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3Com Corporation (COMS)

F1Q07 Earnings Conference Call

September 21, 2006 5:00 pm ET

Executives

Edgar Masri - CEO

John Vincenzo – Director Investor Relations and PR

Don Halsted - EVP and CFO

Analysts

Long Jiang - UBS

Matt Shimao - Bear Stearns

Alex Henderson - Citigroup

Jeff Evanson - Sanford Bernstein

Manny Recarey - Kaufman Brothers

Eric Buck - Brean Murray

Jennifer Tennenbaum - RBC Capital Markets

Scott MacKay - Lehman Brothers

Presentation

Operator

Good day and welcome to the 3Com Q1 2007 quarterly conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Director of Investor Relations, Mr. John Vincenzo. Please go ahead, sir.

John Vincenzo

Thank you and thank everyone for joining us today. 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 our goal to reach profitability and improve it in the coming periods; our plan to reduce costs and increase sales; strategic plans for our SCN segment; go-to-market plans and partner relationships; our organizational structure; the future ownership of H-3C and negotiations with Huawei; H-3C sales; coordination among our businesses; and return of capital from H-3C.

These statements are neither promises nor guarantees but involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. These risks include without limitation, the risks detailed in the Company's SEC filings such as our Form 10-K for the 2006 fiscal year.

On this call we'll also discuss several non-GAAP financial measures including non-GAAP operating loss. For each non-GAAP measure, the most directly comparable GAAP measure and the required reconciliation to the most comparable GAAP measure can be found in tables at the back of the press release announcing our results. The press release is available on the Investor Relations section of our website, www.3Com.com.

With that, I will turn the call over to Edgar Masri.

Edgar Masri

Thank you, John. Good afternoon. everyone. Thank you for joining us today. I am very excited to be participating in my first quarterly earnings call as the new President and Chief Executive Officer for 3Com. As many of you know, this is my second term at 3Com and I am extremely pleased to be here. When Eric and the Board of Directors approached me about this opportunity to lead 3Com, it was a fairly easy decision for me. I know this Company and this industry and I see tremendous opportunities for us to succeed.

For the next few minutes, I would like to share at a high level, some information about my background, my initial impressions of the 3Com business, including Huawei 3Com or H-3C, and some key areas of focus that I have set for the Company. Given the fact that I joined the Company with only two weeks remaining in our first fiscal quarter, I will speak very briefly on the actual financial results. I will leave the details of the quarter to our Chief Financial Officer, Don Halsted.

From an overall consolidated financial perspective, we had $300 million in revenues and $5 million non-GAAP net loss. These results were delivered while managing the implementation of significant aspects of our SCN, or Secured Converged Networking segment restructuring plan. We also had a slight improvement in our operating loss, despite working through the restructuring.

While I am pleased with the fact our results were in line with expectations, and I believe that we have the potential to drive 3Com to profitability, I recognize that we are not yet where we need to be. We need to bring a level of consistency to all areas of our business so each group increases sales and profitability. Don will review our overall performance in more detail during his financial review. But I want to highlight a few areas that exemplify the performance that we are looking to drive throughout 3Com.

First, H-3C delivered 77% year-over-year growth, while improving profitability to its 7% operating income level as compared to their standalone performance of a year ago.

Second, our Secured Converged Networking segment delivered operating model improvement that, despite some erosion in top line performance, has reduced our operating loss more than 30% over the year-ago period. Our goal is to continue improving profitability over the coming period. To stabilize and grow the SCN portion of our business, we need to make changes that will enable our partners to sell more and take advantage of the opportunities in each market. In a moment, I will share one step that I believe will help us stabilize our SCN business.

Cost-saving initiatives, such as the restructuring that was announced at our last earnings call, are underway. This keen focus on expense control in our SCN segment will continue and will enable us to lower our GAAP operating expenses in the segment to $89 million for the quarter, which included $3 million of increased expense for the adoption of FAS 123, down from $96 million in the fourth quarter of fiscal 2006. We also increased our overall cash position in our SCN segment through several initiatives, ending the quarter with $719 million in cash and short-term investments. This was all done while increasing our cash. On a consolidated basis, we ended the quarter with $916 million in cash and short-term investments.

