Sierra Wireless Q2 2006 Earnings Conference Call Transcript (SWIR)

Jul.28.06 | About: Sierra Wireless, (SWIR)

Sierra Wireless (NASDAQ:SWIR)

Q2 2006 Earnings Conference Call

July 27, 2006, 5:30 pm ET

Executives

Jason Cohenour - CEO

Dave McLennan - CFO

Analysts

John Bucher - BMO Capital Markets

Dev Bhangui- Haywood Securities

Jeff Kvaal - Lehman Brothers

Deepak Chopra - National Financial Bank

Amit Kapur - Piper Jaffray

Erik Zamkoff - Morgan Joseph

Gus Papageorgiou - Scotia Capital

Amy Nam - JP Morgan

John Bright - Avondale Partners

Operator

Thank you for standing by. Welcome to the Sierra Wireless, Inc. second quarter 2006 results conference call. (Operator Instructions) I will now turn it over to Mr. Jason Cohenour, President and CEO. Please go ahead sir.

Jason Cohenour

Thanks, Shawna, and welcome to everybody on the call. With me on the call today is Dave McLennan, our CFO. Today we'll be covering Q2 results for the Company and also discussing guidance for the second half. Our agenda is as follows: Dave will read the forward-looking statements disclaimer; I'll do a business update; Dave will cover off our Q2 financial performance, our Q3 financial guidance, as well as an indication on Q4; I'll then summarize and we'll open the line for questions.

Dave McLennan

Thanks, Jason, and good afternoon, everyone. I will start with our forward-looking statement disclaimer, which is as follows:

Certain statements on this conference call that are not based on historical facts constitute forward-looking statements or forward-looking information within the meaning of applicable securities laws. These forward-looking statements are not promises or guarantees of future performance, but are only predictions that relate to future events, conditions or circumstances, or our future results, performance, achievements, or developments, and are subject to substantial known and unknown risks, assumptions, uncertainties and other factors that could cause our actual results, performance, achievements or developments in our business or in our industry to differ materially from those expressed, anticipated or implied by such forward-looking statements.

Forward-looking statements include all financial guidance for the third and fourth quarters of 2006, disclosure regarding possible events, conditions, circumstances or results of operations that are based on assumptions about future economic conditions, courses of action, and other future events. We caution you not to place undue reliance upon any such forward-looking statements, which speak only as of the date they are made.

These forward-looking statements appear in a number of different places and can be identified by words such as may, estimates, projects, expects, intends, believes, plans, anticipates or their negatives or other comparable words. Forward-looking statements include statements regarding the outlook for our future operations, plans and timing for the introduction or enhancement of our services and products, statements concerning strategies or developments, statements about future market conditions, supply conditions and customer demand conditions, channel inventory and sell-through, revenue, gross margin, operating expenses, profits, forecast of future costs and expenditures, the outcome of legal proceedings and other expectations, intentions and plans that are not historical fact.

The risk factors and uncertainties that may affect our actual results, performance, achievements or developments are many and include, among others, our ability to develop, manufacture, supply and market new products that we do not produce today that meet the needs of customers and gain commercial acceptance, our reliance on the deployment of next-generation networks by nature wireless operators, the continuous commitment of our customers and increased competition.

These risk factors and others are discussed in our annual Information form, which may be found on SEDAR and our other regulatory filings with the Securities Exchange Commission in the United States and the Provincial Securities Commission in Canada. Many of these factors and uncertainties are beyond the control of the Company; consequently, all forward-looking statements are qualified by this cautionary statement and there can be no assurance that actual results, performance, achievements or developments anticipated by the Company will be realized.

Forward-looking statements are based on management's current plans, estimates, projections, beliefs and opinions and the Company does not undertake any obligation to update the forward-looking statements to the assumptions related to these plans, estimates projections, beliefs and opinions change.

And with that, Jason, I'll turn it back to you for the business update.

Jason Cohenour

Thanks, Dave. Second quarter of 2006 represented our fourth consecutive quarter of strong operational execution, improved financial metrics and excellent growth. Intense focus on our core business of wide-area wireless for mobile computing has driven a remarkable business recovery, following our restructuring one year ago and has helped us to continue to strengthen our market position.

During the second quarter, we grew our sales of HSDPA AirCards considerably. We continued strong shipments of our AirCard 580 for EV-DO networks. We executed purchase arrangements with major wireless operators for our next generation AirCard products. We continued to improve our channel position in Europe, including the selection of our AirCard 850 by a major operator group.

We grew our embedded modules business by 74% over Q1. We added three more laptop OEMs to our roster of customers, bringing our total to eight, further bolstering our leadership position in this potentially high-growth sector. We also continued to carefully reinvest in our business and to further strengthen our strategic position to drive future growth.

Our Q2 revenue increased 22% over the first quarter of 2006 and 152% over the second quarter of 2005. Our revenue of $55.2 million represents record second quarter sales. Our strong revenue growth also helped us to drive better than expected net earnings of $3.8 million.

We are very pleased with our Q2 results and also recognize that continued hard work and strong execution is required before we achieve the goals we have set for ourselves in terms of product line strength, market position and sustained financial results.

Moving to business development highlights, I'll start with activities in our AirCard and MP business. AirCard sales increased 23% over Q1 to nearly $40 million. Increased sales of our HSDPA AirCards, particularly in North America, were the significant contributor to our AirCard growth. During the quarter, we experienced a considerable increase in demand for our AirCard 860 from Cingular wireless and commenced shipments of the AirCard 860 Rogers Wireless in Canada, as well. We believe that our channel position with Cingular continues to be very strong.

In EMEA, sales of our AirCard 850 for UMTS and HSDPA continued to be solid, although down slightly from Q1. We had significant shipments of the AirCard 850 to distributors and operators in the U.K., Italy, Israel, and South Africa. We also commenced initial shipments to Swisscom, in support of their HSDPA launch and secured a key channel slot with a major European operator group. We expect to launch the AirCard 850 in several countries with this operator group in Q4.

