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Extreme Networks, Inc (NASDAQ:EXTR)

Fiscal Q4 2006 Earnings Conference Call

August 2, 2006 5:00 pm ET

Executives

Gordon L. Stitt - President and Chief Executive Officer

William Slakey - Chief Financial Officer

Michael Palu - Acting Chief Financial Officer, Vice President, Controller

Analysts

Jeff Hubert - Banc of America Securities

Samuel Wilson - JMP Securities

Subu Subrahmanyan - Sanders Morris Harris

Jiong Shao - Lehman Brothers

Tal Liani - Merrill Lynch

Long Jiang - UBS

Manuel Recarey - Kaufman Brothers, L.P.

Jennifer Tannenbaum - RBC Capital Markets

Erik Suppiger - Pacific Growth Equities

Alex Henderson - Smith Barney Citigroup

Presentation

Operator

Good afternoon, ladies and gentlemen, and welcome to the Extreme Networks fourth quarter earnings conference call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question-and-answer session.

(Operator Instructions)

As a reminder, this conference is being recorded today, Wednesday, August 2nd of 2006. I would like to turn the conference over to Bill Slakey, Chief Financial Officer with Extreme Networks. Please go ahead, sir.

William Slakey

Thank you. Good afternoon, everyone. Thank you for joining us. On the call with me today is Gordon Stitt, President and CEO of Extreme Networks. This afternoon, we issued a press release announcing our financial results for Q4 of FY2006. A copy of this release is available on our website at extremenetworks.com.

This call is being broadcast live over the Internet today and it will be posted on our website and available for replay shortly after the conclusion of the call.

Let me note that some of the remarks made during this call may contain forward-looking statements about financial and business guidance, product introduction, customer development and prospective real estate transaction. These reflect the company's current judgment on these issues.

Because such statements deal with future events, they are subject to risks and uncertainties that could cause the actual results to differ materially. In addition to the factors that may be discussed during this call, important factors that could cause actual results to differ materially are contained in the company's Form 10-Q and 10-K, which are on file with the SEC and available on our website.

With that, let me turn the call over to Gordon.

Gordon L. Stitt

Thank you, Bill, and thanks, everyone, for joining us. I would also like to welcome Mike Palu to the call. Mike will take over as acting Chief Financial Officer at Extreme starting next week.

I will begin this call with a summary of the financial results, review some quarterly highlights, and then spend a few minutes talking about our strategy. Bill will then follow with a detailed discussion on our financials.

Net revenue for the quarter was $82.4 million, and net loss for the quarter was $1.8 million, or $0.02 per diluted share on a GAAP basis.

Excluding stock-based compensation expense of $2.2 million, non-GAAP net income for the quarter was $400,000, or less than $0.01 per diluted share. Let's just call that breakeven. This is a decline from the $0.03 per diluted share on a non-GAAP basis in the March quarter.

As you know, during the first quarter of this fiscal year, we announced a $50 million stock repurchase program. During the last three quarters, we have repurchased $33.7 million in stock cumulative to date. We are executing to our internal plan and will continue to do so going forward.

Bookings during the quarter were strong, with a book-to-bill higher than one. Unfortunately, we missed some shipments late in the quarter due to product constraints.

Japan business continued to be sluggish this quarter. We have seen similar comments from other networking companies but nonetheless, we are disappointed.

That was the bad news.

The good news is that we saw strengthening demand for our modular product lines, BlackDiamond 8800, the new BlackDiamond 12K and the BlackDiamond 10K product lines. In fact, this demand exceeded our ability to produce within the quarter, and this created the majority of our product constraints.

Much of the strong demand for the BlackDiamond 12K came from metro ethernet carriers. We announced the 12K in February of this year, and immediately went into field trials with carriers. We are currently progressing well through customer internal and external field trials at a number of carriers, both existing carrier customers of Extreme and, most importantly, new carrier customers where this product became our first point of contact.

People are attracted to the technology that we deliver in a 12K for a simple reason -- it is an excellent platform for delivering triple-play networks utilizing low-cost, low complexity ethernet technology.

In addition to the traditional switching and routing capabilities for which we are well-known, the 12K delivers four very important capabilities to ethernet-based triple-play networks:

  1. Subscriber management through our hierarchical quality of service;
  2. Ethernet cross connect simplified content distribution;
  3. Network scale, using vMAN and MAC in MAC technologies; and
  4. ExtremeXOS, which enables XML-based management insight and control.

I believe the combination of these capabilities is a formula for success in this market. We offer full subscriber management, with scale to thousands of users, with multiple services per user. Carriers talk about triple-play -- we can actually handle up to eight plays per subscriber.

The ethernet cross connect simplifies carrier networks, eliminating the need for routing at the edge or aggregation layer.

It also supports the opposite of net neutrality -- that is, it allows carriers to control the bandwidth of content providers driving data into the network, as well as the bandwidth being allocated to individual users. This gives carriers high levels of flexibility in how they design services and how they react to regulatory changes.

We can plug into the net neutrality debate no matter which side you are on.

We also this week just sent out a press release regarding the first trial of MAC in MAC, which can be used to scale a network to support millions of users. This technology provides a very simple low-cost way to build large triple play networks.

The fourth unique differentiator is that the BlackDiamond 12K runs ExtremeXOS, our open operating system. XOS provides the carrier with an XML interface to deliver insight and control -- insight into how the network is being used and control over how customers use it, whether business, residential or content providers.

We are pretty excited about the BlackDiamond 12K and its underlying technology. We are developing follow-on products in this category, so that we can provide these benefits to a broad range of customers and to allow those customers to deliver those services in different points of presence. We believe we have a lead over our competitors in our technology base and our technology is a great fit for the problems at hand.

This is a dynamic, rapidly growing market, and we have expectations for the future growth of triple-play networks based on ethernet technology.

Let me shift gears now and talk about what we are doing in some specific region, and specifically, the Americas.

Last fiscal year has been a disappointment for the Americas region. We saw turnover in our sales force and declining sales. During the previous quarter, we executed on a number of plans to improve our top-line performance, particularly in the U.S.

