The change includes an increase in cash and cash equivalents of $269 million and a decrease in short-term investments of $111 million.

Key components of the change in cash and cash equivalents, aside from the decrease in short-term investments, are the following:

  1. The consolidation of H-3C's cash, cash equivalents, and short-terms investments of $138 million as of January 31st, the start of the consolidation period.
  2. Cash provided by operations was a positive $15 million, comprised of $33 million positive cash from the H-3C operations, offset in part by $18 million of cash used in the SCN operations. These figures include $4 million for restructuring- related payments.
  3. Cash provided by the issuance of 3Com common stock was $9 million, primarily driven by the exercise of options and our employee stock purchase plan.
  4. Lastly, cash used for capital expenditures amounted to $6 million.

The cash changes described above include H-3C's cash activities for the month of February and March. The year end cash, cash equivalents and short-term investment balance of $864 million is comprised of $695 million from the SCN segment, and $169 million from H-3C.

The owners of H-3C, 3Com and Huawei, have agreed on a return of capital of $80 million. This is expected to be completed by the end of the calendar year following Chinese regulatory approval, and will result in an $80 million reduction in the H-3C cash, a $39 million increase in the SCN cash, and a decrease in the minority ownership liability to Huawei.

Other items of note in our consolidated balance sheet include the following:

  1. We are now reporting notes receivable on our balance sheet, which represent acceptances issued by major Chinese banks recorded in the H-3C balance sheet for which its March quarter end was $63 million.
  2. Accounts receivable increased $54 million sequentially, driven by the inclusion of H-3C's receivables, more than offsetting the decline in the SCN segment receivables.
  3. Inventory increased $120 million, driven by the inclusion of H-3C balances, more than offsetting declines in the SCN segment. H-3C carries higher inventory due to their Chinese direct touch model, the structure of their supply chain, and increased inventory buffers to support rapid growth.
  4. Accounts payable and accrued liabilities increased $162 million, driven by the inclusion of H-3C's balance sheet.

So to conclude, our H-3C segment continues to show strong performance. Our SCN segment is reducing its losses, but there remains a lot to do. Our cash used in operations has improved in the SCN segment, and when combined with H-3C, our net cash provided by operating activities was positive for the quarter.

I'd like to turn the call back to Scott Murray to start the question-and-answer session.

Scott Murray

Thank you very much, Don. Operator, I think we'd now like to open the call for questions, please, if we could.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Matt Shimao - Bear Stearns.

Matt Shimao - Bear Stearns

Hi guys, how are you? First, let me just try to make sure I have some of the numbers straight. For the pro forma revenues, looking through your tables, I think I have $166 million for 3Com, $156 million for Huawei-3Com, and an elimination entry of $18 million to total $304 million?

Don Halsted

I believe that that is right.

Matt Shimao - Bear Stearns

Okay, great. So that looks good. Then looking at the EPS, starting with your GAAP loss of $0.04, I see you show your pro forma loss of $0.02. Now, when I factor in the interest and other and the taxes and the minority interest and equity interest in the JV, it looks like I'm showing actually a net loss of $0.01? Is that right for your results?

Don Halsted

Matt, I'm not sure of the calculation that you just did, because I did not actually give a pro forma number on an EPS. What I think I did was tell you how much at least the restructuring and amortization was of the $0.04, which represents about $0.03.

Matt Shimao - Bear Stearns

Okay, so your pro forma operating loss is $0.02? That's on table B, right?

Don Halsted

The operating loss is at the operating line, not at the net income line. So I generally do not express that as a per share number.

Matt Shimao - Bear Stearns

Okay. Just one more thing looking at the EPS, then. When I look at your last table, which shows the one month for Huawei-3Com that's not included in the actual results, it looks like they had a profit of $6.5 million. So if you were to include that, to look at your EPS as if you're looking at three months of 3Com and three months of Huawei, that would be an additional $0.01 of benefit to your EPS line. Am I looking at that correctly, or not?

Don Halsted

Actually, Matt, I don't think you are. Because the effect of that month of performance is reflected in the net income, but it's reflected because we had a minority interest of $3 million in the net income line.

So the only difference between January and the February, March at the net income line, is you move from 49% participation to 51% participation.

Matt Shimao - Bear Stearns

Got it, I understand. So on the operating income line, loss of $0.02, and we need to figure out what the actual EPS is by looking at the interest and other and taxes and so forth. Okay, good.