Overall, we're very pleased with our rapid progress in Europe and believe that our market position continues to improve. As European operators move to offer high-speed HSDPA services more broadly in the second half of 2006 and throughout 2007, we believe we're well-positioned to capture share in a growing market. In fact, we expect revenue from Europe to increase significantly in the second half.

Our HSDPA AirCards are now approved on 17 networks around the world. Our EV-DO AirCard business continued to be strong in Q2. Difference of our AirCard 580 to Sprint grew considerably compared to Q1. We also had solid shipments of the AirCard 580 to TELUS in Canada and to Telecom New Zealand. We believe that our channel position with these operators continues to be strong.

We also had a stronger than expected revenue contribution from our AirCard 775 for EDGE. Over time, we expect our AirCard 775 customers to transition to our newer HSDPA AirCards, which also backward compatible with EDGE.

Following unusually strong Q1 sales of our rugged mobiles, MP revenue was down in Q2. We are now in a technology transition phase with our rugged MP products, moving from 2.5G versions to 3G versions. We expect our MP product line will be fully refreshed with 3G capability during Q1 of 2007. Once refreshed with 3G capability, we believe that this product line will once again be an important contributor to our results.

Moving to an update on new AirCard and MP products. Development of our next generation EV-DO and HSDPA AirCards continues on track. During the quarter, we introduced the AirCard 875 wireless wide-area network card for HSDPA networks. The AirCard 875 will operate on three UMTS frequency bands while also offering quad-band class 12 EDGE and GPRS connectivity. The AirCard 875 was support peak theoretical data rates of 3.6 megabits per second on the downlink, upgradeable to 7.2 megabits per second in the future.

Commercial shipments of the AirCard 875 are expected to begin late in the current quarter. Our next generation EV-DO PC card, the AirCard 595 for Rev A, as been available to infrastructure vendors and network operators for testing and integration purposes throughout the second quarter. We successfully performed live demonstrations of this product at the CTIA trade show event in early April with Sprint, Nortel and Lucent.

AirCard 595 supports peak theoretical data rates of 3.1 megabits per second on the downlink, and 1.8 megabits per second on the uplink. AirCard 595 is expected to commence commercial shipments late in the current quarter. We now have purchase arrangements in place with Sprint for the AirCard 595 and with Cingular for the AirCard 875.

Also during the second quarter we introduced our first 3G rugged mobile products; the MP 595 for EV-DO Rev A and the MP 875 for HSDPA. Commercial shipments of the MP 595 are expected to begin in the fourth quarter of this year, with the MP 875 shipments to follow in the first quarter of 2007. The MP has an established loyal customer base with public safety and field service organizations and has historically been a strong margin contributor to our business.

We also have additional products for the mobile computing markets currently under development, including express cards. We believe that the market for the express card form factor is currently small, but that the importance of the category will grow over time. We intend to compete in the express card segment when the market size is commercially attractive.

Moving to highlights in our OEM business. During Q2 embedded modules sales increased 74% over Q1 to nearly $14 million. A key driver of this growth was significantly increased sales of embedded modules to our laptop OEM customers. Sales to these customers increased 180% from Q1 to nearly $8 million. We are very encouraged with the momentum increase in this category.

We also increased our roster of OEM customers significantly during the quarter, earning a number of new design wins. In the laptop OEM category, we added three new customers. Our design wins with these customers span both HSDPA and EV-DO technologies, and as is customary, we plan to discuss the names of our new customers closer to the launch of their products.

With the addition of these customers, we now have design wins with eight laptop OEMs for our 3G wireless embedded module solutions. Collectively, our laptop OEM customers now have 25 discreet platform and airlink combinations commercially available. In addition to this significant platform in airlink expansion, several of our laptop OEM customers are adding new carrier launches, as well.

We believe that is aggressive design win, platform, airlink and carrier expansion should be good catalysts for growth in our OEM business. We also believe it underscores our strong leadership position in this potentially high-growth segment.

During the quarter, we also continued to invest in and improve our OEM integration services capability. Our investments in this area included leadership personnel, engineering personnel, refined processes, and capital equipment. Integration Services has long been a key differentiator for us in the OEM segment and we believe that it is now an even stronger point of differentiation.

With respect to new OEM product initiatives, development of our next generation EV-DO and HSDPA embedded modules continues on track. Our next generation EV-DO revision A minicard, the MC 5725, has been available to OEM customers for testing and integration purposes throughout the quarter. We have design wins for this module and expect to commence commercial shipments in the fourth quarter.

During the quarter, we also introduced the MC 8775 minicard for HSDPA. The 8775 will support peak theoretical data rates of up to 3.6 megabits per second, upgradeable to 7.2 megabits per second in the future. The 8775 offers connectivity to all three UMTS frequency bands and all four EDGE GPRS bands used worldwide.

The 8775 has been available to OEMs during the quarter for testing and integration into notebook computers and other devices. We have design wins for the 8775 minicard and expect to commence commercial shipments late in the current quarter.

Now moving to some general comments about the state of our business. Our channels continue to report strong sell-through of our products during the quarter, highlighting growing market demand. We were also able to strengthen our inventory position on certain key products during the quarter. We believe this puts us in a better position to react quickly to increases in customer demand, while also keeping our inventory exposure risks at a manageable level.

During the quarter, we saw moderate deployment of new high speed 3G data services around the world. We also saw very strong indications from both GSM and CDMA operators that new technology deployment activity and new service launches would gain momentum in the second half of 2006 and throughout 2007. We view such deployments, coupled with the anticipated aggressive promotional activities, as important growth catalysts for our business.

In the short term, we are managing a tricky technology transition with some of our largest customers. We expect a decline in demand for some of our current products from these customers during Q3, as they prepare to launch our next generation products late in the quarter. We expect this to put pressure on our financial results in Q3, but to help drive considerable growth and an improvement in operating metrics in Q4.

