3Com Corporation (COMS) F4Q09 Earnings Call July 9, 2009 8:30 AM ET
Gene Skayne - Vice President of Finance, Corporate Treasurer, and Head of Investor Relations
Bob Mao - Chief Executive Officer
Jay Zager - Executive Vice President and Chief Financial Officer
Jeff Evenson – Sanford Bernstein
Jeff Kvaal – Barclays Capital
Greg Mesniaeff – Needham & Company
(Operator Instructions) Welcome to this 3Com's Quarterly Earnings Conference Call. At this time for opening remarks and introductions, I would like to turn the call over to Gene Skayne, Vice President of Finance, Corporate Treasurer, and Head of Investor Relations.
Let me start by going over today’s agenda. We will start with the Safe Harbor statement. Following that, I will turn the call to Bob Mao, 3COM’s Chief Executive Officer, who will provide an update on our business. Bob’s comments will be followed by Jay Zager, 3Com’s Executive Vice President and Chief Financial Officer, who will add insight into our financials. Following Jay’s comments, we will open it up to questions.
First our Safe Harbor disclosure. The remarks to be 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 integration activities, strategic initiatives, future financial performance, financial condition, and cash flows, future expense controls and savings, product and solution development plans and strategy, and market position.
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 the risks detailed in the company’s SEC filings.
On this call, we will also discuss several non-GAAP financial measures. The most directly comparable GAAP measure and the required reconciliation can be found, one, in the tables at the back of the press release announcing our results; two, attached as an exhibit to our Form 8-K for this earning’s release; or three, on the investor relations portion of our website, www.3Com.com. The press release together with other related financial information is available on the investor relations section of our website.
Now I will turn the call to Bob Mao, 3Com’s Chief Executive Officer
Thank you everyone for joining us on this call as we review our results for the fourth quarter and the full fiscal year 2009. Let me start by stating that 3Com had a solid and very satisfying year. We delivered four successful quarters of improved financial performance. At the beginning of the year we laid out three key objectives for fiscal year 2009; increased revenue, improved margins, and generate cash.
Despite the ongoing global economic crisis I’m very pleased to report that 3Com has managed well throughout this turbulent year and we delivered on all three goals. Our total revenue grew 1.7% in fiscal year 2009. Our non-GAAP operating profit more than doubled to $150.6 million or 11.4% of revenue in the past year and we generated $280.5 million in cash from operations during the year, including a $60 million resolution of a patent dispute.
We continue to make progress in the enterprise networking market, having won numerous marquee accounts in all our geographies throughout the year which I will highlight later in my remarks. In May we participated in the Interop trade show in Las Vegas where we introduced our One Company, Three Brands strategy and brought out our successful H3C brand onto the world stage. These products have been developed, tested, and installed in the China market providing us with established reference sites in banking, telecom, and other vertical segments.
We also introduced several new H3C products at the show including the S12500 high end data center core switch and the S5800 family of flex chassis switches. The S5800 is an industry first in being able to function as a modular chassis switch as well as a fixed form factor stackable switch. It can be deployed at any layer of the network from the edge to the aggregation layer and to the core as well as top of the rack in the data center.
We also introduced our H3C network management platform, the intelligent management center (NYSE:IMC) which is used for managing resources, services, and user access on large scale networks. Going forward the entire family of H3C products will be sold to large enterprises worldwide under the H3C brand. This will compliment our TippingPoint brand for high end security and 3Com brand for small/medium business. We’re extremely pleased with the reaction from our customers and analysts to our product and solution offering for the enterprise market both at the show and since then.
We had a strong finish to the year; we saw solid profitability in the fourth quarter. Our revenue came in line with our guidance and we exceeded our guidance for operating profit, earnings per share and cash from operations. Jay will provide additional details on Q4 performance later on.
Our China business remained solid, which has allowed us to deliver higher year over year profitability while operating in a very challenging global economic environment. The ongoing global economic crisis continues to have a significant adverse impact on our revenues but we’re beginning to see signs of stability across our geographies. In the fourth quarter we saw a sequential revenue increase in the North America region, while the rate of decline in EMEA, Asia/Pacific and Latin America regions slowed from the prior quarter.
