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Gene Skayne - Head of Investor Relations

Bob Mao - Chief Executive Officer

Jay Zager - Executive Vice President and Chief Financial Officer

Ron Sege - President and Chief Operating Officer

Dr. Shusheng Zheng - Executive Vice President and H3C Chief Executive Officer


Steven Salberta - Boenning & Scattergood

Jeff Kvaal – Barclays Capital

[Jonathan Kofsky] – Sanford Bernstein

Nim Park – Goldman Sachs

3Com Corporation (COMS) F1Q10 Earnings Call September 24, 2009 8:30 AM ET


(Operator Instructions) Welcome to this 3Com Quarterly Earnings Conference Call. At this time for opening remarks and introductions, I would like to turn the call over to Gene Skayne, Head of Investor Relations.

Gene Skayne

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’ll go back to Bob who will open the meeting for questions. I would also like to add that joining us today are Ron Sege, 3Com’s President and Chief Operating Officer, and Dr. Shusheng Zheng, 3Com’s Executive Vice President and H3C Chief Executive Officer.

Let’s start with our Safe Harbor disclosure. The remarks to be make 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, 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.

Bob Mao

We’re pleased to report that 3Com delivered another solid performance in the quarter, exceeding our guidance for revenue, operating profit, earnings per share, and cash. Our revenue came in at $290.5 million US dollars. We achieve non-GAAP operating profit of $26.3 million. We delivered non-GAAP earnings of $0.08 per diluted share and we continue to generate cash from operations, ending the quarter with $666 million in cash and short term investments.

We saw business stabilize in the quarter across all our geographies. The North America, Asia/Pacific, Latin America regions each showed sequential revenue growth, while the Europe, Middle East, and Africa regions delivered essentially flat sequential revenue. Our Direct Touch China business continued to do well, delivering strong sequential and year over year revenue growth in the quarter. As expected, and discussed during the previous earnings call, sales for Huawei declined in the quarter.

Our security business TippingPoint had another solid quarter delivering year over year and sequential revenue growth. We’re gaining market share in the enterprise networking space. A recent report by the Dell’Oro Group showed that the second quarter calendar this year was the fourth consecutive quarter we increased our market share for enterprise Ethernet switching port shipped. That report also showed that we grew our revenue shares for the second consecutive quarter. We continue to expand into new markets as we build on the existing strengths in select verticals.

We just had our first data center wins outside of China with our S12500 switch. To frame my commentary on our regional and segment results I would like to summarize our view of industry trends. In meetings with larger enterprise customers and channel partners we have observed three important trends:

Value, which I have referred to in previous calls, continue to be prevalent in customers evaluation and selection criteria for networking purchases. 3Com’s broad product line combined with our significant price performance advantage and strong feature set resonates in today’s marketplace.

Virtualization and consolidation of corporate and service provider data centers are at the forefront in customer’s minds. As a result, we’re seeing great interest in our data center solutions. In addition, our products are being recognized by independent testing labs for delivering significant performance advantages and energy efficiency.

Heightened security demand at multiple layers of the network is another trend that we’re seeing. Recent high profile cyber crime attacks on websites and retailers coupled with increasing compliance requirements are driving interest in security solutions. With H3C and TippingPoint solutions 3Com is uniquely positioned to meet these needs.

Let me now turn to our regional and segment highlights. We continue to expand to different vertical markets in China. For example, we’re making good progress in the China carrier market where we have become a leading supplier of Wi-Fi networks to China Telecom and China Mobile. In Shanghai we are the provider for a series of projects for the World Expo 2010. The Expo will deploy several of our switching and routing platforms as well as our security and surveillance products, and our intelligent management center (Pending:IMC).

We also have significant wins in corporate data centers where we’re deploying our data center switching solutions, the S12500 along with routing and security solutions for such customers as Hsiang-Ya Hospital which was established by the Yale China Association. Tangshan Railway Vehicle, the manufacturer of China high speed trains and Guangdong Provincial Taxation Bureau.

North America revenue increased sequentially for the second quarter in a row. During the quarter we won a core to edge network solution for Taser International, a developer and manufacturer of advanced electronic control devices for use in the law enforcement and related markets. Taser is launching a new service that requires a combination of switching, routing, Ethernet connectivity, and managed servers. 3Com is providing a single vendor solution with worldwide logistic support for implementation, warranty, maintenance, and network management.