I want to ask you about the JV. So the JV had a very strong quarter. Looks like the gross margins are up 49%, annual growth, year-over-year, 90%. Looks like the pro forma operating income was 19% and net income of 24%.

Can you talk about the primary growth drivers for the JV? Looking forward over the next 12 months, would you expect the JV's primary growth drivers to remain the same or change?

Scott Murray

Sure. Let me address that for you, Matt. Clearly, what we've seen with H-3C is that it continues to do well in China, which is a very dynamic market. It has a very strong presence there. It is a very Chinese-driven business model with respect to its go-to-market. So we've been very pleased with that growth model that we've seen for them.

As Don mentioned, we are not providing forward-looking guidance, so we can't comment on what it might look like down the road. But as we look at its growth over the prior year -- and clearly it's been on a build model, with introducing new products, adding new employees, adding new customers and frankly, probably picking up a little bit of share there, as well.

Matt Shimao - Bear Stearns

Well, when we look at what's driving the strong margins, it seems like it's this high-end mix. It sounded last quarter that you didn't expect that to continue, but it has.

Now, can you comment if you expect that higher-end mix to continue? Or if it should revert to lower-end mix, and so these are basically peak margins? What are your thoughts there?

Scott Murray

Well, it ultimately depends on the mix of products that we’re selling, clearly. We've been pleased with the mix that they've had to date, which is a combination of switches and routers and some of their other products for the networking space in China.

We've also not seen the pricing pressure that we've seen around the rest of the world with some of the networking space. So we feel pretty good about the historical margins. Again, not providing forward-looking guidance, but if you look at the results that we've seen for the quarter, we've obviously been pleased with them.

Matt Shimao - Bear Stearns

What about the demand trends, though? Is there a reason for customer demand to be more focused towards the higher end in China now, that would be a sustainable demand trend? What are your thoughts there?

Don Halsted

I think if you go back over the past year, and you look what are the engines that have driven the growth that they've had, the H-3C has gotten growth both from its operations inside of China and the operations outside of China. But actually, more growth from the operations inside of China.

So one of the things that's happened is we've continued to have a strong mix of our direct margins, versus what would be OEM margins outside of China. Then inside of China, their mix has been strong on the higher-end switch and router area, where they frankly enjoy better margins. That is the trends that we've seen, certainly over the course of this past year.

Matt Shimao - Bear Stearns

Okay. Now looking at the JV's head count of 4,000 what would you expect the head count to be at the end of calendar 2006? What drives the Huawei's 3Com OpEx? Is it primarily head count or are there other investments being made that would increase Huawei-3Com OpEx per employee significantly over the coming year?

Scott Murray

Sure, there's obviously a number of things that go into the operating expense around SG&A, sales and marketing, and programs that they use. As we said, there was approximately 4,000 people at the end of the year. You do create some element as you reach critical scale. It's not going to continue to grow at the same rate that it has in the past from a head count perspective, and we will get some leverage related to that. Although we do expect that to continue to grow over the coming months as the business model there builds, and they continue to grow the revenue line.

If you think about the model in China, it is a little bit different than the rest of the world. It's very focused on customer interaction, customer service; and a very direct model, as opposed to a channel-driven model. So it does have more employees, and obviously, the average pay per employee is different than it is throughout the rest of the world in Europe and the Americas.

Matt Shimao - Bear Stearns

Quickly shifting gears. Looking at the cost discipline at 3Com -- ?

Don Halsted

Matt, this has to be the last one. Because we've got a whole list of other people right behind you and 18 minutes left.

Matt Shimao - Bear Stearns

Last one. Cost discipline at 3Com. Table H, looks like your OpEx is $88.5 million. Is that a comparable number to the $103 million last quarter? What drove the savings? When you look at the 1, 500 employees is it less 250 from that number, or what is the 250 being subtracted from?

Scott Murray

The 1,550 was the number at the end of May. So the 250 is less from that. The 250 relates primarily to the SCN business. So we're taking some fairly focused efforts there with respect to that.

Don Halsted

Let me answer your first question in there, Matt. That is, if you do look at the expenses, remember in the third quarter, we had about $9 million that was one-time items. So your starting points were closer to $102 million in the third quarter. So when you look at that drop, it's about a 13% decline. Inside of that, there is $1 million or $2 million that is now classified as cost, and was part of the gross margin bridge. There is a couple of million in there that is lower operating due to, frankly, the underperformance on the revenue.