Now back to Dave to cover the results.

Dave McLennan

Thanks, Jason. Our results are reported in U.S. dollars and are in accordance with U.S. GAAP. For the second quarter of 2006, our revenue was $55.2 million. Gross margin was $18.9 million, or 34.1%. Operating expenses were $16.7 million and our net income was $3.8 million, or $0.15 per share. During the quarter, Cingular and Sprint each accounted for more than 10% of our revenue and in aggregate, these two customers represented approximately 49% of our revenue. Our top five customers included two laptop OEMs.

As a result of adopting the new accounting standards for stock-based compensation on January 1st, our second quarter results include a non-cash stock-based compensation expense of $1 million. Prior to 2006, the impact of stock-based compensation was not reflected in our income statement.

To assist in understanding the impact of the stock-based compensation expense on the various components of our cost structure, the Q2 results, as reported in the financial statements presented in our press release, include stock-based compensation expense as follows. Cost of goods sold, $101,000. In sales and marketing, $325,000. In R&D, $200,000. Administration, $368,000.

Excluding stock-based compensation from our results, net earnings would be $4.8 million, or $0.18 per share. Results for the second quarter of 2006, relative to the guidance we provided for the quarter on April 20th of '06 were as follows. Second quarter revenue was $55.2 million, better than our guidance of $52 million. Gross margin was 34.1%. This was in line with our guidance of 34.5%.

Operating expenses, including stock-based compensation expense, were $16.7 million, higher than our guidance of 16 million. Net income of $3.8 million, or $0.15 per share, was 50% higher than our guidance of net income of $2.6 million, or $0.10 a share.

Our free cash flow, being cash flow from operations less CapEx for fixed assets and intangibles, was negative $1.5 million. This was in line with our guidance of a slightly negative to slightly positive cash flow.

Looking at Q2 2006 results compared sequentially to the first quarter of 2006, revenue increased to $55.2 million from $45.2 million, an increase of 22%. Within this, AirCard sales increased to $39.8 million, up 23% from the first quarter. Very strong HSDPA sales in North America, as well as strong EV-DO and EDGE sales, drove this growth.

Embedded module sales increased to $13.8 million, up 74% from Q1. Within these category, sales to our laptop OEM customers increased to $7.8 million, up 180% from the Q1 level of 2.8.

rugged mobile sales decreased to $700,000, down from 3.8 in Q1. With respect to our rugged mobile business, we are now in a technology transition phase with our MP products. This is having a near-term negative impact on our sales. We expect our MP product line will be fully refreshed with 3G capability during the first quarter of 2007. Once refreshed, we believe this product line will once again be an important contributor to our results.

Second quarter gross margin was 34.1% compared to 36.8% in Q1. As expected, our gross margin declined as a result of ASP pressures on key products, such as HSDPA cards and reduced sales of rugged mobile products, which is our highest margin product.

Our operating expenses were 16.7 million in Q2, compared to 14.8 million in Q1. The largest component of this increase is related to $1.4 million of additional R&D expenditures for the development and certification of new products, which will be launched in the second half of this year, as well as an increase in engineering service personnel to support our growing embedded module business. Q2 net earnings were 3.8 million, or $0.15 per share, compared to earnings Q1 of 2.6 million, or $0.10 per share.

With respect to our balance sheet, comparing it to March 31st, 2006, our cash, short and long-term investment balance was essentially flat at 101.6 million at the end of Q2. Inventory levels increased during the quarter from 11.2 million to 19.7 million. This was planned in order to be in a better position to support potential increases in customer demand.

For the most part, this increase in inventory occurred late in the quarter, so it did not have been an impact on Q2 cash flow, but will impact Q3 cash flow.

Looking at revenues on a segmented basis, firstly by product line, in the second quarter PC card revenue was 72% of our mix, or $39.8 million, compared to 72%, or 32.3 million in Q1. OEM was 25%, or 13.8 million in Q2, compared to 18%, or 7.9 million in Q1. MP was 1%, or $700,000 in Q2, compared to 8% or 3.8 million in Q1. And other was 2% in both quarters.

Looking at revenues by distribution channel, in Q2 the carrier channel accounted for 53% of our revenues, compared to 51% in Q1. Resellers, 20% in Q2 versus 30% in Q1. OEMs at 26% in Q2 versus 19% in Q1. And direct was 1% in Q2. The increase in our OEM channel from Q1 reflects the 180% increase in sales of embedded modules to our laptop OEM customers.

Looking at revenues by technology, in the second quarter, GSM-based revenues, including EDGE and HSDPA, amounted to 56% of our revenues, or $31.2 million, compared to 49% of our revenue, or $22.3 million in Q1. CDMA-based revenues were 42% in Q2, or $23.2 million, compared to 49%, or $22.3 million in Q1. And other was 2% in both quarters.

During Q2, increased sales of HSDPA and EDGE AirCards, as well as HSDPA embedded modules resulted in a 40% increase in our GSM-based business relative to Q1. And of the $31.2 million of GSM technology sales, $22 million was from HSDPA products. We also saw modest growth in dollar terms in our CDMA business during the quarter.

Finally, revenues by geographical segment. In the second quarter, the Americas contributed 67% of our revenue at $37 million, compared to 69%, or $31.2 million in Q1. Europe was 13%, or $7 million in Q2, compared to 18%, or $8 million in Q1. Asia-Pacific was relatively flat at 6%, or $3.4 million compared to 7% or $3.3 million in Q1. And our worldwide PC OEM category was 14% in Q2, or $7.8 million, compared to 6%, or $2.8 million in Q1.