One of our key focus areas over the past year has been on growing revenue in the enterprise networking market, especially outside China. Our timing appears to be quite good as we are finding that in today’s economic climate, enterprises are taking a closer look at the value they get from their IT spending and are looking to do more with less. Our full product portfolio was best in class performance and lower prices offers customers a compelling value proposition for their networking needs.
Our security business, TippingPoint, which offers intrusion prevention systems, had another solid quarter, delivering year over year revenue growth of almost 11%, while improving profitability.
Now I will turn to our networking business and the individual geographies and segments, starting with our China based sales segment. Our China based revenue continues to be solid, delivering year over year revenue growth despite a modest Q3 to Q4 sequential decline. We attribute the sequential decline primarily to the shut down resulting from the Chinese New Year celebration falling within our Q4 reporting period, and to lower sales to Huawei.
Direct touch sales saw double digit growth over the same period a year ago and now account for 70% of our China based revenue, compared with 64% last year and 67% last quarter. As expected, sales to Huawei declined 20% sequentially and a more modest 9.6% compared with the same prior year period coming in at $44.5 million during Q4 ’09. For the full fiscal year sales to Huawei reached almost $230 million, a 3.3% increase over the prior year, exceeding our expectations.
Our China based revenue accounted for almost 55% of our total revenue in the quarter, down from 59% in the prior quarter. I would like to remind you that our China based revenue consists of revenue generated in China, Hong Kong and Japan. During the quarter our China team wrote major contracts to provide networking solutions for new and existing customers in a variety of vertical markets. One of our long standing customers, Agriculture Bank of China, added additional S7500 high end multi-server core switches, along with our security solution, and our industry leading management portfolio IMC.
We also gained traction with our new data center switch, the S12500, providing a full data center solution to Taobao, the leading business to business internet marketplace in China, as well as to Sohu.com, China’s premier online portal.
Now I will turn to our other regions of North America, EMEA, Latin America and Asia/Pacific. In North America there were two customer wins that represent the type of forward thinking customers who recognize and validate the high value and high performance our H3C enterprise networking solutions provide.
The first is the Massachusetts Institute of Technology (MIT) which is one of the first to purchase our new flex chassis switch the S5800. They will be deploying H3C technology at the core and the edge of the network. MIT emphasis high speed and performance, and the S5800 gives them that, plus every feature they want, the flexibility they need and the total cost of ownership advantage that they have not found with other vendors.
The second customer is Quinnipiac University in Connecticut, which is ranked as one of the top 20 wired colleges by PC Magazine. As the IT at Quinnipiac underwent their analysis to upgrade their existing network they were looking for excellent products at a competitive price and outstanding support. In fact, in recent press interviews they stated that 3Com exceeded those criteria with our H3C portfolio.
Other wins of note in the quarter include the Longwood Board of Education in New York where we’re providing a total core edge and wireless switching solution, and Pinellas County public schools in Florida, the 25th largest school district in the US, which placed a significant order for our stackable edge switches.
Our EMEA region continues to make significant progress in penetrating large enterprise accounts. For example, in Q4 the team won a major deal with South Africa Home Affairs, the government entity responsible for issuing IDs and all legal documents for citizen records as well as immigration and visa documentation. We are deploying a core two edge H3C enterprise networking solution. Our price performance advantage was one of the key reasons for the win.
Another large EMEA win in the quarter was a mill industry investment, one of Saudi Arabia’s largest international businesses. They’ll be leveraging our H3C portfolio for complete core to edge network infrastructure to replace their existing network. The entire infrastructure will be managed by IMC. This was yet another deal where the customer was not only impressed by our price performance leadership but also by the level of responsiveness from the account team.
In Latin America the largest private bank in the Southern Hemisphere and one of the 20 largest in the world, Bank Itaú of Brazil, signed on for our H3C enterprise switches. Additionally, Casinos de Buenos Aires is the deploying core edge and wireless which is as well a TippingPoint IPS solution. Like so many of our customers, the Casino and Bank Itaú selected 3Com because of the trusting relationships they formed with our direct touch sales team, as well as the outstanding price and performance our solutions deliver.