So when we get ourselves back on track there, I expect the run rate is going to be a couple million higher than the $89 million in terms of what we're starting with, but then the savings from the restructuring will kick in. These comments, by the way, are before any effect of FAS 123R, because it's not in our current numbers.

John Vincenzo

Matt, if I might suggest, we can move forward, and these have been great questions for today. We really appreciate it. Thank you.

Operator

Our next question comes from Jiong Shao - Lehman Brothers.

Jiong Shao - Lehman Brothers

Good afternoon. I have two quick questions, if I may. Could you just talk about the OpEx savings, when everything is said and done for your current restructuring plan, the 250 head count reduction and 21 facility closures, the timing for that?

Don Halsted

Thank you, Jiong. First, the reductions will be in the SCN segment. The savings are also going to focus on the non-TippingPoint part of the SCN segment, and therefore they will be offset in part by some increased spending that is going to happen in TippingPoint.

We expect to see the effect on the total SCN starting to happen in the second quarter '07. So you'll see it on the total segment line. Full implementation is over the next couple of quarters, with a payback on the restructuring charge of about two to three quarters.

Jiong Shao - Lehman Brothers

The total savings, Don, is going to be? You mentioned what the total charges are going to be over the next couple of quarters, but total savings going to be?

Don Halsted

When it's fully implemented, the net of the increases and the heritage decreases should have in that segment, from there, it will net our direct operating expenses down about 10% or so, before the effects of FAS 123R.

Jiong Shao - Lehman Brothers

Okay, great. Thanks.

Scott Murray

You have one more question, Jiong?

Jiong Shao - Lehman Brothers

Yes, thanks. My second question is on Europe. I was wondering, could you provide a little bit more color on what you see in terms of price competition. Is there any change in competitive dynamics there from existing vendors, or from the relatively newer vendors coming up from the lower end of the market?

Also relate to that, Don, I missed what you said about RoHS. I think you mentioned RoHS, but I didn't quite catch what exactly you said about that. I think the RoHS is supposed to kick in July 1st. How is that going to impact 3Com here?

Don Halsted

Where it's going to impact us is primarily in the connectivity product area, where we are basically going to end-of-life some of our products because we are not going to do the redesign necessary to make them compliant in the EU to the RoHS.

As we said, we've been on a harvest strategy in the connectivity device part of our business for, I think, the past two plus years. So we are just noting that we actually are taking the decision of ending some of those products.

Jiong Shao - Lehman Brothers

Competition in Europe, pricing pressure?

Scott Murray

It continues to be a pretty competitive market. One of the things that Don mentioned, is we made some price changes in our gig products, and 10% to 25% effective June the 1st. We believe that a focused go-to-market strategy there, with the right pricing model and the right product strategy, we'll be able to continue to be fairly competitive in the marketplace. But Europe is a fairly competitive market today.

Jiong Shao - Lehman Brothers

Thanks, guys.

Operator

Our next question comes from John Marchetti - Morgan Stanley.

John Marchetti - Morgan Stanley

How are you? One quick clarification, Don. On the 10% savings net-net, should we think of that as sort of all of fiscal '07, relative to fiscal '06? Should we expect that to slowly kick down as we go through the fiscal year? Just trying to get a sense for when we should be at sort of that 10% lower level?

Don Halsted

It's going to be trending down, literally, over the course of the next two, three, four quarters.

John Marchetti - Morgan Stanley

Okay. Scott, now that you've been there a few more months, if you could just give us a sense, you're starting on the SCN business now. You mentioned trying to beef up some of the TippingPoint stuff.

Do you feel like this is the right track that you need to be on to get all this business set in line, just keep pushing on the H-3C business, get TippingPoint actually up a little bit higher, and really realign the cost structure of the SCN business?

Scott Murray

Really well said. Clearly, it's a continuous process of looking at the business, both investments and managing our costs carefully. As I said earlier, there is still work to be done, but the restructuring announced today is a good step to aligning the business model with the current realities in the marketplace.

We do continue to invest in TippingPoint, and we'll be investing in sales and continuing R&D there on many of the new product offerings, and also continue to invest in H-3C.