We had strong revenue growth during Q2 in the Americas, driven primarily by increased sales of our HSDPA AirCard 860 to Cingular in the U.S. and initial shipments to Rogers Wireless in Canada, as well as higher EV-DO AirCards 580 and EDGE AirCard 775 sales. In Europe, sales declined slightly; however, this represents our second largest quarter ever for sales in Europe and we're pleased with our progress in Europe. Our channel position is improving ahead of back-end loaded HSDPA network deployments by the operators and our HSDPA product has now been selected by a major European operator group. We expect Europe to be a source of significant growth for us in the second half.

Moving to guidance, we are providing financial guidance for the third quarter ending September 30th, 2006. In addition, given the significant level of new product launch and technology transition occurring between now and the end of the year, and the resulting impact this is expected to have on our business, we're also providing revenue guidance for Q4. This guidance reflects our current business indicators and expectations. Inherent in this guidance are risk factors that are described in detail in our regulatory filings, and our actual results could differ materially from the guidance presented. Our guidance includes a significant contribution from products expected to be launched during the period, and therefore there are uncertainties associated with the launch and early ramp of new products that could affect our ability to achieve guidance. All figures are estimates based on management's current beliefs and assumptions and are subject to change.

Our financial guidance for Q3 '06 is as follows: revenues of $51 million, gross margin of 31%, operating expenses of $16.9 million, and break-even net income. This guidance includes stock-based compensation expense of approximately $1 million. During Q3 we expect our inventory position to grow in support of existing and new products. As a result of this inventory build, we expect cash flow to be negative for Q3.

With respect to Q4, at this early stage, we expect revenue to be not less than $65 million and earnings per share to be positive. This expectation of significant revenue growth in Q4 is driven by the launch and ramp of next-generation products in both HSDPA and EV-DO technologies and the resulting gain in share of a growing market.

With that, Jason, back to you to summarize.

Jason Cohenour

Thanks, Dave. For the second quarter of 2006 represented our fourth consecutive quarter of strong operational execution, improved financial metrics and excellent growth. Intense focus on our core business of wide-area wireless for mobile computing has given a remarkable business recovery and has helped us continue to strengthen our market position.

Our Q2 revenue increased 22% over the first quarter of 2006, and 152% over Q2 of 2005. Our strong revenue growth also helped us to drive better than expected net earnings. Our AirCard business was strong, once again, in Q2, delivering considerable sequential growth. We also bolstered our AirCard channel position, winning a key launch slot with a major European operator group, and securing purchase agreements from other major operators for our next generation AirCard products.

We also made very strong development progress on our next generation AirCard products, and we expect to commence commercial shipments of these products in the current quarter.

We had excellent growth in our OEM business, as well. OEM revenue was up 74% from Q1 and sales to laptop OEMs was up 180%. We also added considerably to our roster of OEM customers, securing several new design wins during the quarter, including three new laptop OEM customers. Given our laptop OEM revenue results and our lineup of design wins, we're confident that we have secured a strong leadership position in this nascent but potentially high growth segment.

As with our next generation AirCard products, we made strong development progress in our new embedded modules for HSDPA and EV-DO Rev A. We have already secured design wins for these new products and are on track to launch them in the third and fourth quarters, respectively. We are very pleased with our Q2 results and also recognize that continued hard work and strong execution is required before we achieve the goals we have set for ourselves in terms of product line strength, market position and sustained financial results.

In the short term, we are managing a tricky technology transition with some of our largest customers. We expect this to put pressure on our financial results in Q3 but to help drive strong growth and an improvement in operating metrics in Q4.

Our focus for the balance of 2006 is to continue to execute on our new product pipeline and the business development activities related to bringing these new products to market. This focus, combined with strong execution, has driven excellent growth in our business and a significantly improved market position over the past year.

Looking forward, we are very bullish on our outlook for the market and for our company. We believe that operators around the world will continue to deploy constantly enhanced high-speed wireless data services and that OEMs will continue to embed high-speed wide-area wireless capability into a growing number of platforms and devices. We believe that these are good catalysts for the markets and that we are well-positioned to capture a growing share of this growing market.

With that, Shawna, I'll open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes Amit Kapur from Piper Jaffray. Please go ahead with your question.

Amit Kapur - Piper Jaffray

Great. Thanks a lot, guys. Just looking at your Q3 guidance, it looks -- is it fair to say, I guess it looks like the revenue is shifting toward the OEM module side of things? Is that the primary reason for gross margins coming down sequentially or are you starting to see a little bit of change in your gross margin structure within the product lines, as well?

Dave McLennan

Hi, Amit, it's Dave. I think a couple of factors. One is product mix is certainly a factor, but we are seeing fairly intense ASP pressure in our products. We've seen that with the first round of HSDPA -- the 1. HSDPA products. So that is, as well, putting pressure on gross margin.

Jason Cohenour

The other thing I'll add is that we mentioned a couple of times, Amit, we don't expect strong MP sales, which historically has been a disproportionate contributor to gross margin percentage.

Amit Kapur - Piper Jaffray

OK, great. In terms of the ramping OEM business that you're seeing, are there particular OEMs that you are seeing that are more aggressive or is it pretty much strength across the board?

Jason Cohenour

Well, we had, as Dave indicated, two of our top five customers were laptop OEMs. I'm not going to comment on which two they were and which have more momentum at this moment in time. And that's a little bit tricky, right, because some of the laptop OEMs are a little ahead. There's a timing factor there and those laptop OEMs who got to market first and who got subsequent platforms to market ahead of their competitors of course had a near-term advantage in terms of revenue.

From a trajectory standpoint, we see all laptop OEMs moving in this direction and we see all laptop OEMs getting to multiple platforms in the market, and eventually all of them on to multiple carrier networks.

Amit Kapur - Piper Jaffray

OK, great. One final question before turning it over. Can you maybe comment on levels of channel inventory you're seeing out there and are there carriers that are different in the levels?

Jason Cohenour

We're comfortable with channel inventory at this point in time. You know, we've got to -- obviously two big customers that we cited as 10% customers. We're comfortable with their current channel inventories. Clearly they are, as well, and that's why we're expecting a decline in sales to those customers in the current quarter, but we're quite confident by the time we're ready to launch our next generation AirCards with those customers that those channels will be in a state that will be able to accommodate those products and go to market.