Now let me share with you some information about my background and why I was so enthusiastic to return to 3Com and lead the Company as its CEO. Over the past several years I worked in the venture capital industry and it taught me several valuable lessons, many of which I can apply here at 3Com. I have seen firsthand how organizations with a robust entrepreneurial culture and bright employees with passion and vision can build successful companies. In short, successful companies know how to change the rules of the game. They create best-in-class products and solutions, and deliver them to their customers and partners with a commitment to excellence. When I look at 3Com, I see the ingredients we need to build a successful company. The key is to mix them together to drive profitability and growth.

3Com has very talented employees in place. We have a portfolio of products that few companies can match and a well-established stable of channel partners to deliver these products and solutions to our customers. I plan on leveraging these assets to build a profitable business.

During my first tenure at 3Com, we were successful, particularly in the switching market, because we weren't afraid to change the rules of the game. What I mean by that is we identified where the industry and our customers were heading and built leading products to meet that demand. We did it better and faster than our competitors, which led to market share leadership. We must return to this formula. H-3C is changing the game in China through its innovative and more cost-effective products, which is why it is gaining market share. TippingPoint changed the security game when they identified the need for true deep packet inspection capabilities and built the industry's leading intrusion prevention systems. We need to take that same approach in the data and voice portion of our SCN segment.

While my focus is going to be on building a profitable business that creates shareholder value, I'm also an engineer and a marketer at heart. I believe that we will not be successful simply by building the next switch or router. We must have a vision for what is coming next and we must act on it.

To give you an example of what I mean, back in the '90s we had a strong regional presence in the Modular Systems market. But our solution did not resonate globally and as a result, we found ourselves losing share. 3Com could not compete on a worldwide basis because we were competing against well-entrenched competitors that were spending more on R&D budget and marketing.

Rather than continue to lose market share, we identified a paradigm shift. While we continued to sell the modular systems we also started developing a stackable line of switches that gave customers the flexibility of a modular system at a fragment of the cost. We beat our competitors to market and we became the market share leaders in that category. I share this anecdote with you not to tout the past, but to show you how if you change the rules of the game, you can win.

I believe we have several key initiatives underway that will show how 3Com is harnessing its entrepreneurial culture to develop new technologies that deliver differentiated solutions to our customers and partners. I look forward to sharing some of those advancements as we get closer to launching them.

Specifically regarding H-3C, I spent my first full week with 3Com in China meeting with H-3C management and employees and our partners at Huawei. In my short visit there, I can see why the joint venture has been so successful to date. Thanks to the tireless leadership of H-3C's Chief Operating Officer, Dr. [Jiang], H-3C's employees have a passion for the Company and a desire to build a global powerhouse in networking technology.

As you all know, we are in the midst of negotiating with Huawei for an increased ownership stake in the joint venture and these negotiations will continue to remain confidential. But, to give you some perspective on how we are thinking about the transaction, I would like to point out that a key to these negotiations in addition to agreeing on the appropriate valuation of H-3C, management retention is a critical issue as maintaining Huawei's involvement with the Company as a significant OEM customer. While our goal is to complete this transaction in a timely manner, we cannot predict the outcome of our negotiations at this stage.

I am excited about the opportunity to further align H-3C with our overall business as it brings value from both a technological and market perspective. With an increased ownership stake, one of our top priorities will be to increase the sales of H-3C products outside China, particularly in emerging markets. H-3C has gained some traction in other markets and we will leverage this momentum through solution selling. Bob Mao, our recently appointed Executive Vice President of Corporate Development, will work closely with H-3C's leadership team to make this happen.

Over the course of my first month as CEO, I have identified three key areas that I believe will help make us successful at both a strategic and operational level. They are:

  1. focus;
  2. alignment;
  3. accountability.

With that in mind, we will build an organizational structure that best enables us to capitalize on the distinct market opportunities of each area of our business. This approach will sharpen each group's focus on gaining market share and allow us to better align the technical and business resources needed to grow each business.

As we've stated in previous calls, we have found different go-to-market approaches are effective for each group. H-3C employs more of a direct sales model as does TippingPoint, which has a track record of success in selling direct to large organizations. The remaining business in our SCN segment takes a vertical market approach for small and mid-size businesses through our strong base of channel partners and our relationships with system integrator and service provider partners that provide access to these types of accounts. We anticipate that each of these go-to-market approaches will yield improved results over time, if we manage them correctly.