Finally, the Asia/Pacific team had several strong large enterprise wins including RHB Bank, one of the largest banks in Thailand, with over 800 branches country wide. The bank will deploy several hundred of our MSR routers. In Malaysia, the Ministry of Education and Islamic Science University selected a variety of products from our H3C enterprise portfolio including core and edge switches in IMC.
As you can see, from some of these wins, we’re building our existing strengths in the Government and Education verticals and expanding into other verticals especially the banking and the financial services area.
As one company with three brands, we also achieved success in the quarter with our 3Com branded portfolio which is primarily geared towards small and medium sized businesses. For example, Maricom, a leading provider of independent test services evaluated several of our 3Com switches as part of its certified green test program and found them to be up to 40% more energy efficient then the industry average. Maricom evaluated the overall environment impact and the business enabling green benefits of the products provided to customers and rated them Maricom Green Certified.
Now I will turn to our security segment TippingPoint. Our high end network security business continues to show resilience in these challenging economic times, delivering double digit year over year revenue growth in the quarter with a significant improvement in profitability. The improved profitability is driven by operational efficiency, resulting from integration of the TippingPoint administrative functions with the rest of 3Com.
In addition to the Bank Itaú win in Latin America another significant win in the quarter was the Province of Ontario in Canada. We were brought into this deal through Toulouse, one of Canada’s largest service providers, to displace the existing vendor.
Now I would like to comment on our sales and marketing activities. During fiscal year 2009 we continue to make investments in dedicated customers facing resources to address the enterprise market throughout the world. This investment is paying off, as measured by marquee wins and by pipeline growth. Our value proposition is clearly resonating in the marketplace.
We continue to carefully manage our discretionary spending to ensure we weathered the current economic storm and are positioned to win in the marketplace. We’re carefully scrutinizing all hiring and have cut back on all other discretionary spending. We’re also carefully monitoring our capital spending.
In closing, I would like to say that we’re very pleased with our overall performance during the quarter and the full fiscal year. We were able to modestly increase our revenue during a year when the overall networking market declined and we delivered improvement in our operating profit and earnings per share. We also generated a significant amount of cash from operations during the fiscal year. That we achieved these results in the midst of one of the most dramatic economic downturns in several generations is a result of the successful execution of our strategy.
For fiscal year 2010 we will focus on growing our market share, particularly outside of China, as we continue to execute on our strategy.
Now I will turn the call over to Jay.
3Com continues to do well despite the difficult economic environment in which we operate. Q4 sales were $295.1 million, a sequential decline of 9.1% and 8.2% lower than a year ago. Full year sales were $1.317 billion, a 1.7% increase over the prior year. Favorable foreign currency translation contributed $7.2 million to the Q4 results and $55.4 million to the full year results.
On a GAAP basis net income for the quarter was $20.2 million or $0.05 per diluted share. For the full year net income was $114.7 million or $0.29 per diluted share. This was our first profitable year on a GAAP basis since fiscal year 2000. On a non-GAAP basis net income for the quarter was $37.2 million or $0.10 per diluted share. For the full year non-GAAP net income was $176.7 million or $0.45 per diluted share.
Our networking business had sales of $264.6 million, 9% lower than a year ago and 9.8% lower sequentially. Within networking, our China based sales segment has revenues of $162.4 million consisting of China Direct Touch sales of $113.5 million a year over year increase of 12.8%, Huawei sales of $44.5 million which was 9.6% lower than a year ago and 20.3% lower sequentially and other sales of $4.4 million primarily reflecting sales in Hong Kong and Japan.
As expected we saw a continued decline in sales to Huawei. In the quarter, Huawei sales represented about 27.4% of China based sales and 15.1% of 3Com’s consolidated sales. Despite this reduction, full year 2009 sales to Huawei actually increased by a modest 3% as fiscal year ’09 sales to Huawei were much stronger than we expected.