I am pleased that during Q4, we saw continued signs of a turnaround. We saw sequential growth in the Americas sales for the second quarter in a row. We have been hiring aggressively and started this new quarter with a full team in place.

We also appointed a new Vice President of Sales for the Americas, effective this past July 1. Eileen [Booker] is a two-year Extreme veteran who brings significant management experience, domain expertise and leadership capabilities to this role.

We have renewed confidence in the Americas and we will be hiring aggressively during this quarter and through the year to open new offices and increase penetration into existing regions.

We expect the combination of new leadership and increased sales headcount will line up nicely with our product side.

Most of our American sales are enterprise, so I would like to talk about enterprise products and then follow-up with some discussion on channels.

We just refreshed our enterprise product line with new additions to our BlackDiamond 8800, a new series of stackables and the introduction of the enterprise version of the BlackDiamond 12K. BlackDiamond 8800 has grown significantly since its introduction early last year. This product line is targeted at the enterprise and at enterprise data centers.

The new products we introduced include an entirely new lineup of gigabit line cards, which significantly improve the performance and scalability of the BD 8800 at reduced price points.

Our new series of stackables, code named Jaguar, has received excellent reviews from the industry. It extends XOS to lower-cost platforms, broadening our footprint for this important differentiating technology.

The enterprise version of the BlackDiamond 12K is tied to our security strategy, which I talked about extensively during last quarter's call. The 12K brings all the same benefits of the BlackDiamond 10K, but at a lower entry price and smaller physical size. Like the 10K, it implements CLEAR-Flow, our security rules engine, which allows security to be delivered on every port of the switch, as opposed to the in-line model that the rest of the industry uses.

During the first half of this fiscal year, we re-engineered our U.S. channels program and began recruiting and training converged resellers. Think of these as former voice resellers who are now coming into the IP telephony market. These resellers bring significant voice expertise and importantly, a significant customer base.

Our partnership with Avaya, combined with the unique technology we have developed, we believe has positioned us very, very well for this new channel.

Growth in our Avaya partnership revenue grew 60% over the same quarter last year. Avaya-related bookings again exceeded 10% of our worldwide business -- an extraordinary performance. Convergence continues to be the major driver for enterprise upgrades and we believe we are very well positioned with partnerships, channels, and products.

Continuing on the theme of convergence, I am very proud of the effort we made in helping Avaya with the 2006 FIFA World Cup network. We set up a large-scale event network for converged communications across each of the stadium sites in Germany. This network hosted thousands of people and a vast array of global media, including television, radio and print outlets.

Extreme helped Avaya deliver an outstanding converged infrastructure, both built with our BlackDiamond switching platforms.

Some of the highlights and results of this network include:

  • Network availability of five 9s -- that is 99.999% up-time with zero outages and no downtime during the events;
  • Over 21,000 terabytes of data transferred over the network;
  • Nearly 800,000 minutes of IP telephony calling time supported on Avaya IP phones; and
  • Over 640,000 network log-ins from users.

Truly, an outstanding performance.

In the Americas, the New York Academy of Sciences has just recently selected Extreme along with Avaya to provide the network infrastructure for a new museum as one of the first organizations to be located at the former World Trade Center site.

This museum is an impressive center of innovation, hosting more than 200 Noble laureates. The museum will utilize our BlackDiamond 8800 and Summit X450 switches, with enhanced availability from our modular operating system, XOS.

This allows the network to remain operational during software upgrades or process failures.

The Boston Red Sox are also utilizing Extreme converged wireless LAN solutions to improve their operations and mobility at historic Fenway Park this summer. Our new generation Summit WM wireless switching platforms enhance the reliability and speed of the ticketing systems, allowing for fast access of the Internet to visiting media during and after the games, as well as enhancing food and beverage services at the park.

As part of an Extreme-Avaya converged solution, the wireless has been a strong complement.

Healthcare organizations and hospitals continue to benefit from our wired and wireless network solution, giving them the ability to host both converged applications and emerging mobility and security requirements.

Our customer, Hancock Regional Hospital of Indiana, was profiled in Computer World Magazine with the very recent addition of Extreme's wireless connectivity to their existing LAN infrastructure. Like many healthcare organizations, Hancock is assisting its nursing staff, having placed more than 30 of our Altitude access points throughout its buildings to provide smooth wireless connectivity, reaching out not only to PCs but to innovative Wi-Fi phones that keep the staff up to date anywhere they roam throughout the facility with critical patient and operational information.

The voice network is set up to securely deliver phone calls and with separation from the rest of the data network, meeting Hancock's security requirements.

In Brazil, the University of Sao Paulo, the prestigious medical school hosting thousands of undergraduate students, post-graduate students and staff, has selected Extreme Networks to create a robust and reliable network infrastructure that also maximizes its IT spending.

High availability was a must-have with their new network that features our BlackDiamond 8800 family, modular switches and our Summit X450 switches featuring our modular operating system, XOS. The success of the network hinges on its ability to maintain high performance throughout application upgrades and under heavy use from users.

In China, we have seen success in our enterprise business. The Bank of Shanghai is implementing Extreme's high-performance platforms, including our BlackDiamond 8800 and Summit 400 switches. In addition to supporting the Bank with extensive transactions and traditional data applications, the network now supports converged applications. These applications benefit from Extreme's high availability and traffic prioritization with quality of service.

As a result, the Bank of Shanghai now has established an innovative financial network that features Internet-based banking, the use of high quality IP video and voice convergence.

In the carrier ethernet space, we continued the success of our new ethernet platform, the BlackDiamond 12K, and the technology that drives metro deployments, what we call multi-dimensional ethernet.

This includes emerging technologies, such as MAC in MAC, which allows a very simple and cost-effective ethernet network to scale and manage services for as many as 16 million users. This is in contrast to more expensive routed networks that feature much more complexity and much higher cost.