Additionally, we will continue to leverage each part of our business in an integrated matter whenever possible. To give you an example, there is synergy on both the product and go-to-market front between 3Com's network business and H-3C and we intend to fully leverage this.

Another area of focus for us to improve the performance of our SCN segment will be to better leverage our partner channel to deliver solutions to customers. A priority for me is to meet with our partners and convince them of the value in working with 3Com. To support this increased focus on the channel, we recently redesigned our partner program to better support and reward our partners around the world. We believe this global program will generate greater alignment amongst our partners and ultimately help our partners produce positive results.

Over the past few weeks, I have spent a great deal of time speaking with many of our employees and our partners around the world, and these conversations have reinforced my enthusiasm for the potential 3Com has to offer. I am encouraged by the overall performance of H-3C and portions of our SCN business and TippingPoint.

We have identified areas for improvement in our business and are building solutions to address that. I am confident that we will return 3Com to profitability, create long-term shareholder value, and change the game in the networking industry.

With that, I will turn the call over to Don Halsted for an in-depth review of our financial results.

Don Halsted

Thank you, Edgar. As in the fourth quarter, I will be reviewing 3Com's results first, on a consolidated basis and then the performance of our two operating segments. I will conclude by discussing key cash flow and balance sheet items. During my review I will be using pro forma and pro forma non-GAAP measures of the historical results of H-3C and 3Com as a consolidated entity to calculate comparative values. Please refer to our fiscal fourth quarter press release for disclosures of absolute values and reconciliation for these values.

Also of note, we adopted FAS 123 R effective in this reporting period. We are excluding stock-based compensation expenses for purposes of our non-GAAP operating loss metric as documented in our press release. Concurrent with our adoption of FAS 123 R, we have adjusted our prior period non-GAAP operating loss contracts to reflect historical stock-based compensation expenses included in those previous period results, which were primarily related to restricted stock amortization and compensation costs associated with acquisitions. In some of the discussion analysis, I will highlight the effects of adopting FAS 123 R in order to have meaningful comparison with prior periods.

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

Let me start with a consolidated results review. The fiscal first quarter consolidated revenue was $300 million, a 69% year-over-year increase compared to 3Com's historical GAAP results. This increase is explained by the inclusion of H-3C's results in the current quarter partially offset by lower revenues in the SCN segment. The more meaningful comparison is against a pro forma revenue that includes the actual H-3C results for the prior year quarter. On this basis, the year-over-year revenue growth is about 16%, driven by increased sales in our H-3C operating segment, offset in part by lower revenues from our SCN operating segment.

Table C in our press release provides geographic and product-based supplementary revenue disclosures. On a geographical basis, we had year-over-year declines in North America and in India of 15% and 7%, respectively. Latin America grew 9% year on year and the Asia Pacific region increased almost 700%, reflecting the inclusion of H-3C results in the current period, offset in part by declines in SCN revenues.

On a sequential basis, North America grew 2% due to the strong education buying season offset in part by the effects of implementing the restructuring plan. Latin America sales declined sequentially 18%, largely due to the regular seasonal decline in government buying cycles, and grew 9% compared to the same quarter prior year. The consolidation of H-3C does not have an effect on North America or Latin America results.

India was up 3% sequentially, reflecting higher H-3C sales offset in part by lower SCN sales. Our APR region grew by over 40% sequentially, primarily as a result of the inclusion of the third month of H-3C sales, increases in H-3C sales offset in part by declines in SCN sales.

On a product basis, all product areas increased over the prior-year period with the exception of our connectivity products area. Networking sales almost doubled over the prior period, driven by the inclusion of H-3C results, offset in part by reduced sales of SCN offering. On a sequential basis, the increase in networking sales is largely explained by the inclusion of a full three months of H-3C's performance plus the H-3C growth.

Security products increased by more than 50% over the prior year period, driven by increased sales of our SCN security products and the inclusion of H-3C security offerings. Sequentially, security growth was about 3%. This growth was due to the inclusion of a full three months of H-3C revenue and about flat sales of our TippingPoint products, offset by declines in our sales of other SCN security offerings.