China sales have remained relatively strong throughout this fiscal year as the economic downturn has had less of an impact in China then the rest of the world. We continue to benefit in China from the expansion of our vertical markets such as finance and banking and from product solution expansion such as video surveillance.
Our rest of world network segment had sales of $102.2 million, a year over year decline of about 25% but essentially unchanged from the prior quarter. Within rest of world network sales North America had sales of $28.0 million, 9% lower than a year ago but 16.6% higher than Q3. EMEA had sales of $42.4 million about 34% lower than a year ago and 3% lower than Q3. Latin America had sales of $17.1 million, 15% lower than last year and 14% lower than Q3, and Asia/Pacific had sales of $14.7 million down 30% from last year and 4% lower than Q3.
During the fourth quarter we continued to feel the effects of the global economic slowdown across each of our geographic regions. As we reported last quarter, we continue to participate in many more enterprise deals and our pipeline continues to grow. We believe that this positions us well when the global economy recovers.
TippingPoint’s Q4 sales were $32.4 million, 10.8% higher then a year ago and 2.8% lower than Q3. Within this total, product revenue was $19.4 million and maintenance revenue was $13.0 million. This compares with prior year product revenue of $18.3 million and maintenance revenue of $10.9 million. TippingPoint continues to have strong product sales while simultaneously increasing its maintenance revenue annuity stream.
From a consolidated viewpoint, 3Com’s Q4 non-GAAP gross profit was $177.3 million or 60.1% of sales. Included in these results was a one time favorable gain of $5 million relating to the timing in inter-company transactions. 3Com’s gross margin has improved in every quarter this year, reflecting the favorable impact of our new products, continued product cost reductions, the shift toward more enterprise networking sales, and the declining sales to Huawei which carry lower gross margins.
R&D expenses on a non-GAAP basis were $41.3 million or 14.0% of sales compared with $50.4 million or 15.7% of sales a year ago. Sales and marketing expenses on a non-GAAP basis were $75.6 million or 25.6% of sales compared with $76.6 million or 23.8% of sales a year ago and $82.9 million in Q3. In general and administrative expenses on a non-GAAP basis were $22.0 million or 7.4% of sales compared with $24.3 million or 7.6% of sales a year ago.
Headcount at the end of the year was 5,868 people, an increase of 20 people in the quarter. During the year we reduced overall headcount by 235 people, primarily as the result of integration savings as well at through attrition. We did not implement any company wide reductions in force during fiscal year 2009.
Operating profits on a non-GAAP basis were $38.5 million or 13.0% of sales compared with $23.2 million or 7.2% of sales in the prior year period. Net interest expense was $400,000; other income was $6.9 million, primarily as the result of the vast software subsidy in China. Our non-GAAP profit before tax was $45.0 million, our tax provision of $7.7 million primarily reflects tax expense in jurisdictions unable to leverage our NOLs primarily China, where our tax provision in Q4 was approximately 15%. As a result of these factors, our non-GAAP net income was $37.2 million or $0.10 per diluted share.
Let me now turn to our balance sheet. At the end of the fiscal year, our cash and short term investments balance was $644.2 million compared with $560.0 million at the end of Q3 and $503.6 million at the start of the fiscal year. In June we moved approximately $55 million of cash from China to the rest of the world and we expect to move an additional $100 million of cash from China later this quarter.
During the quarter we generated $84.1 million of cash from operations and we also generated $15.2 million from the sale of patents. Accounts receivable were $112.8 million, a reduction of $1.3 million from Q3. Our DSO in the fourth quarter was 34 days compared to 32 days in Q3. Notes receivable were $40.6 million in Q4 compared with $85.8 million in Q3. This reduction was due primarily to lower sales to Huawei.
Inventory was $90.4 million about $17 million lower then the prior quarter. Capital spending was $3.8 million and for the full year capital spending was $16.6 million. Our debt balance at the end of the year was $200 million as we made a $13 million payment in the quarter. We expect to make our next scheduled principal payment of $48 million in September.