IP-Only, a leading Swedish Internet and telecom provider that delivers ethernet services, wavelength and dark fiber to Swedish and international operators, as well as to demanding enterprises, television and multimedia service providers, has selected and is now deploying the BlackDiamond K12 switch. IP-Only plans to use the MAC in MAC scalability for a large deployment in the Nordic countries. As a wholesale provider, they will take advantage of Extreme's multi-dimensional ethernet as a cost-effective infrastructure to offer other service provider customers the ability to reach residential customers with triple-play services.

Service provider T2, which is located in Slovenia, is now deploying our BlackDiamond 12K along with our BlackDiamond 10K switches and Summit X450 switches. All these switches feature our advanced modular operating system, ExtremeXOS, for increased availability and advanced features. T2 now has a highly redundant and scalable ethernet backbone to support triple-play services that are based on [video cell] technology delivered to residential communities. These multimedia services reach thousands of customers and deliver video, data and voice with preferential treatment of traffic, the equality of service.

As you can see, we continue to win enterprise customers that are focused on convergence and new metro ethernet carriers that are embracing our vision of multi-dimensional ethernet.

One more topic, and then I will summarize my comments.

On May 12th this year, I announced my plans to retire as CEO of Extreme Networks and become Chairman of our Board of Directors. This decision was a personal one based upon a commitment I made to my family several years ago. Subsequent to the announcement, we began a search for a new CEO. I am pleased to report that the search is proceeding well. We have screened dozens of candidates and selected a small number for consideration. I am very pleased with the caliber and quality of the candidates.

In talking to these candidates, it is invigorating for me to hear why they find Extreme attractive. They see what I do, that Extreme is a company rich in assets. We have great people, strong technology base, global distribution system, a network of partners, a strong brand, and our position in two key markets, the enterprise network infrastructure market and a strong position in the emerging market for ethernet triple-play services. Plus, we have a strong cash position to invest and to grow our portfolio of products and services.

As we have announced, I will stay actively involved with the company. Once we choose the individual and they start as CEO, I will assume the role of Chairman of the Board and work closely with the CEO and the rest of the board in building Extreme into a large, profitable company.

As the company's largest individual shareholder, I can assure you that I have every incentive to dramatically increase the value of Extreme.

In summary, as we start our new fiscal year and leave fiscal 2006 behind us, I would like to review why I am so optimistic about our future.

First of all, the metro ethernet market, a market that we pioneered, is starting its next phase. We are moving from a so-called best efforts environment to a triple-play environment. Quality of service, subscriber management and content delivery are critical success factors. I believe our BlackDiamond 12K and its underlying technology deliver unique capabilities to this market.

We are seeing early success with new and existing customers, and I believe this will continue through the fiscal year and well into the future. This market is growing rapidly and we have the opportunity to ride that wave.

Secondly, I believe our Americas region is back on track. After a series of issues, we have a full team, new leadership, and we expect to increase headcount and sales throughout the year. This is combined with our new enterprise product cycle, which brings new functionality, new price points, new security capabilities and the benefits of XOS network-wide.

With that, I would like to turn things over to Bill.

William Slakey

Thank you, Gordon. I am going to briefly review our financial results for the quarter, and then provide you with some of our current thoughts regarding future performance.

This was a quarter in which revenues were lower than we might all have expected, given our typical seasonality. However, it was also a quarter in which we saw further sequential improvements in our U.S. sales and finished a year of good growth overall in our European operations and our Asia-Pacific operations. We also began to increase the size of our sales force and marketing spending, which we believe will be an important part of improving our revenue growth in future quarters.

On the balance sheet, cash generated from operations was slightly ahead of profitability, and we continued our share repurchase program. We have now repurchased 5.8% of the shares that were outstanding when we announced the program in October.

Let's look first at revenue. Revenue for the quarter was $82.4 million, consisting of $66.8 million in product revenue and $15.7 million in service revenue. Our book-to-bill was above one. Our backlog of product orders increased during the quarter, compared to Q3, as did our deferred revenue balances.

Services revenues were up 1% compared to the year-ago quarter and down 4% sequentially. Product revenue decreased 3% sequentially and 17% year over year.

Shipment of modular products represented 44% of sales, with stackables representing 56%, consistent with the mix in Q3.

The split of enterprise sales and service provider sales was 78% to 22%, a slight shift towards enterprise business for the quarter. This is consistent with the stronger U.S. sales, which is typically a more enterprise-centric geography.

Bookings of XOS-based products continued to increase as a percentage of our total revenue. All told, sales of XOS products represented in excess of 30% of product bookings, up slightly as a percentage from Q3. Bookings of BlackDiamond 12K increased sequentially in the quarter, helped in part by availability of the enterprise version of the product, as well as the carrier version.

We also saw increases in BlackDiamond 8800 sales and a solid contribution from BlackDiamond 10K.

Sales of some of our older chassis and stackable products declined, which is consistent with a shift towards newer product.

New bookings for PoE ports were once again in excess of 10% of total ports booked. We expect PoE ports to continue on a growth trajectory, driven by demand for IP telephony and wireless.

This quarter, as you heard from Gordon, bookings through our Avaya channels, both direct and resellers, increased sequentially and were in excess of 10% of total product bookings.

This was a very solid quarter for Avaya sales. Avaya revenues were up sequentially in the U.S., EMEA and Asia, and in total were up more than 60% compared to Q4 a year ago.

Looking at revenues geographically, in EMEA, our European operations, which includes the Middle East and Africa, our revenues were $29.8 million. This was down 11% sequentially, off an unusually strong Q3. I should also note that the product constraints we experienced during the quarter impacted our European revenues in particular. We expect those constraints to be cleared this quarter.

For the year, revenues in EMEA were $124.8 million, up 6% from fiscal 2005. For the quarter, and for the year, we saw a particularly good growth in Germany and Eastern Europe, driven in part by new wins at regional service providers.

Revenues in Japan were $6.4 million, down from $7.7 million sequentially. This was a disappointing result driven in part, we believe, by softness in the overall market, particularly the service provider segment.

As Gordon mentioned, the BlackDiamond 12K is in testing with a number of Japanese carriers.