Amit Kapur - Piper Jaffray

OK, thanks a lot, guys.

Operator

Your next question comes from Erik Zamkoff from Morgan Joseph. Please go ahead with your question.

Erik Zamkoff - Morgan Joseph

Good morning -- good afternoon. I was hoping you could talk to us about potential timing in terms of when the new embedded customers come on line. And then in terms of the major European customer that you were talking about, I was wondering if you could couch it by indicating to us how many European carriers have a presence in more than three countries.

Jason Cohenour

You know, Eric, I can't give you any more hints on the European operator group, if that's what you're seeking. It is one of the major European operator groups and we think it's going to be -- hopefully have a significant impact on our business, not just in Q4, but beyond.

And with respect to the laptop OEM, I think you're referring to the new customers.

Erik Zamkoff - Morgan Joseph

Correct.

Jason Cohenour

We just secured design wins with three new customers. You know, some of those will have products entering the market by the end of the year and some of them will have products entering the market at the top of 2007.

Erik Zamkoff - Morgan Joseph

I guess another way, if I can attack that from a different way, verses the number of laptop OEM deals shipping today, how many do you think you have shipping by the end of the year? How many do you think you'll have shipping by midway next year? And just I guess general market -- you had sort of hinted at some market assumptions on prior calls. Do you think the market is now bigger for that technology than previously thought?

Jason Cohenour

No, I think that our previous statements still stand. We still view 2006 as a bit of a training-wheels year. Notwithstanding our great percentage growth Q1 to Q2, it's still small dollars, right? So we do think that it's a bit of a training-wheels year and we do think that 2007 will hopefully be a stronger growth year for laptop -- for our sales of embedded modules to laptop OEMs. By then, the laptop OEMs will be better at integrating, positioning and selling, and the wireless operators will be better at understanding how to promote these solutions, as well.

It's right about where we expected it would be. It's becoming now an important real contributor to our results and we think that's going to grow over time. I think I mentioned earlier on the call that we now have our eight laptop OEMs, some of them have zero platforms in the market, of course. Some of them have many more. But of our laptop OEM customers, there are now about 25 different platforms and airlink combinations currently in the market. And without giving you specific numbers, we think that's going to grow considerably between now and the end of year.

Erik Zamkoff - Morgan Joseph

Got you. And can you highlight for us some of the business models that you're seeing out there for embedded ? Are you seeing more all-you-can-eat plans? Is it pay as you [grow]? What are you sort of seeing out there in that department and how has that changed?

Jason Cohenour

In the U.S., it continues to be primarily flat rate all-you-can-eat for a flat rate monthly fee for all you can eat, with the exception, of course, of Verizon's pay-as-you-go plan, which I think is a creative implementation. And in Europe, it's a bit of a hodgepodge. There are some European operators that within country, you can get flat rates. We have yet to see aggressive pan-European flat rate pricing.

Erik Zamkoff - Morgan Joseph

Thank you.

Operator

Your next question comes from Jeff Kvaal with Lehman brothers. Please go ahead with your question.

Jeff Kvaal - Lehman Brothers

Thank you both very much. First question is on these new products that you are beginning to ship this quarter, next generation stuff, is that something that is likely to be meaningful in this quarter or is that more of a hey, we're just getting it under the wire and it's mostly about the December quarter?

Jason Cohenour

It's a meaningful part of our guidance -- of our Q3 guidance. We do expect it, however, revenue from those products to hit late and that's why we alerted that there's always risk with precise new product launch timing. And there's going to be a limitation on how quickly we can ramp production. So while it's going to be a meaningful contributor, it's not going to be as meaningful as we believe it will be in Q4 once we get production ramped on those products.

Jeff Kvaal - Lehman Brothers

OK, and also, I did not notice, you mentioned Verizon as part of your roster of carriers on the next generation stuff. Any updates on that front?

Jason Cohenour

No updates for you. We're working hard. We believe that the AirCard 595 gives us an opportunity to potentially re-enter that channel, but we've got no other new news on that for you, Jeff.

Jeff Kvaal - Lehman Brothers

OK, Jason. And then Dave, maybe for you, to what extent does this slowing in the demand for current generation products and ramping demand for next-generation products in the fourth quarter change your OpEx plans? Or how we should think about OpEx over the next two or three quarters?

Dave McLennan

Well, you see the guidance we provided for Q3. You know, and we're in a -- and that reflects the spend rate in a heavy development launch period. And that's the circumstance we're going to be in here in Q3. I'm not going to go beyond that in terms of Q4 and OpEx, but you know, we are investing in our business and developing products, so we're at the spend rate we are to support those product rollouts.

Jeff Kvaal - Lehman Brothers

OK, but there's no exceptional need to be ramping spending to promote -- there's no contingency in the spending plan, given perhaps the shift in the revenue plan?

Dave McLennan

No, I mean, we're certainly stepping through this transition in Q3 and we have visibility at this early stage on a solid Q4 top line. And we're spending at the current rate to achieve that.

Jeff Kvaal - Lehman Brothers

OK, thank you both very much.

Operator

Your next question comes from John Bucher from BMO Capital Markets. Please go ahead with your question.

John Bucher - BMO Capital Markets

Thank you. Just a couple of quick ones here. What's the headcount and the integration services that you're talking about? It seems like as you add up a number of new OEM customers, laptop manufacturers and the like, that there may be more integration services required there. Do you expect this to grow significantly and how big a piece of your headcount is that right now?