Revenue in EMEA stabilized in Q1 coming in flat with the prior quarter. We continue to get traction with our focus on enterprise networking markets, winning several marquee accounts in Q1. For example, our team won a major deal with auto manufacturer Peugeot Citroen. Peugeot will use H3C enterprise networking solutions as a significant part of its land infrastructure. Another large EMEA win in the quarter was the Russian Savings Bank, one of the oldest and largest banks in Russia. We’re providing a broad range of H3C core and stackable switches for their networking structure.

We’re also seeing our business stabilizing in Latin America with modest sequential growth in the quarter led by Brazil. Brazil’s airport administration INFRAERO expended its relationship with 3Com selecting our high performance core to edge networking solutions from H3C for more airports.

In Argentina we are providing a combined wire and wireless solution for SENASA the agency responsible for insuring and certifying the health and quality of agriculture production, fisheries and forestry.

Finally, our Asia/Pacific region showed recovery in the quarter delivering solid sequential revenue growth. The Asia/pacific team delivered a major win at the Malaysian Ministry of Foreign Affairs during Q1. The Ministry will use 3Com’s H3C enterprise solution portfolio to upgrade their network backbone. Our significant wins in the quarter also includes secure voice ready network deals with UMMC the second largest hospital in Malaysia and core and edge networking solutions for Australia’s Liverpool Council which governs 38 suburbs.

Turning to our security segment, customers are demanding better security at multiple layers of the network. In response to their needs we announced the unique three element strategy that integrates solutions from H3C and TippingPoint. First, we’re now shipping worldwide new flexible security appliances and embedded security blades in our H3C switches.

Second, we will be integrating TippingPoint technology as blades in our H3C switching solutions. This will enable our customer to cost effectively leverage our award winning TippingPoint digital vaccine technology throughout their networks. Third, we’ll help our customers reduce operating costs by delivering unified network and security management based on the TippingPoint security management system and the H3C intelligent management center.

During the quarter one of Europe’s largest energy companies EDF Energy chose the TippingPoint solution to provide land security for nuclear plants.

Turning to our SMB business, during the quarter we updated our popular baseline plus 2900 family. The baseline 2900 is our lead gigabit Ethernet smart managed product line. The new models are more energy efficient, deliver more ports for the money and add new enterprise class features such as static routes, link layer discovery protocol and single IP management.

Now a few words on our sales and marketing activities. We continue to make investments in dedicated customer facing resources to address the enterprise markets throughout the world, while remaining focused on profitable growth in each of our regions. Our strategy remains to use Direct Touch resources to win marquee accounts and to use market visibility from these wins to attract large enterprise bars and system integrators. A good example of this strategy is our win at the Russian Savings Bank where we worked in partnership with one of the largest system integrators in the country CROC.

We’re focused on continuing to improve our sales productivity through better opportunity targeting and qualification and tighter sales and pipeline management.

Now I will turn the call over to Jay.

Jay Zager

Q1 was another solid quarter for 3Com. Revenue was $290.5 million a sequential decline of 1.5% and 15.2% lower than a year ago. Revenue exceeded our guidance as our non-China business particularly in North America and Europe finished stronger than we initially anticipated. Favorable currency translation contributed $2.8 million to our results.

On a GAAP basis our net income was $7.5 million or $0.02 per diluted share. This compares with net income of $79.8 million or $0.20 per diluted share a year ago. Last year’s results benefited from a one time $70 million gain from the resolution of a patent dispute. On a non-GAAP basis our net income was $30.6 million or $0.08 per diluted share compared with prior year net income of $43.4 million or $0.11 per diluted share.

Our networking business had sales of $259.2 million, 17.9% lower than a year ago and 2% lower sequentially. Within networking our China based sales segment had revenues of $152.0 million consisting of China Direct Touch sales of $118.3 million, a year over year increase of 16.2% and 4.2% higher sequentially. Huawei sales of $28.1 million, which was 57.3% lower than a year ago and down 36.8% sequentially, and other sales of $5.6 million primarily reflecting sales in Hong Kong and Japan.

We were extremely pleased by the strong showing of our China Direct Touch sales. Sales were strong in many of our key verticals including finance and banking and to several major internet service providers. In addition, we saw significant growth in sales of our Wi-Fi network solutions to key carrier customers. The decline in sales to Huawei was in line with our expectations and continues the trend that began in the second half of our last fiscal year.

In this quarter Huawei sales represented 18.5% of China based sales and 9.7% of 3Com’s consolidated sales. It is important to note that of our $52.2 million year over year revenue decline $37.7 million or 72% was attributable to the decline in Huawei sales. This was a far greater contributor to our year over year decline then was the weakened economic environment.