Looking at Asia outside of Japan, revenues were $10.7 million, up from $9.3 million sequentially, and up from $7.8 million in the fourth quarter a year ago. This is a very good quarter for Asia for us, and it capped off a very strong year in which revenues were up 25% compared to fiscal 2005.

Our growth in Asia this year was in large part a result of adding new enterprise customers in existing geographies, and expanding through the Avaya channel into new geographies like India. It was a very solid effort by our team there.

In the U.S., revenues were $35 million, up 3% from $33.9 million in the March quarter. These revenues were down compared to Q4 a year ago, but the sequential improvement does represent further progress off the difficult December quarter we experienced this fiscal year.

Looking forward in the U.S., we have a new VP of Sales in place, and have added new sales teams in a number of cities. Many of these salespeople came on board in June, and many more have come on board in July. As these sales teams become more productive in fiscal Q1 and Q2, we are optimistic that better results lay ahead for us in the U.S.

Turning now to costs and expenses, the cost of goods and operating expense figures in comparisons I will be discussing will not include stock-based compensation expense. These expenses added $2.2 million to our total cost for the quarter. For those of you who want to want to note it in the model, the breakout of these expenses by P&L line item in the quarter was as follows:

  • $250,000 increase to product cost;
  • $140,000 increase to service cost;
  • $888,000 increase to sales and marketing expense;
  • $663,000 increase to R&D expense; and
  • $340,000 increase to G&A expense.

This breakout is also included in Table 4 in our press release.

Looking at gross margins, total gross margin as a percentage of sales was 53.1%. This was down from 54.3% sequentially and up from 53% flat in the fourth quarter a year ago. This represents our 10th consecutive quarter of year-over-year increases in gross margins as a percentage of sales.

Product gross margins were 54.2% compared to 56.2% in the March quarter and 54.6% in the year-ago quarter.

Product margins are down sequentially and year over year due primarily to lower volume. On a year-over-year basis, the impact of lower volumes is muted somewhat by lower overhead expenses and improved per unit costs compared to a year-ago.

Service gross margins were 48.7% compared to 46.5% in the March quarter and 44.4% in the same period a year ago. Service gross margins are up year-over-year and sequentially, as a result of lower return rates, lower per unit repair costs, and better pricing.

At 53.1% total gross margin, we are operating below the target range of 54% to 57% that we had previously laid out for investors. We do believe that gross margins on both products and services can continue to improve over time, through a combination of higher revenue, operational improvements and new product sales. That said, given the number of pricing mix, cost and volume variables involved, we do not expect that gross margins will improve lockstep each and every quarter.

Turning to operating expenses, sales and marketing, R&D and G&A expenses for the quarter were $45.5 million, not including stock-based compensation. This was up from $43 million sequentially and down from $51.4 million in Q4 a year-ago.

Sales and marketing expenses increased by $2 million sequentially, as a result of increased hiring of salespeople, primarily in the U.S. as outlined for you by Gordon, and as a result of increased expenses for demonstration equipment and marketing programs, primarily related to the introduction of the BlackDiamond 12K.

R&D expenses increased by $1 million sequentially, as a result of headcount additions and project spending, particularly related to ExtremeXOS and hardware projects.

Compared to Q4 of last year, sales and marketing, R&D and G&A expenses are down $5.9 million. Expenses in the year-ago quarter included significantly higher legal expenses, higher R&D costs associated with the amortization of warrants related to the Avaya agreement, higher variable sales costs, and higher G&A expenses related to Sarbanes-Oxley compliance.

Regular headcount at quarter-end stood at 847, up from 820 at the end of the March quarter. Headcount increased in sales and in engineering during the quarter. The majority of the hiring in the engineering organization was in our India operations.

Looking at net income, Q4 on a GAAP basis, we reported an operating loss of $3.9 million. Adding in $1.9 million in net other income, results in a loss before tax of $2.1 million. After adding in a tax benefit of $200,000, the GAAP loss after tax is $1.8 million, or $0.02 per diluted share.

On a non-GAAP basis, excluding $2.2 million in stock-based compensation, profit after tax was $400,000, or less than $0.01 per share on a diluted basis, the same earnings per share as a year ago.

The $200,000 tax benefit for the quarter was the result of truing up tax accruals that were based on the expectations of somewhat higher profits for the year. For the year, our effective tax rate was 16%.

Total shares used to calculate non-GAAP diluted EPS in the current quarter was 120.2 million.

Total shares outstanding at quarter-end were 117.3 million, down 2.5 million from the end of the March quarter.

Looking at the balance sheet, cash and cash equivalents, short-term investments and marketable securities on July 2nd totaled $433.1 million, down $11.6 million sequentially.

Cash flow from operations during the quarter was $1.4 million.

Net inventory at quarter-end was $19.3 million, down slightly from $20.6 million at the end of Q3.

Inventory turns stood at eight for the quarter, in line with the March quarter. Our inventory turns are relatively high for our industry, and this created some problems for us this quarter relative to product constraints. Looking forward, investors should expect that our inventory levels will increase somewhat in order to avoid similar issues in the future.

Accounts receivable were $27.7 million, up from $27.5 million sequentially. DSOs at quarter end stood at 30 days, similar to the results at the end of Q3.

Accounts payable were $20.1 million, down from $21.6 million in Q3.

Deferred revenue was up $2 million in the quarter. This is due both to the seasonal pattern in our service bookings, which are typically up in Q4 because customers prefer to arrange annual renewal dates to fall in the December and June quarters, and up as a result of product shipments in transit, or not accepted at quarter-end.

During the quarter, we used $13.1 million to repurchase 2.9 million shares, reflecting a pace that was generally in line with our previously stated goal of completing our $50 million share repurchase program within a 12-month period.

To date, we have used $33.7 million to repurchase 7.1 million shares of stock since the beginning of the program.

Other items to note, depreciation and amortization for the quarter totaled $3.8 million, and capital expenditures for the quarter was $1.5 million.

Regarding sale of the [campus], we remain on track to close this and to move to a new campus in the second-half of calendar year 2007. As a reminder, the sale is contingent, most particularly on successful rezoning of the property for residential development. We anticipate that process will take 12 to 18 months from now, and that the sale will be completed at the end of that time.