Jason Cohenour

Our headcount is not at 298 at June 30th, so it's up considerably in Q2. I'm not going to share with you specifically how many of those people reside in our OEM integration services team, but it's significant. And in addition to those directly employed by us, we've also partnered with a couple of third parties to handle peak loads of integration services. So it's a key part of our expense run rate, John. We anticipate that it's going to stay there. We want to control how quickly it grows, of course, and over time we'd like to see that team contribute significant revenue, as well. We don't think it's going to be a big earnings driver necessarily, with respect to OEM integration services, but it is a key enabler in terms of getting our OEM customers to market and a key differentiator for us.

John Bucher - BMO Capital Markets

OK, and then shifting in some of the balance sheet items. I think, Dave, you mentioned you expect third quarter inventories to grow. And also it seems that Accounts Payable increased fairly significantly. Just wondering, how much of that is related to component purchases? And do you see the need to purchase some components well in advance? Are there any shortages out there? I guess there are three things wrapped up in that question.

Dave McLennan

Sure. Certainly I did comment on the inventory build in the quarter. You know, I would expect that we will see some more of that as we step through Q3. In terms of the Accounts Payable number, some of that inventory build -- a good portion of that inventory build happened late in the quarter, so you see that in the payables. And we're also building inventory to provision for products that are getting toward the end of their life and that, you know, we need to have inventory to meet customer demand over a period of time going forward. So those are the kinds of things that are driving our inventory build right now.

In terms of loading up for some of the new products that are being launched in Q3, we have an arrangement with our contract manufacturer that allows us to forecast requirements and then they go out and purchase components on our behalf. And ultimately, we are committed to taking those on to our balance sheet if they do not get built out and sell through, but I think in Q3, we won't see a lot of component build-up for the new stuff. It will largely be on the books of our contract manufacturer as we step into the launches of those new products.

John Bucher - BMO Capital Markets

OK, final question. And thank you for taking them. Jason, when do you think that OEM module units will surpass PC card unit shipments on a quarterly basis? You think a year from now? We're at a point where, unit wise, quarterly module units are about on a parity with or greater than PC unit card shipments?

Jason Cohenour

I think that's going to happen over time. And our view is probably -- our industry view is that probably in the 2008 to 2009 timeframe, shipments of embedded modules to laptop OEMs is roughly equal to the sales of accessory devices like PCMCIA cards and express cards. And you'll certainly -- you know, I think you'll see that reflected in our business, as well.

John Bucher - BMO Capital Markets

Great, thank you very much.

Jason Cohenour

You're welcome.

Operator

Your next question comes from Dev Bhangui from the Haywood Securities. Please go ahead with your question.

Dev Bhangui - Haywood Securities

Hi. Good afternoon, guys, and congratulations on a good quarter, Jason and Dave. Just had a quick question here in terms of [inventory]. Dave, you said inventory was up in Q2 to about close to 20 million and is going to go up further in Q3 to satisfy the increasing customer demand in Q4. Can you just delineate for us how much is going to be, or what percentage is going to be finished product versus components and whether you are expecting any kind of write-downs as you new transition from the previous edition of HSDPA to the next-gen HSDPA?

Dave McLennan

You know, this is -- as we step through this, it will be more weighted to finished goods, Dev.

Dev Bhangui - Haywood Securities

OK.

Dave McLennan

And you know -- so we will have a higher proportion of finished goods in our inventory. In terms of write-downs, if we felt that that inventory level was not supportable, we would certainly be writing that down now, and we haven't done that. We feel that the inventories that we have now and that we will build on-hand are there to service future customer demand. So we're building inventory to meet that.

Dev Bhangui - Haywood Securities

OK. The second question is to either of you -- I guess more importantly Jason. Jason, the 51 million guidance, I guess, for Q3. It's kind of lower than what guidance you guys gave for Q2. [inaudible] and this one is going to be a transitional one. The question is not about the magnitude because Q3 is usually sequentially higher than Q2, but it's the kind of -- with this kind of tapering off of Q3 [inaudible] did this come to you guys as a surprise? Or did you guys know about this before, having been in constant communication with your major carriers and customers? How did this evolve over time?

Jason Cohenour

Well, we weren't sure is the straight answer, Dev. If you were to turn the clock back 120 days, we were concerned. As I recall, we had management meetings. We were concerned about the Q2 outlook. And you see how that played out. So with respect to Q3, we were unsure. We knew that we were going to bring our customers through a technology transition -- a couple of our key customers through a technology transition in Q3. We were unsure just a month or so ago of the precise timing of our product launches. We were unsure of just how much of our existing product those customers would need. So it was a tricky situation and frankly, we didn't put pin in on guidance until this morning sometime.

Dev Bhangui - Haywood Securities

OK. The third question I had was, Jason, regarding Europe. I know that Sierra Wireless has been making great strides in terms of garnering a high market share in Europe. This particular quarter, you guys had [inaudible] compared to 8 million in Q1. And I know that the company has already declared that you've been shipping since Q1 to two significant customers. You've added some more customers now including this large group. So based on that, do you feel -- I mean, right now, the market share for Sierra Wireless of Europe is pretty small [inaudible] and I'm just wondering whether you are encountering any type of [inaudible] or you are fairly confident of making [inaudible] strides in terms of garnering a high market share in Europe.

Jason Cohenour

I mean, it's a very competitive market. We're not going to color that any other way and we've been saying that for a while. Turning the clock back a little ways, in Q3 we were telling the market that for us in Europe, there was nowhere but up. So we tripled our business in Europe in Q4 and we grew it by 50% in Q1. We were off a tiny bit in Q2 for Europe, but it was still our second highest revenue quarter ever in the region. And during Q2, we feel like we strengthened our strategic position there with respect to more engagement with specific operators, securing a channel slot with a major operator group. We've had really strong progress with our OEM customers in getting their platforms certified on two major European operator networks. We've gotten design wins with European-based manufacturers with both laptops, as well as fixed wireless terminals. So overall, our feeling with respect to Europe is we have momentum. And we've got a much better opportunity in Europe to capture share than a risk of losing share in our view.