Our rest of world network segment had revenues of $107.2 million a year over year decline of 23.6% but a 4.9% sequential improvement. This sequential improvement is a positive sign that the networking market is stabilizing. Within rest of world networking sales North America had sales of $30.2 million, 12% lower then a year ago and 8% higher then Q4. EMEA had sales of $42.1 million, 32% lower then a year ago but essentially unchanged from Q4. During the quarter we saw positive signs in several European countries particularly in France, while Eastern Europe continued to show weakness.

Latin America had sales of $17.7 million, 24% lower then a year ago and 3.3% higher then Q4. Within Latin America we were encouraged by the improved performance in Brazil while Mexico continued to show weaker performance.

Asia/Pacific had sales of $17.2 million, 19% lower then a year ago and 17% higher then Q4. We continue to see a strong pipeline in all of our rest of world regions and we are encouraged by these results.

Overall the networking business had a gross margin of 55.4% and operating income of $21.3 million, those are on a non-GAAP basis. TippingPoint’s Q1 sales were $32.6 million a year over year increase of 15.6% and 0.7% higher sequentially. Within this total product revenue was $19 million and maintenance revenue was $13.6 million. On a non-GAAP basis TippingPoint’s gross margin was 72.4% and its operating income was $5.0 million or 15.4% of revenue. Our TippingPoint management team is focused on growth while simultaneously improving the profitability of the business and we’re seeing the results of these efforts.

From a consolidated viewpoint 3Com’s Q1 non-GAAP gross margin was $167.1 million or 57.5% of sales compared with 55.6% of sales a year ago and 60.1% of sales in Q4. Our Q4 results included the favorable impact of several one time adjustments. R&D expenses on a non-GAAP basis were $38.5 million or 13.3% of sales compared with $46.3 million or 13.5% of sales a year ago.

Sales and marketing expenses on a non-GAAP basis were $83.2 million or 28.6% of sales compared with $85.7 million or 25.0% of sales a year ago. As we indicated during last quarter’s conference call we increased sales and marketing resources in China and at TippingPoint as part of our overall evaluation of the market opportunities in those two segments.

General and administrative expenses on a non-GAAP basis were $19.1 million or 6.6% of revenue compared with $21.4 million or 6.2% of sales a year ago. Starting this quarter we have made a minor change in the way we calculate G&A expenses in that we are now allocating all IT and real estate costs to each P&L line item. Any prior period presented in our published financial data have been adjusted to conform to this year’s presentation.

Ending Q1 headcount was 5,814. Operating profits on a non-GAAP basis were $26.3 million or 9.1% of sales compared with $37.0 million or 10.8% of sales a year ago. We exceeded our operating profits guidance this quarter as a result of the higher then expected revenue results. Net interest expense was $1.1 million while other income was $11.5 million reflecting the VAT software subsidy in China.

Our non-GAAP profit before tax was $36.8 million. Our tax provision of $6.2 million primarily reflects tax expense in jurisdictions unable to leverage our NOLs primarily China. As a result of these factors our non-GAAP net income was $30.6 million or $0.08 per diluted share.

Looking at our balance sheet our cash balance including short term investments was $665.8 million compared with $644.2 million at the end of fiscal year 2009. During the quarter we generated $16.9 million of cash from operations despite a $48 million long term incentive payment to our Chinese employees. We continue to carefully manage our cash and in Q1 we had strong working capital performance. As we indicated in our last conference call we were able to move about $155 million of cash from China to our other operations.

Accounts receivable were $101.5 million a reduction of $11.3 million from Q4. Our DSO on the quarter was 31 days compared with 34 days in the prior period. Notes receivable were $46.9 million compared with $40.6 million in Q4. Inventory was $86.2 million a sequential reduction of about $4 million. Capital spending was $3 million down from $3.8 million in Q4. Our debt balance remained unchanged at $200 million. Next week we plan to make a scheduled principal payment of $48 million. We also plan to make an additional accelerated payment of $40 million. These two payments will reduce our overall debt balance to $112 million.

Now I’d like to provide some insights into the current quarter and briefly comment on the full year. Q2 should be another solid quarter for 3Com. We’re currently projecting revenues to be slightly higher this quarter in the $295 to $305 million range. Within this total we expect that China based sales will show a modest sequential improvement. This growth will come from our direct sales business which has continued to experience strong sequential growth. Sales to Huawei will decline sequentially and should be in the $15 to $20 million range.

In the networking rest of world and at TippingPoint revenue should be slightly higher then Q1. Gross margins should remain at or about the Q1 levels. G&A spending is expected to be essentially flat when compared with Q1 while R&D and sales and marketing expenses are expected to increase sequentially consistent with our strategy to continue to invest to support future growth opportunities.