Turning now to future quarters -- as a reminder, we do not offer specific financial guidance for upcoming quarters. Instead, we will offer some thoughts on issues or trends that could affect our financial performance positively or negatively in the coming months.

Looking first at revenue, on the plus side, we are increasing the size of our sales force. We began to do that in the June quarter and will continue through at least the December quarter, by which time we expect to have increased our sales headcount by about 10% from the beginning of Q4 just completed.

The BlackDiamond 12K is now shipping in both enterprise and service provider configurations and, as Gordon mentioned, the product is currently in tests at a number of service providers, including customers that previously have not purchased Extreme equipment.

In addition, in July, we introduced and began shipping a next generation set of blades for our 8800 modular switch family, as well as several additional members of our Summit X450 fixed-configuration switch family. These new products significantly enhance the performance and features of the 8800 and X450 product lines.

On the revenue risk side, we believe the rate at which we are able to get our new salespeople onboard and productive will be an important driver of our success. In addition, the September quarter is a seasonally weaker quarter for Extreme, in part because European revenues make up a large part of our revenue stream, and in part because it is the first fiscal quarter from a sales plan standpoint.

On gross margins, on the plus side, we expect that additional revenue beyond the levels we saw this quarter would be a positive for both our product and services gross margins. Further increases in our U.S. business would also typically be good for gross margins, in particular.

In addition, we will be moving past some of the incremental product costs associated with the early ramp of the BlackDiamond 12K.

On the risk side, we expect that the large service provider deals that will likely be up for bid in fiscal 2007 will no doubt be highly competitive. In addition, our gross margins, particularly on services, will likely be impacted by higher costs associated with recently enacted environmental regulations.

On operating expenses, we have done a very solid job in controlling expenses over the last year, with operating expenses down 6% year-over-year on a non-GAAP basis. However, we believe additional sales headcount and marketing expenses will play an important part in increasing our revenues and returning to positive year-over-year revenue comparisons.

We will also continue to drive our XOS-based new product cycle, in both the enterprise and service provider markets, which is likely to increase R&D spending.

In G&A areas, we do have ongoing litigation that is likely to increase our legal expenses in fiscal 2007.

On balance, taking all these factors into consideration, investors should expect that our operating expenses will rise from the $45.5 million we saw this quarter, not including stock-comp expenses.

We will continue to monitor our balance sheet metrics -- which I believe are generally very good, relative to our peers in the industry -- and we expect to continue our share repurchase program.

Our anticipated tax rate for fiscal 2007 is 20%.

As always, I will note there are risks associated with our business. Investors should note our quarters are back-end loaded with approximately 50% of our business done in the last month of a quarter, so it is fair to say our visibility can be limited. It is still a case where one or two large deals a quarter can make the difference between sequentially up or sequentially down revenue.

With that, let me turn the call back over to Gordon.

Gordon L. Stitt

Thank you, Bill. To conclude, I wanted to thank our team of very dedicated employees here for their hard work during the past year. This has been a challenging time, but you have performed magnificently and positioned us for success during this new year.

As this is Bill Slakey's last call with us as CFO, I would like to thank Bill for his contributions to Extreme and for his tireless efforts towards our success. Speaking for the team here and for the Board, we all wish him the very best in his future endeavors.

With that, I would like to open the call to questions.

Question-and-Answer Session

(Operator Instructions)

The first question is from Tim Long, with Banc of America Securities. Please go ahead.

Jeff Hubert - Banc of America Securities

Good afternoon. This is Jeff Hubert dialing in for Tim. A couple of questions. On the product revenues, weak again sequentially. Would product revenues have been up without the push-outs? Are these deals now closed?

William Slakey

Yes, potentially, product revenues would have been up without the constraints. The deals were closed last quarter. We were simply constrained on products, particularly in Europe.

Jeff Hubert - Banc of America Securities

So that should be fulfilled this quarter?

William Slakey

Yes, sir.

Jeff Hubert - Banc of America Securities

Then, on the supply issues, were those at EMS or were they more at the component level?

William Slakey

A little bit of both, somewhat related to the environmental regulations and component changeovers that were happening across the space during June.

Jeff Hubert - Banc of America Securities

But those issues are resolved now?

William Slakey

They will be resolved this quarter.

Jeff Hubert - Banc of America Securities

Still a little bit of carryover?

William Slakey

Yes, but we expect them to be taken care of shortly.

Jeff Hubert - Banc of America Securities

Last question, obviously with some major management changes, were there any sales force retention issues and changes in the quota-carrying sales force? What are you doing to make sure your quota-carrying sales force stays with Extreme and remains loyal during these transition days?

Gordon L. Stitt

First of all, there are some management transitions but as I noted, I am not leaving the company, just taking a different position. I think that is important for all of our employees, who understand that.

Secondly, if you look at the Americas, where we have had the most attrition during the last several quarters, we were very aggressive in our hiring during the June quarter. We brought on a lot of folks. We began this quarter, the September quarter, with a full team in place and with a new VP of Sales for the Americas.

If you look at that, we are starting off the year very, very strong, and our plans are to continue to hire within the Americas and to grow that sales force, given where we are with product and momentum.

Jeff Hubert - Banc of America Securities

Thank you.

William Slakey

Thank you. We are going to try and keep the questions limited to one per analyst, just to make sure we can get through everyone. Next question, please.

Operator

Thank you. The next question is from Samuel Wilson with JMP Securities. Please go ahead.

Samuel Wilson - JMP Securities

Good afternoon, gentlemen. A question and a clarification. First, a clarification -- based on last quarter's product sales, and what you did this quarter, it was at least a $3 million to $4 million deferral, or was it greater than that?

William Slakey

I do not want to put a specific figure on the deferral, or the constraints because there is a lot of moving parts there. Bookings were up and we had more revenue than we could ship, and we have it in backlog for this quarter.

Samuel Wilson - JMP Securities

Sure, but your revenues were down significantly. You could have been down in revenues and still had bookings above. Do you think if you would not have had the constraints, would you have met Wall Street estimates of $88 million for revenue?