Now I’d like to provide some insights into the current quarter and recent comments on fiscal year 2010. As we had previously indicated as the result of the rapidly changing economic environment these projections have become more difficult. As of now, we are projecting Q1 revenues to be in the $270 to $280 million range. Within this total we expect that China based sales will show a 5% sequential decline. We expect Direct Touch sales to show a modest increase while sales to Huawei will decline from $45 million in Q4 to between $25 and $30 million in Q1.
In the networking rest of the world segment and at TippingPoint revenue should be essentially at Q4 levels. Gross margins are expected to be below Q4 due to the lower revenue projections and the fact that the Q4 margins were aided by a one time $5 million favorable adjustment. R&D and G&A spending are expected to be essentially flat compared with Q4, while sales and marketing expenses are expected to increase sequentially as we will be investing in additional sales and sales support resources primarily in China and TippingPoint.
As a result of these factors we anticipate that Q1 operating profits on a non-GAAP basis should be in the $15 to $20 million range. Other income which reflects primarily the software subsidy in China should be approximately $10 million in the quarter and we expect to record a tax provision of about $7 million. Earnings per diluted share on a non-GAAP basis should be between $0.03 and $0.05. We expect to see a decline in our Q1 cash balance due to an anticipated $50 million payment in China for long term incentive employee payments.
Looking beyond the current quarter we anticipate continued sequential reduction in sales to Huawei. We expect Huawei sales to decline significantly this year from $229 million in fiscal year 2009 to a range of between $50 and $100 million in fiscal year 2010. As we have stated, sales to Huawei in fiscal year ’09 were harder than we originally anticipated. We believe that it will be extremely difficult to fully offset this projected fiscal year 2010 Huawei sales decline, particularly given the current economic conditions and the uncertain timing of the economic recovery.
We view fiscal year 2010 as a year of transition for 3Com as we grow our enterprise and security business throughout the world while experiencing the expected reduction in sales to Huawei. During the year we will continue to make appropriate investments to take advantage of our strong and timely value proposition and the anticipated economic recovery. We will focus on growing our market share outside of China. We believe that our strategy will enable us to finish the year well positioned with greater geographical diversity and less dependence on Huawei sales.
Now I’d like to open the meeting to questions.
(Operator Instructions) Your first question comes from Jeff Evenson – Sanford Bernstein
Jeff Evenson – Sanford Bernstein
One of the initiatives we’ve heard about in security is the introduction of some lower through put and appropriately lower priced boxes that could go to small and medium sized businesses. I’m wondering if you could give us some color on the outlook for those and how you incorporated them into your guidance.
We are obviously working very extensively on expanding our security offerings through basically two efforts; the TippingPoint effort which continues to offer the high end IPS security solutions and as we’ve talked in prior quarters we’re also starting to incorporate much of the security technology into our core routers and switchers. At this point that’s the essence of our strategy. Obviously all of these activities are reflected in our guidance. Beyond that we have no other specific product plans that we’re announcing at this time.
Jeff Evenson – Sanford Bernstein
You talked in your guidance about increasing sales and marketing expense as you look to do more direct sales on a global basis. I’m wondering if you could share with us any metrics like number of customers who spend over $500,000 or $1 million annually that we could start tracking to look at the success of these initiatives.
We don’t track the data that way. We’re obviously focused on marquee wins. Sometimes its difficult to quantify the wins because what’s happening in this environment is we will bid on a particular contract, we’ll win the contract but as the contract plays out the timing and the amount of the sales may be substantially different then the original contract bidding process. We at this point don’t keep any kind of running track as to how many wins we’ve had over a certain financial level or sales level.
Jeff Evenson – Sanford Bernstein
What metrics do you track internally to tell you that the addition of direct sales is working?
The key one is basically revenue per sales person.
Your next question comes from Jeff Kvaal – Barclays Capital
Jeff Kvaal – Barclays Capital
On the revenue side I was wondering if you or Bob would be able to help us understand a little bit more about why you think your pipeline is healthier. Is there a way you could quantify that for us and when we might see that turn into revenue growth particularly outside of China?