Dev Bhangui - Haywood Securities

OK. And one last question if you don't mind. Here, as per the Company release, you guys have said that you have since the close of second quarter, [inaudible] agreements with other large operators. And these other large operators are -- other than this large group that you're talking about. And you guys have said earlier that you are already shipping to two significant carriers, so what I'm looking at is these large operators, how many of them are there and are these all [inaudible] that you guys have been shipping to already?

Jason Cohenour

I'm not sure if you've gotten the messaging right. Let me clarify a couple of things. With respect to our next generation products, we made it very clear we have purchase arrangements in place with Sprint for our AirCard 595 and with Cingular for our AirCard 875. And with respect to our currently shipping HSDPA products, the most significant news with respect to Europe is we've secured a channel slot with a major European operator group that will launch in a number of markets during Q4 -- a number of countries during Q4. In addition to that, we've made some other progress, as well. It's not candidly as important as securing a major operator group, but we do anticipate, as an example, to start shipping in a material way into the German market in the second half of this year.

Dev Bhangui - Haywood Securities

OK. That's all I've got right now. Thanks, Jason and Dave.

Operator

Your next question comes from Deepak Chopra from National Bank. Please go ahead with your question.

Deepak Chopra - National Financial Bank

Good evening, guys. I was wondering, with respect to Cingular, what's your sense of market share there? Some of your competitors have been talking about -- and in fact, they're gaining shares. I was wondering if you could talk about market share [inaudible] And also maybe is that where you're seeing most of the ASP pressure coming from, your HSPDA side?

Jason Cohenour

Yes, there's no doubt -- to answer the ASP question first -- no doubt we've had significant ASP pressure there. Our view is we have a strong leadership position in the Cingular account and in Cingular channels. We are in retail. As far as we've seen, we are the one retail player. And we are, we believe, the lead card for the to be. So we have a lot of confidence in their composition. We've [V to B] So we've got a lot of confidence in our channel position. We'd had to be aggressive on price to maintain what we view as the number one channel-share position. And we're going to defend that, Deepak. And we're going to defend it by bringing the products to Cingular that they need ahead of our competition and by not being shy on price.

So yes, I'm not sure what our competitors are talking about, with respect to their share gains or our share losses. We don't feel like we've seen any degradation in our position at Cingular.

Deepak Chopra - National Financial Bank

And in terms of margins on the new products when you start shipping them in Q4, it looks like similar [inaudible] start higher, then come down over time? It seems like the piece pace that products -- the margin cycle is much shorter and quicker nowadays than it used to be even 12 to 18 months ago. Maybe you could talk a little bit about that.

Jason Cohenour

Yes, I would agree. I think you've characterized it correctly. I don't believe we're going to have an opportunity to have six, nine months of a green field where we can harvest tremendous gross margin on new product launches. I do think you're going to still see a little bit of that, you know, going out initially at higher prices, but I do think that the ASP pressure is going to come sooner than in has historically.

Deepak Chopra - National Financial Bank

Should I imply that margin in Q4 will be better than Q3 from that statements?

Jason Cohenour

Well, we're not guiding for gross margin in Q4.

Deepak Chopra - National Financial Bank

That's right. Thank you.

Jason Cohenour

You know, long-term, Deepak, we've talked about where our business model is going. And I know -- gross margin guidance of 31% may have been perceived as a surprise to some, but certainly we've been talking about a business model that goes to gross margins in the low thirties and that's where we believe our business is going to be. That's where we need to be in terms of ASPs to compete effectively. And at that levels, we need to drive volume and we need to contain OpEx. So our operating margin goal remains the same, as well, at 10%, but we're not going to be a mid thirties gross margin business. We are a low thirties gross margin business, in our view.

Deepak Chopra - National Financial Bank

OK, thank you very much.

Jason Cohenour

Sure.

Operator

Your next question comes from Gus Papageorgiou from Scotia Capital. Please go ahead with your question.

Gus Papageorgiou - Scotia Capital

Thanks. Just quickly on Q4. Traditionally, you've only provided one quarter's worth of guidance on revenue, but can you kind of give us a sense on how confident you are on the Q4 revenue guidance and what is it based on? Is it based on firm orders? Kind of give us a little bit more color on that Q4 revenue guidance?

Jason Cohenour

Sure. We feel as comfortable about our Q4 revenue guidance as we do about our Q3 full P&L guidance. The reason we put Q4 out there is because, candidly, we knew that our Q3 guidance might be perceived by some as a bit of a disappointment as we step through a transition. And because it was an unusual situation in our business, meaning a technology transition with a couple of key customers putting pressure on a single quarter, we thought it was -- would be helpful for investors to see through that and see our -- an indication of our view of Q4.

So what's driving Q4? New products and new channels, quite simply. At the end of Q3 is when we launch two key new products to a couple of very key customers, who have been big contributors to our revenue base in the past. And in addition to those customers, we anticipate, over the course of Q4, to launch other new products and to open additional new channels. And that's what's fueling our forecast for Q4.

Gus Papageorgiou - Scotia Capital

Just one clarification --

Dave McLennan

We also wanted to be consistent with our other messaging, in that we stated clearly in the past that we saw some decent growth prospects in the second half of the year. You know, that's what we're targeting to deliver. When you look at Q3 and Q4 together, as we step through this transition, it's some significant growth.

Gus Papageorgiou - Scotia Capital

OK, and just a follow-up here. Just looking at your OpEx, specifically the R&D, since the third quarter of 2003, you guys have been significantly outspending the competition in R&D and I'm just wondering why is that? I mean, is there room for that R&D number to come down a bit? It's quite a gap and I'm just trying to get a hold of why is that gap so strong? I mean, it's a meaningful gap and it's been persistent for quite a long time. So what is driving that? Does that mean either your R&D number has been to go down or has the competition got to come up?