William Slakey

Not necessarily, no.

Samuel Wilson - JMP Securities

Then, my question -- can you just give us an update on how OEM sales are going for the products you launched at NetWorld and Interop, or Interop, or whatever it is called this year -- you know, the security stuff?

Gordon L. Stitt

I am sorry, Sam, I am not sure what you mean by OEM. You mean the security products?

Samuel Wilson - JMP Securities

Yes, the security products and then the relationship with ISSX and those things.

Gordon L. Stitt

The relationship with ISS, we did not expect to have revenue during this past quarter, or even in the September quarter because there is joint development going on there, but that development is progressing and that is moving ahead towards our expectations.

Samuel Wilson - JMP Securities

Then on the rest of the other products you announced?

Gordon L. Stitt

The other products, our Sentriant, original Sentriant, continues to sell well and the Sentriant AG is just launching and shipping this quarter.

Samuel Wilson - JMP Securities

Thank you very much.

William Slakey

Thank you, Sam. Next question, please.

Operator

Thank you. The next question is from Subu Subrahmanyan with Sanders Morris Harris. Please go ahead.

Subu Subrahmanyan - Sanders Morris Harris

Thank you. My question is on your hiring plans. You talked about having a full team now. Where the focus is going to be on hiring, any particular geographies that you are going to focus more in terms of hiring? When do you expect to be done and start seeing the benefits of that hiring in terms of revenues?

Gordon L. Stitt

I do not think we will ever be done. If things are going well, we will continue to hire sales reps. Your question in terms of where our focus is, is primarily in the U.S. and North America, and then also in EMEA. The U.S. has been a disappointment to us over the last year, with the exception of the last two quarters where we have seen an increase in sales, but we have really regained a lot of confidence in our local home market here.

As I said, we enter the quarter with a full team in place with all slots filled, and we began the quarter by opening up additional positions which will allow us to open up in cities where we did not have a presence, and also increase our density of sales reps and systems engineers in some of the existing cities.

Subu Subrahmanyan - Sanders Morris Harris

I was trying to figure out, when the op-ex ramp starts to kind of tail off, and when will be kind of in a more steady-ish op-ex kind of environment?

Gordon L. Stitt

Particularly again focused on the sales area, we expect that we are aggressively hiring this quarter to have people in place as early in the year as possible. Then it will taper off as we move into the December quarter, in terms of the increase.

Subu Subrahmanyan - Sanders Morris Harris

You expect the benefits more in early calendar '07 from these hires?

Gordon L. Stitt

We expect some near-term benefits, particularly as we put people into existing regions. Where we have some regions -- for example, today where we might have one or two reps and they are running full out, but we have an installed customer base, so putting reps into those cities should bring a fairly near-term benefit. As we open up new territories, that generally is more of a six-month window to get sales moving.

Subu Subrahmanyan - Sanders Morris Harris

Thank you.

William Slakey

Thank you. Next question, please.

Operator

Thank you. The next question is from Jiong Shao with Lehman Brothers. Please go ahead.

Jiong Shao - Lehman Brothers

Thank you very much. I actually have a question with two parts, obviously they are related. The first part is, other than the supply constraint, it sounds like due to RoHS, did you see any changing demand towards the end of the quarter? Do you see any slowdown or not? Then, extrapolate that to the next quarter. If I look at the last three years, your September quarter was either flat or up a couple of percent. You already mentioned that it is seasonally the toughest quarter, but this year you have some push-out orders from the June quarter. Just directionally, how should we think about that? Should we think about likely to be down, slightly up a little bit like in past quarters? Thank you.

William Slakey

Again, we do not want to get into giving guidance for any particular quarter. On the plus side, from a revenue and a bookings standpoint, we will have a larger sales force going after orders. We will enter the quarter with some amount of backlog, a larger backlog than we entered the last quarter. Those would be some of the important positives, along with some of our new products availability and 12K.

On the downside to that, typically the seasonal patterns would be somewhat weaker on an ongoing bookings basis, but I am going to leave it to you to decide exactly how to calibrate that in your model.

Jiong Shao - Lehman Brothers

Okay, sure. The first part?

William Slakey

Regarding linearity or demand through the quarter?

Jiong Shao - Lehman Brothers

No, the demand toward the end of the quarter. Did you see any softening in demand in the month of June or towards the second half of June?

William Slakey

No, with 50% of our business done the last month of a quarter, which is very typical and was typical this last quarter, that last month usually looks pretty good to us, and it was the case this time around.

Gordon L. Stitt

Next question, please.

Operator

Thank you. The next question is from Tal Liani with Merrill Lynch. Please go ahead.

Tal Liani - Merrill Lynch

I want to ask about the history, actually, not the outlook. Your revenue this quarter is down to levels that we have only seen, I think, lower than this level was only March of 2000. Throughout the difficult years of the industry, you maintained over $82 million of revenue. If you look at the last three quarters, you had sequentially down revenues, both on a sequential basis and a year-over-year basis, but your commentary is very positive, which is confusing me, given the negative trends we have seen in the last three quarters.

Can you go back and look at the fiscal '05, fiscal '06 -- what led to this decline in revenues almost every quarter? What led to the step-down from $95 million to $100 million of revenues per quarter to $82 million to $85 million per quarter? Why didn't we see better revenues, given that you did have product cycles and you did invest in sales and new channels before that?

William Slakey

Going through the '05 to the '06 comparisons, I think there are two things that stand out to me. One is that we did grow our business in Europe 6% year over year, we did grow our business in Asia 25% year over year. Japan has been a real problem spot for us. Those revenues have come down to the point now where there is $5 million to almost $10 million less in quarterly revenue there for us, and for a company our size, that takes a lot out of the growth rate.

Now, looking forward, how do we expect to improve on that? An awful lot of that comes down to capturing some portion of the next generation networks that are going to roll out there on the service provider side, and doing what we can to expand our enterprise business there.

Obviously we have not had the success on those fronts that we had hoped over the last two quarters, but that remains the plan, and I think we are getting closer to hopefully seeing some improvement there.