One of the key initiatives that Ron Sege put in place when he came on board about a year ago was to add much more metric discipline to the sales process and it really started with quantifying a pipeline, I think prior to Ron’s coming on board we weren’t tracking or measuring that at all. We actually break our pipeline into four category, I think we call them A, B, C, and D, depending upon where we are in a particular sales cycle. We track that by those four categories right now in all of our regions except for China and we clearly are seeing substantial increases across the board in all four categories of our pipeline.
Jeff Kvaal – Barclays Capital
Are these pipeline projects a three or six or nine month project, how should we think about that?
It varies, it depends on the customer, and it depends on the particular transaction. Obviously there are some transactions which we meet the customer, get a bid, get contract done within a current quarter. The bigger contracts obviously the process is more complex, there are more stages to it and in some cases it could be a six to 12 month process or even beyond that.
Also at times we may also enter into prove of concept testing with a customer.
Jeff Kvaal – Barclays Capital
Should we think about your revenues in terms of making up the loss of Huawei revenues over the next year should that we coming primarily from your efforts in China or do you think that a lot of that will be made up outside of China?
As you see that our sales in China aside from Huawei has been growing and we also have been growing our networking revenue outside China as well. We expect to offset the Huawei decline from both sources.
Jeff Kvaal – Barclays Capital
On the margin side obviously OpEx came in much more disciplined then we had expected. Could you help us understand some of the variables there and how sustainable we should think of that through the course of fiscal ’10?
Clearly what we’ve been saying throughout the last several quarters is we are making investments in sales and marketing and primarily in customer facing activities. Outside of that, all discretionary spending we are putting pretty much a lid on and really tightening our controls quite a bit. Some of the reduction unfortunately in our sales and market expense this quarter was due to the fact that we had lower sales then originally anticipated and through some commission savings.
In general what you’re seeing from the teams in the field in particular is each of our regions manages to their own internal P&L and as the revenues move and switch they’re taking appropriate local actions to control expenses so we’ve been fortunate in that we haven’t had a put in place any major corporate wide directives, very specific directives. We have teams out in the field across the board who understand the economic environment and on a local basis are taking whatever actions they deem appropriate to control spending. I think you’ve seen the results of that over the last couple of quarters.
Your next question comes from Greg Mesniaeff – Needham & Company
Greg Mesniaeff – Needham & Company
I was wondering when you look at the sequential increase in US sales without much of an increase in sales and marketing expenses is it fair to assume that that increase was really low hanging fruit and that as you continue with your strategy of targeting the enterprise customer base here in the US the sales and marketing expense levels will ramp up rather significantly.
On this one primarily due to two counts, one is we’re more efficiently managing our channel sales. Secondly, while doing that we’re able to shift our resources without adding the total expense more onto addressing the networking market sales.
I don’t think there’s any low hanging fruit these days in this environment. I think it’s a matter of working very hard to go after business and I think the combination of the new product announcements, the products coming out of China, the marketing campaigns and frankly lots of hard work on the part of our sales and marketing teams are paying off.
Greg Mesniaeff – Needham & Company
If you could just give a little bit more granularity on the sales and marketing going forward. Is it going to be a ramp in your direct sales force or can you give us some indication of how that is going to play out?
I could tell you what our plans call for which basically says that we will selectively grow our sales and marketing expense. We see in particular a tremendous opportunity in TippingPoint which has weathered the economic downturn better than the core networking business. Then in the short term in Q1 we’re going to see some incremental spending in China as we start to effectively replace Huawei sales with great Direct Touch sales.
Frankly what will happen during the year is Ron and his team will essentially make adjustments depending upon how the economy works. If the revenues are looking strong we’ll make appropriate investments if revenues are not looking strong we won’t make those investments. We’re really running this on a quarter by quarter basis in terms of tactical spending decisions looking at how the recovery is playing out in the various regions.
It appears we have no further questions at this time. I’d like to turn the call back to our speakers for any additional or closing remarks.
Thank you everyone for joining our call today. Enjoy the summer and we’ll speak to you again after our first quarter.
That does conclude today’s call.
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