As a result of these factors we anticipate that Q2 non-GAAP operating profits should be essentially unchanged from Q1. We expect or record a tax provision of about $8 million in the quarter. In addition, we expect to record a one time $10.8 million favorable tax adjustment to the quarter reflecting the final resolution of the calendar year 2008 tax rate in China. This $10.8 million adjustment will not be reflected in our non-GAAP results.

Earnings per share on a non-GAAP basis should be between $0.06 and $0.07. Despite the $88 million loan payment projected to be made in Q2 we expect our cash balance to remain essentially unchanged from Q1.

Regarding the full year, we expect that sales to Huawei will be between $60 and $80 million. We continue to believe that it may be difficult to fully offset this projected Huawei sales decline in fiscal year ’10.

Now I’d like to turn the meeting back to Bob.

Bob Mao

We are pleased with the start to our new fiscal year and the opportunities we see ahead of us. For fiscal year 2010 we will continue to make appropriate investments in anticipation of the expected economic recovery. With a strong comprehensive product portfolio we’re well positioned for worldwide top line growth in FY11 and beyond.

Now I would like to open the meeting to questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Steven Salberta - Boenning & Scattergood

Steven Salberta - Boenning & Scattergood

Can you give us some statistics around the deal sizes you’re seeing in both the North American market and in China and overall volume of deals that you’re seeing?

Bob Mao

We’ll have Ron Sege answer you on the North American side.

Ron Sege

I can’t give you the specific stats but I can tell you that in North America deals size and deal activity are definitely increasing both quarter on quarter and year on year. This is consistent with our strategy of refocusing from SMB to large enterprise. We’re definitely moving to more of an annuity business in North America and the rest of our rest of world regions.

Bob Mao

Our China side is a large market we are doing large volume. Our average size of deals is in the $200,000 to $300,000 US dollar range with large projects going upwards to $5 or $6 million. Of course the small end goes into the tens of thousands.

Steven Salberta - Boenning & Scattergood

Can you discuss the China carrier business? You mentioned a couple deals there and I assume that you’re competing pretty aggressively against Huawei for that business. What does pricing look like and what sort of gross margins can you generate from those deals?

Bob Mao

As we said, the China carrier side with China Telecom and China Mobile we are winning in the Wi-Fi networks. In this one we are competing with many providers and Huawei is one of the providers.

Jay Zager

Traditionally our sales to Huawei cover primarily our switching and routing products. We have never had an OEM agreement with Huawei on Wi-Fi networks. This is a business that we’ve been able to compete with traditionally.

Bob Mao

Its not just a couple of deals it is deals through many provincial city networks which China Telecom and China Mobile offers.

Steven Salberta - Boenning & Scattergood

The deal that you talked about on the call they were through Huawei OEM.

Bob Mao

The Wi-Fi are direct. The Wi-Fi networks we deal directly with China Telecom and China Mobile.

Jay Zager

Those deals are showing up in our China Direct Touch sales, which is one of the reasons why we’re able to have significant year over year growth in that business, I think it was up 16% year over year.

Steven Salberta - Boenning & Scattergood

Can you discuss what the margin the China networking gross and operating margins should look like? If we went to the low end of your fiscal year $60 million guidance for Huawei what should the margin structure look like if we went to the high end what would it look like in that scenario?

Jay Zager

Pricing tends to be relatively consistent around the world. In general the margins on our China products sold in China is essentially equivalent to those margins sold in the rest of the world. There’s no particular difference in the margin structure in China.


Your next question comes from Jeff Kvaal – Barclays Capital

Jeff Kvaal – Barclays Capital

Would you mind talking a little bit about where the pipeline is coming from and whether you think the strengthening quarter on quarter despite the higher revenues or how we should think about this trajectory there with the comment about how quickly that is turning into revenues for you folks?

Bob Mao

I’ll let Ron answer this question.

Ron Sege

You’re asking in terms of verticals or you’re asking in terms of geography?

Jeff Kvaal – Barclays Capital

Geography was the way I was thinking of it but also compared to where you might have been a quarter ago and then how your progress is in converting that pipeline to revenue.

Ron Sege

The simple answer is its tracking very closely to macro economic activity. As you know we made a significant investment in EMEA sales resources a year ago and the EMEA economy has suffered more then other geographies. As you might imagine pipeline creation has slowed there as well. Conversely in North America we’ve seen perhaps more aggressive increase in our pipeline then we had expected. Latin America is probably somewhere in the middle.