Jason Cohenour

I think -- we're not going to talk about our competition because then I'll get an email from another CEO probably. But I think the direct comparable, Gus, on R&D spend is probably more Novatel, right? Because we're more similar. We're both two technologies-stream companies. So yes, there's a gap there between us and Novatel and perhaps other comparables, as well, and a couple of things are driving that. You know, speaking very frankly, one of those things has been execution. I think we've been out executing our direct peers with respect to new product development and getting into market first. We've had a good strong track record over the last four quarters of doing that. Our intent is to continue to out-execute our competition and get to market first. It's been part of our recovery strategy. So that's key.

Dave McLennan

Just let me interject here for a second. It also reflects a leadership position that we've got in the OEM business -- the PC OEM business, with eight design wins and 25 platform airlink combos. That is a significant undertaking that we have with our customer base and, you know, that requires investment on our part.

Jason Cohenour

Yes, a key part of that investment is in integration services. We're not going to -- you know, we can't sugarcoat that. That takes investment, it takes people, it takes capital. So we do believe that the trajectory of wide-area wireless for mobile computing is going to be increasingly embedded and we do believe that's going to require strong integration services. So that's been a key part of our investment. So is there room for that number to go down in absolute terms? You know, as we look out into the future, probably not in the short term to midterm, we don't believe, but as a percentage of our revenue, we believe it will come down sharply as we drive volume.

Gus Papageorgiou - Scotia Capital

Great, thank you.

Operator

Your next question comes from Amy Nam from J.P. Morgan. Please go ahead with your question.

Amy Nam - JP Morgan

Hi, gentlemen. It's Amy Nam for Paul Coster. Dave, first of all on the taxes, it looks like you got a bit of a benefit this quarter. Can you give us a sense of how we should think about the taxes for the remainder of year?

Dave McLennan

Yes, our tax revision has moved around a little bit here as we step through the year and do our taxes, planning on an entity-by-entity basis. You know, if you look at the first six months of the year, our tax provision was just under $200,000. And I would expect it to be of a similar magnitude for the second half of the year. On a longer-term basis, we'd certainly hope to manage our tax provision to the 25% area, but that's a longer-term view. In '07, given our loss carry-forward positions we have in our various entities, I would expect that our tax rate would be in the 10 to 15% area.

Amy Nam - JP Morgan

OK, great. And then my next question, with regards to ASP pressure on the embedded side, Jason, maybe you could address how that dynamic is similar or different to the kind of ASP pressure you're seeing on the PC card business.

Jason Cohenour

Well, it's definitely there. It's a little bit of a different dynamic in that you have to be aggressive on price to get initial design wins, which we've been doing. And then once you get the initial design win, there's little opportunity for -- once you get a design win on a certain platform, there's not a lot of opportunity for a competitor to displace you over the life of that platform.

So you can get a little more stability in your gross margin after design win. However, you still need to be aggressive over the life of that platform because, you know, one of the things -- oh, in addition to that, sometimes there is contacted ASP reduction over time with those laptop OEMs. So it's a more stable picture and it gives us an opportunity to kind of target the cost reductions we need over time in order to maximize gross margin. And then you need to be aggressive again on the next round. So you tend to price initially at a lower gross margin percentage than you would perhaps with PC cards, and then you have a longer period of time to drive out cost, while ASP can stay stable over a longer period of time.

Amy Nam - JP Morgan

Okay, thanks.

Jason Cohenour

Sure. Shawna, we have time for one more question.

Operator

Your last question comes from John Bright from Avondale Partners. Please go ahead with the question.

John Bright - Avondale Partners

Thank you and good afternoon, Jason and Dave. Jason, both you and Dave have been through technology transitions before. Jason, I propose to you, what you think you've learned from the past ones you've gone through and maybe how have you been better prepared to manage for it as you're going into one now?

Jason Cohenour

Well, you know, it's an interesting question. We have been through them before. One of the key things that we want to be very careful of as we enter technology transitions is not to shortchange customers who are buying existing products. And you know, one of the things we've done in the past is perhaps be a little less aggressive on having a strong inventory position, and that has created a situation where some customers who aren't in a technology transition may not have an ability to purchase some of our existing products. So we're trying to give those customers ample runway on our existing products. That why you seen some inventory build on our balance sheet.

And with respect to how to manage transitions so there isn't a revenue gap like we're seeing in Q3, in our view, that's all about customer concentration. And we have that in our business, it's a fact of life, and we're working very hard to reduce that customer concentration. We've made good progress on it over the past four quarters. As Dave indicated, we've got two laptop OEM customers now in our top five customer list. And we're making good progress in Europe. So over time, reducing our customer concentration will tend to smooth out the financial result bump that can often happen when you go through a technology transition. And that's what we're seeing in Q3.

John Bright - Avondale Partners

Well, along those lines, Jason, we've seen your competitors continue to talk about fixed mobile convergence. In the past on these calls, you've talk about partnering potentially with the likes of Cisco or others. And then Novatel, I guess a day ago reported that they've got some orders from a North American carrier. What is your thought on that strategy at this juncture?

Jason Cohenour

It's the same. Our strategy is the same. We're going to bring embedded modules directly to Novatel and Options competitors in the fixed wireless terminal convergence space. We have design wins in the space. We've announced some of them. Digi, for an example, is in our press release. We have other unannounced design wins in that space and those products will be hitting the market probably late this year and through the first half of 2007. And when those products are in the market, I think they'll be a real difference-maker for us in our embedded modules business.

John Bright - Avondale Partners

Right. And then one last one, if I could. Dave, on the inventory side of the equation, would you be willing to describe the inventory as it is today, but maybe by technology, or more specifically, giving an inclination on how much is EDGE?

Dave McLennan

Yes, John, not willing to get into that granularity, but it is spread over a variety of things. It's not just in one bucket, if that helps.

John Bright - Avondale Partners

Thank you, gentlemen.

Jason Cohenour

That's it, we're done taking questions.

Operator

Ladies and gentlemen, this concludes the conference call for today. Thank you for participating. Please disconnect your lines.

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