But I think we've taken a fairly realistic look at our business, and a combination of a number of factors around go-to-market discipline, verticals, cost realignment, looking at the number of sites. As we may have said in the past, we've got over 60 sites. So by consolidating 20 sites, there's all sorts of ancillary costs related to that, as well.

So it's really not just a head count exercise. It's a business definition discipline around how we're going to run the business, the ROIs with respect to marketing and channel program, the type of products that we're bringing to market. The CD program that Don mentioned was a great example as we look at the economics of some of these products and make some tough decisions, but they need to be made.

John Marchetti - Morgan Stanley

And then if I could have just one last follow-up here, Scott.

Scott Murray

Sure.

John Marchetti - Morgan Stanley

In terms of broadening the sales funnel or the channel for the H-3C products outside of China, as you look at where you are today, how much work do you think needs to be done on that side of the business to try to get the H-3C products out to a broader market?

Scott Murray

Well, today, 3Com is selling many of those H-3C generated products through the development labs that come out of H-3C. Some of our 5500 products, our switching products, and building those under the 3Com brand, and the H-3C brand is the primary brand within China.

We are looking at some other emerging European and emerging APR-based countries. But as Don and I said in our remarks, H-3C is primarily focused on China and growing that business. There are clearly are going to be international opportunities where we work jointly with them on go-to-market strategies and bringing products to bear, some of which are being developed today around extended switch and router technologies for not only Chinese markets, but for international markets as well.

John Marchetti - Morgan Stanley

Thank you.

Operator

Our next question comes from William Becklean - Oppenheimer.

William Becklean - Oppenheimer

Hi, how are you? It sounds to me like in the markets outside of China, the strategy's changed a little bit from trying to drive the business up into the low end of the enterprise business. Broadly, it sounds like you've retreated and are now trying to focus on vertical segments to try and bring the broad product line.

A second piece of the question, at the very low end of the market, are you still trying to develop product down there, or are you willing to give up the low end of the market?

Scott Murray

Two good questions. We are still focusing on the enterprise space, both through our own channels. But as we look at markets where we believe we can be competitive and build share around specific verticals, we've selected markets like government, education, healthcare, amongst the other ones that we're working with.

We're still working with our channel partners, our systems integrators, and other partners for these medium and larger enterprise customers. TippingPoint is another great example that is very aligned with many large enterprise accounts and creates a pathway into there.

Clearly, H-3C has built enterprise business within China with their applications for extension. Within the lower end of the business around some of the office connect products, we continue to invest in those, and frankly have a pretty good SMB business taking those to market, and we're going to continue to do that, obviously.

William Becklean - Oppenheimer

Okay, thanks, Scott.

Operator

Our next question comes from Manny Recarey - Kaufman Brothers.

Manny Recarey - Kaufman Brothers

Good evening. Three questions. Can you tell me how much revenue was a result of the H-3C products through 3Com? I think it was about $30 million in the last quarter?

Don Halsted

Yes, and we're increasingly not going to be trying to drive that, because you can pick some of it up from the eliminations. But for this quarter, that number was up pretty significantly. It was up closer to $40 million than $30 million.

Manny Recarey - Kaufman Brothers

Okay, great. Two other quick questions. Can you give any comments on the U.S., on the overall spending environment? Were enterprise customers reluctant to spend? Any comments on that, please?

Scott Murray

Well, we think it's still a relatively competitive market out there, and we are building share within that. I think you can look in the press on various analyst reports on that. We are seeing the security business, which has an element of calendar seasonality to it, you'll see more year-end spending in frankly, the month of December, than you will in the first quarter. So there's some seasonality in that.

Manny Recarey - Kaufman Brothers

Okay. And then one last question. Any comments that you have about Huawei's acquisition earlier this month of Harbour, which I believe makes some products that are competitive with the joint venture?

Scott Murray

Well, as you can appreciate, I hope, I really can't comment on the status of what Huawei is doing, because it is a separate entity. We do point out we've been satisfied with our partnership with them, and satisfied with H-3C.

As we look at publicly available information on their website and industry knowledge, we do believe that the Harbour acquisition was relatively small in the enterprise market in China, and for the most part, that was carrier-based assets that they were interested in. But we really don't have any other information to which you probably have from a public perspective related to that.

Manny Recarey - Kaufman Brothers

Okay, thank you.

Operator

Our next question comes from Long Jiang - UBS.