Same thing about conversion or deal velocity it’s slowed down dramatically in all areas of course because of the economy. I’d say it’s showing signs of improvement in North America and EMEA in particular.

Jeff Kvaal – Barclays Capital

I was wondering if you could walk us through some of the most important two to four quarter variables on the operating margin structure as you get back to historical levels.

Jay Zager

The key variable for us is frankly top line growth. As we’ve indicated with the Huawei sales declining this year that’s going to have a substantial impact on our bottom line in particular. It tends to help our gross margin a little bit but as the Huawei sales decline it makes our comparisons of sales and marketing and R&D in China obviously less favorable then they were. We are seeing an overall decline in margins. This quarter came in at 9.1% as the Huawei business essentially gets removed from our base we should see starting next year in particular solid margin improvement as we grow our top line and move back to our project business models.

Jeff Kvaal – Barclays Capital

Would you mind telling us outright what your implication is for cash flow for the next quarter?

Jay Zager

What we said was we expect cash flow to be essentially flat. We will generate a significant amount of cash from operations but next week we’re going to make an $88 million debt repayment and so we expect that we will be able to fully offset that cash with strong operations performance. At this point we expect to end Q2 with roughly the same cash balance we had in Q1 but obviously our net cash position will be about $88 million stronger.


Your next question comes from [Jonathan Kofsky] – Sanford Bernstein

[Jonathan Kofsky] – Sanford Bernstein

Have you seen Huawei competing in the enterprise market in China? In the enterprise market in China can you talk about your revenue split between system integrators and bars and Direct Touch now and where you expect that to go?

Jay Zager

We don’t provide that level of detail so we can’t give you that cut. I’ll let Bob comment on the overall Huawei performance in the marketplace.

Bob Mao

We do see competition from Huawei on discrete project by project situations. We are not seeing Huawei as a pervasive enterprise networking player as you would understand an enterprise player was complete distribution networks and bars. This is nothing new. As I answered Steve’s question on that Wi-Fi case when we compete often times its not HVC going up directly against Huawei it’s many competitors competing for the same project. We don’t really single out Huawei and often times they’re not even our focus and visa versa.


Your next question comes from Nim Park – Goldman Sachs

Nim Park – Goldman Sachs

Can you please give us an update on your go to market strategy, specifically if you can highlight any distribution or system integration partners in North America or EMEA or any new additions to the sales team?

Ron Sege

As a reminder, and as Bob said on the call, the strategy remains to invest in Direct Touch selling resources. We continue to do that in absolute terms as well as migrate our old SMB resources to large enterprise focus. As indicated by our growing pipeline and the deals we’ve been announcing here we believe is starting to show results.

We don’t have any specific system integrators to announce in North America. We are engaged with them on large opportunities. In EMEA this quarter we talked about CROC which is a large system integrator in Russia that worked with us on the Russian Savings Bank. Our primary focus right now is to create user demand with what we call marquee accounts and then pull the system integrators in on a deal by deal basis.

Nim Park – Goldman Sachs

Can you help us better understand the sequential decline in gross margin even excluding the one time benefits from Q4? If volumes didn’t decline as much Q over Q as expected and the mix seems to be more favorable to the Direct Touch model.

Jay Zager

Obviously when you back out the one time gain in Q4 there was a slight decline in margin. Its really noise and it’s a function of the particular products we sold in the quarter. Its not any indication what so ever of any trends. The margins I think were 57.5% in the quarter. We think in general they should stay somewhere in that range give or take a point or two in either direction for the balance of this year. I don’t think you should read anything in particular into the sequential change.

Nim Park – Goldman Sachs

Are there any changes in the pricing environment that you’re seeing in the marketplace at this point?

Jay Zager

The pricing environment is always difficult. In general prices in our industry tend to trend downward. There’s nothing unique that occurred in the first quarter that was different then any other quarter of our operations.

Nim Park – Goldman Sachs

I recognize that the wins that you had in the carrier marketing were primarily on the wireless side. Are you at all concerned that as you gain more traction the carrier market in China that Huawei might get more aggressive in the enterprise base at all?

Bob Mao

The short answer is no.


With no more question in the queue I’d like to turn the call back over our presents for any additional or closing remarks.

Bob Mao

Thank you everyone for joining us on this call today. We look forward to speaking with you again at the end of Q2. Have a good day, have a good quarter.


This does conclude the call for today. We thank you for your participation.

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Source: 3Com Corporation F1Q10 (Qtr End 05/29/09) Earnings Call Transcript

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