Then, the second issue that hit us was the U.S. business in the December quarter of this year fell off unexpectedly, and Gordon has taken you through some of the steps that we are taking to address that. I think there we are starting to see some apparent visible in the financial results, tangible results from those efforts. Revenues are starting to grow again in the U.S. We have product cycles that can help there, and now we will have an expanded sales force and new sales leadership, all of which I think can get us back on track in the U.S.

The '05 to '06 comparisons are in large part problems in Japan, somewhat less problems in the U.S. Going forward, we are trying to address both those things as well as keep Europe and Asia on track.

Gordon L. Stitt

Just to echo some of Bill's comments, because I think your question is an important one. If you look at the decline in Japan and you look at us overall, managing these four major geographies, when we have seen the decline there, which is heavily influenced by a carrier pause, and we have certainly heard this from other companies in this space, but because that was such an important part of our business two years ago, it has had a big impact. If you just think of it, that is a big hole to fill with growth from other regions.

As Bill mentioned, Europe has grown, but the combination of Japan falling off and then some missteps in the U.S. really hurt.

I do believe we have the U.S. poised for a strong rebound here. We have a full team in place. We have a new Vice President in place, and last year, last calendar year particularly, we experienced a lot of turnover. If I look back, we had a lot of people on our sales force who had been on board for a long time. We kind of hit the natural half-life of salespeople. We brought on a lot of new folks, a lot of energy in our organization here in the U.S., in Europe and in Asia as well. As you bring in new people, they really help energize the whole team.

That is one of the reasons that I for one see I have a lot of optimism looking forward.

Tal Liani - Merrill Lynch

What has been the historical relationship between new product launches and revenues? Have you seen in the past rapid correlation or rapid impact on sales, or has it been slower sort of impact?

Gordon L. Stitt

There are two factors that are linked to revenue. One is, let's call it sales headcount, in that the more salespeople you have, the more sales you will get. The challenge there is the one of productivity.

I think as we look back over the last couple of years, we can see our sales productivity vary at different points in the product cycle.

If you look at where we are today, we have spent the last two years really refreshing our enterprise product cycle. With the new Aspen blades and the new Jaguar stackables, we have revamped the bulk of the middle of our product line in enterprise, and I think that, combined with a lot of the convergence features, should help sales productivity in that we have added a lot of stuff, a lot of features that gives them tools to sell, so I think that should help.

Carrier productivity is a bit more difficult to predict and plan for, given the buying cycles of carriers.

As Bill noted, there was a shift, enterprise grew a little more rapidly. As I mentioned in my prepared comments, we are seeing a transition in the metro ethernet carrier space going from what I will call the first generation, which was a best efforts with quality of service, and that has been a five-, call it six-year, seven-year run now. It has been a great run for us and for other players, but the carriers have saturated that market, if you will, and the new market is the triple-play market.

That is requiring more planning. It is a more complex network environment. Although I could not prove this to you with numbers, I inherently feel and believe that we will see that market start to rapidly grow once the first few networks get deployed. So we are in of that low productivity sales cycle with metro, where we are going through trials and getting it in front of the customers.

Once they start to deploy, I believe sales productivity will go up.

William Slakey

Let's move on to the next question, please.

Operator

Thank you. The next question is from Long Jiong with UBS. Please go ahead.

Long Jiang - UBS

My question is related to your 12,000 carrier switch. A while back, you mentioned that you are targeting ramp-up in this segment in the second half of this year. Based on the progress so far, do you think you are on track towards a second half ramp-up for this segment? Related to that, for the ongoing bids that you are competing, what does the average deal size look like? Can you give us some color on that?

I know the bidding process is highly competitive. Do you think gross margin for service provider ethernet, how high does it compare to your enterprise modular switching product segment? That would be great. Thank you.

Gordon L. Stitt

I think there are about a dozen questions in there. Some of them are very difficult to answer, because we do not have the results yet. We do not have the numbers to say that. I would say the business though breaks down into two general segments, and that is taking the carrier business. There are some very large carrier customers.

Those deals do tend to be very competitive. They do tend to take a while, in terms of the initial lab trials and then field trials and then final selection. Those deals do tend to be competitive.

There are a lot of other carriers that are more of what I will call the mid-tier. We talked about one in the prepared comments in terms of T2 in Slovenia -- a great customer for us, a good bit of revenue, but not gigantic.

There is a mix of the mid-sized carriers, and particularly in emerging markets, and then the very large carriers that are in more established markets. We have a lot of the mid-sized customers that have deployed the 12K technology. We are in discussions and trials with some big guys.

William Slakey

Next question, please.

Operator

Thank you. The next question is from Manny Recarey with Kaufman Brothers. Please go ahead.

Manuel Recarey - Kaufman Brothers, L.P.

Thank you. Good afternoon. My question is, looking at the operating profit, excluding stock-based compensation, I think it is a loss of $1.7 million. Revenue in the September quarter is going to be I assume somewhere plus or minus a little bit of what was in the June quarter. Your op-ex is going to be higher. Are you expecting any improvement on the operating income line? When do you think you will be able to return back to an operating profit?

William Slakey

Again, we do not want to get into guidance regarding next quarter or the quarter after that.

As Gordon mentioned, we will not be shy here about hiring on the sales team and spending something on marketing to get demand going, and spend some of that money first, with the anticipation that revenues will follow. Exactly how fast revenues follow will go a long way towards determining where we are profitable and when we are profitable and how much we are profitable by.

For right now, we are not going to give any guidance as to levels of profitability or non-profitability going forward.

Operator

Thank you. The next question is from Mark Sue with RBC Capital Management. Please go ahead.

Jennifer Tannenbaum - RBC Capital Markets

This is Jennifer Tannenbaum for Mark. Just a question on Japan -- you changed management there about a year ago and I think you had one or quarters there of sequential growth, and then it kind of dropped off. Just wondering if you are thinking about making any more changes there in the management or the sales team in Japan.