Long Jiang - UBS

Hi, good afternoon. Can you articulate your target operating margin for the 3Com business after all this restructuring is said and done? That's my first part of the question.

Don Halsted

We said at the beginning, we were not going to be providing the forward-looking guidance. So unfortunately, I'm going to decline to answer that.

Scott Murray

But we did give some sense around some of the impact on the restructuring.

Don Halsted

I gave some run rates, and those were entering the quarter, run rate in the neighborhood of a 38% margin. I gave an idea on the expenses, and then we're obviously working on those areas.

Long Jiang - UBS

Okay. Of the $7 million other income primarily from the JV, do you think it's going to stay at the same level in the foreseeable future, or do you think it's going to eventually go away?

Scott Murray

Well, we've been obviously pleased with that, and as Don said, we're not providing forward-looking guidance. But there is a mechanism within China that you can receive these VAT refunds based upon existing spending levels, is how that works.

Long Jiang - UBS

How much of your JV sales are done through the Huawei resale channel? If you can further break it down between China and overseas, and between low end and high end, that would be great. Thanks.

Don Halsted

It's a good question. We're actually right in the process of looking to determine what we really need to disclose in our 10-K, related to related parties. So I'm going to defer on that, other than I'll say that there's a reasonably significant channel outside of China, and they are also a channel to the carrier markets inside of China.

They have as a consistent route to market in China, as what they have outside of China. We're going to be working through exactly what we need to disclose relative to related parties as part of putting our 10-K preparation together.

Scott Murray

I think it's also important to add that the model in China is different from a channel partner perspective. There's a preponderance of revenue there that comes from a direct touch, direct to customer model, which is why you'll end up with more employees on a percentage of revenue basis than you might otherwise have.

Don Halsted

Basically all the enterprise sales is a direct H-3C sales model that is assisted by some of the channels. It's related to carriers that you get using 3Com, or the Huawei channel legitimately, as that's where their markets are.

Long Jiang - UBS

Okay, thanks Scott and Don.

Scott Murray

Thank you. Operator, I think we're going to take one more question as our time is starting to run out here.

Operator

Our final question comes from Mark Sue - RBC Capital Markets.

Mark Sue - RBC Capital Markets

Is there an element of seasonality in the H-3C business? How should we look at that from a quarter to quarter basis, if you could help us out there?

Scott Murray

Terrific question. There is a little bit in particular around Chinese New Year and some of the holidays that they have there. Clearly, as that market is growing -- and if you look at any of the analyst reports that track that market, it is one of the fastest growing markets in the world. We think that we have a very attractive offering for our customer base in that market.

Mark Sue - RBC Capital Markets

Separately, you mentioned increased competition in Europe. Who's the aggressor there? Is it HP, Cisco?

Scott Murray

I think probably the biggest competition obviously for us is Cisco. Not just in Europe, it's around the world. They are the biggest player in the market. Probably as we look at the competitive landscape, the most competitive.

Mark Sue - RBC Capital Markets

Got it. And then the pricing pressure and the subsequent impact on gross margins, is that the biggest drag on gross margins? How should we see that where you have the benefit of H-3C and the mix of the other high-end products? Any qualitative comments on gross margin trends through increased competition?

Don Halsted

One of the things that I highlighted in the comments, and we went through the reasons that our margin dropped, there was about a percentage point drop in margin due to a combination of volume, price pressure offset by cost improvements.

The real issue is, what's the difference in your price pressure versus the underlying cost pressure? And that in aggregate, cost us about a percentage point in the last quarter.

The real message behind that, is we are definitely seeing a lot of price pressure. We are also seeing some ability to reduce some of the underlying costs as well, which is one of the drivers, industry-wide, of some of the price pressure.

Mark Sue - RBC Capital Markets

I see. Okay, that's helpful. Thank you very much, gentlemen, and good luck.

Scott Murray

Operator, at this time I would like to close the call. I would like to end by thanking everybody for joining us today. We appreciate the good questions, and the time to address the investment community. So thank you very much, everybody.

Operator

Ladies and gentlemen, we thank you for joining us today. That does conclude our presentation. We ask that you please disconnect your phone lines at this time.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: 3Com Corporation F4Q06 (Qtr Ending June 2, 2006) Earnings Conference Call Transcript (COMS)
This Transcript
All Transcripts