Gordon L. Stitt

We have a good organization in Japan. I think we have seen from a number of networking companies that, you know, that market has been pretty rough for them. We have seen that from some companies that are partners and some that are competitors. There has been a pause in carrier spending as the Japan market figures out how it is going to implement its next generation network.

Unfortunately, there is not a lot that the team can do about that. We are certainly working very closely with our existing customers there and with new customers. Once the decisions are made on these carrier build-outs, I think we will have a lot of information about our future success there.

Jennifer Tannenbaum - RBC Capital Markets

So it is not really on the enterprise level then at all in Japan, or a little bit, a mix?

Gordon L. Stitt

A lot of the drop-off in Japan has come from the carrier build-outs.

William Slakey

Thank you, Jennifer. Next question, please.

Operator

Thank you. The next question is from Eric Suppiger with Pacific Growth Equities. Please go ahead.

Erik Suppiger - Pacific Growth Equities

First off, just in terms of the CEO search, do you have any projections as to when that might be done? Secondly, I would be curious, in terms of Japan and the pause that you were referring to, do you have any expectations as to when we might start seeing the build-out of the next generation networks there?

Gordon L. Stitt

Boy, Eric, you asked the two tough questions which result in pure speculation on my part.

On the CEO search, that is very difficult to give a date. I can tell you that we -- and that is our search committee, of which I am a member -- have spent a lot of time in the last several months working on this. We have been at this for three-and-a-half months. We have screened literally dozens and dozens of folks, and had extensive interviews with a smaller number. As I said, I am really pleased with the caliber of people. I think what we have seen in the industry through consolidation and change has resulted in a lot of just terrific executives being available in the marketplace.

We have had the opportunity, quite frankly, to be choosey, but the negotiations with people are time consuming, so I do not want to speculate, other than that we have put a lot of effort and hours into this and we want to make it happen soon.

On Japan, I think some of the directions will be set. I will just say during the summer here. As soon as we learn anything, we will make sure to let you know.

William Slakey

Next question, please.

Operator

Thank you. The next question is from Alex Henderson with Citigroup. Please go ahead.

Alex Henderson - Citigroup

I have a couple of quick questions that are actually more clarifications. First off, what exactly is the timing that you are expecting on the sale of the headquarters?

William Slakey

It is contingent upon re-zoning, which is a difficult process to predict entirely. For that reason, we are putting a six-month window on it, call it the second half of next calendar year, calendar 2007.

Alex Henderson - Smith Barney Citigroup

Second half, calendar. What did you say the moving cost was going to look like when you finally do sell it and need to move out?

William Slakey

I don't think we have said to date, but I would anticipate it would be somewhere in the area of $10 million to $15 million to move out and refit new building.

Alex Henderson - Smith Barney Citigroup

So the net cash increase would be what?

William Slakey

Under that scenario, the net cash increase would be $55 million or more.

Alex Henderson - Smith Barney Citigroup

$55 million. Second, what was the ending share count? I know the average share count for the quarter, but what was the actual ending share count given you were buying back stock?

William Slakey

Yes, it was 117.3 million.

Alex Henderson - Smith Barney Citigroup

The other question was, the legal expense comment, you were implying that your legal expense is increasing. Can you give us some sense of the magnitude and duration of that increase?

William Slakey

Well, we have a number of legal issues that we disclosed in our 10-K, primarily IP related. A fair number of those are going to come to a head here in the next 12 months. They're difficult to predict. Sometimes they result in settlements, sometimes they result in ongoing legal expenses, sometimes they result in trials.

But on balance, Alex, there are enough of them coming to a head in the next 12 months that we need to flag for investors our legal expenses are going to be increasing. They will be a bit lumpy.

Alex Henderson - Smith Barney Citigroup

Are we talking $100,000 a quarter, or $0.5 million a quarter, $3 million a quarter, I mean any, just give us a rough zoning of that?

William Slakey

You bet. We're not talking $100,000, we're talking $500,000 to $1 million and potentially more if things go to trial in a particular quarter.

Alex Henderson - Smith Barney Citigroup

And so maybe $0.5 million in an off quarter and $1 million in a heavy quarter?

William Slakey

We'll just have to see.

Alex Henderson - Smith Barney Citigroup

I'm just trying to understand how to think about it so I mean we've got to model this stuff, right?

William Slakey

Yes, you do. Model it nearer $1 million than $100,000. How's that?

Alex Henderson - Smith Barney Citigroup

This one's a little bit more of a technical question with respect to your carrier business. A lot of companies when they enter large new carrier environments find that they are putting technology in place that goes against new applications. Those new applications force some performance criteria on the deployments.

Are you anticipating software accounting rules to kick in, resulting in you having extended revenue deferral timing on some of these larger customers that you might be going after?

William Slakey

Well, right now, of course, we follow the same revenue recognition we've been following for some time. We do look at revenue recognition and will continue to look at it. Right now, I expect we'll continue to follow our existing policies for the next generation rollout, but as you can imagine -- and Alex you went right through the issues -- increasingly as software becomes a bigger part of what you do, you have to examine and re-examine your rev rec on an ongoing basis.

Gordon L. Stitt

Just one final comment there. Certainly, there are some companies that sell into that market where there's large deferrals due to qualification by the customer and we haven't seen that in the past. In general, we do a lot of the work upfront before the orders come in, before the shipments are made.

So for example, for some of the customers that we're working with in trials today, we've been doing software development for 12 months and hardware development as well for some special features for them. So we tend to do that upfront.

Alex Henderson - Smith Barney Citigroup

One last comment. Thanks for your time and efforts at Extreme, Bill. Good luck in your new endeavors.

William Slakey

Thank you. I appreciate that.

Gordon L. Stitt

Operator, I believe we are finished with the Q&A. With that, I'd like to thank everybody for their time on this call. Again, I'd like to thank Bill for his contributions and to welcome Mike Palu here into the hot seat. Thank you very much, everyone.

Operator

Thank you, sir. Ladies and gentlemen, this concludes today's conference call. (Operator Instructions) You may now disconnect.

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Source: Extreme Networks F4Q 2006 Earnings Conference Call Transcript (EXTR)
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