Voice products increased 4% over the prior year period explained primarily by the inclusion of H-3C, offset by lower SCN voice solutions sales. Service sales were up year-over-year 7% but down 5% sequentially. Finally, revenue from connectivity products was $6 million, approximately a 40% decline over the prior year period, which is consistent with the expected declining trend in this area. Results at the gross margin and certain operating lines will be described in detail in the discussion of the operating segments following this review of the consolidated results.

On a consolidated basis each of these lines was significantly impacted in the quarter by the inclusion of a full three months of H-3C results as it compared to only two months in the fourth quarter fiscal 2006, and no consolidation in the same quarter of fiscal 2006.

The GAAP operating loss for the first quarter was $21 million, compared to $21 million in the fourth quarter of fiscal 2006 and $47 million in the same period of fiscal 2006. The $26 million improvement over the prior year period is due to $14 million of operating improvements in our SCN segment, partially offset by the costs associated with adopting FAS 123 R and $12 million from the inclusion of H-3C's performance in the current quarter. The sequential flat performance is explained by a $6 million improvement in the SCN operating income, partially offset by the cost of adopting FAS 123 R as well as a decline in H-3C's operating income. The underlying segment trends will be reviewed in the segment section.

I will now discuss 3Com's non-GAAP operating loss performance. Management believes that a non-GAAP operating loss measure that excludes unusual expenses is applicable along with restructuring, amortization and stock-based compensation charges, is the best single measure of operating profitability. The reconciliation to the GAAP operating loss is provided in Table D of our press release. With this definition consistently applied, the non-GAAP operating loss was $5 million in the first quarter of fiscal 2007, a sequential slight improvement compared to the fourth quarter of fiscal 2006's non-GAAP operating loss of $6 million, and a year-on-year improvement of $34 million compared to a first quarter of fiscal 2006 non-GAAP operating loss of $39 million.

The primary driver of the reduced sequential operating loss is continued SCN operating expense control, partially offset by increased H-3C operating costs. The improvement over the prior year period results from the benefit of the consolidation of H-3C plus operational improvements in our SCN's segment.

During the period, we recorded a $2 million gain on the sale of our venture portfolios and interest income net for the period was $10 million, which was about flat sequentially and an increase over the prior year quarter of $4 million. The increase is driven primarily by the inclusion of H-3C's results in the current period and increased performance of the SCN portfolio.

Other income net for the period was $5 million versus $8 million in the fourth quarter of fiscal 2006. This decrease was primarily driven by a change in the level of the software subsidy at H-3C which is accounted for on a cash basis. The subsidy in H-3C's other income line is from the Chinese tax authorities providing a subsidy, funded by a portion of the VAT taxes collected by H-3C from purchasers of certain software products.

The provision for income taxes was $1 million for the quarter versus $5 million in the prior quarter, driven primarily by increased deferred tax assets from the H-3C books, as well as a lower VAT provision in the SCN segment.

In our first fiscal quarter we recorded a minority interest charged to our results of $9 million as Huawei's share of the financial performance of the consolidated Huawei-3Com joint venture. The net loss for the quarter was $14 million or $0.04 per share, of which restructuring, amortization and stock-based compensation expenses represented about $0.04 per share. This represents a $0.07 per share improvement over the same quarter in the prior year net loss per share of $0.11 which included $0.02 per share of restructuring amortization and stock-based compensation expenses.

The weighted average number of shares outstanding during the quarter was 392 million shares. This net increase of 2 million from the prior quarter primarily reflects divesting of previously issued restricted stock grants and the exercise of stock options.

I will now turn to a review of our operating segments. Segment results can be seen in our press release in Table E. Let me start by reviewing the SCN segment. Revenue for the quarter was $156 million, a $10 million sequential decline and a $22 million decline compared to the same quarter last year. The sequential decline in total resulted from the effects of implementing the restructuring plan announced in June; and the first quarter had seasonal softness in our Latin America and EMEA regions.

On a product basis, we had a decline in voice revenues and about flat revenues in security. This was offset in part by our growth in our managed switch sales which we attribute in part to the repricing we announced in June.

SCN gross margins where flat sequentially at 36%, yielding a gross profit that was lower sequentially by $3 million due to lower revenues. At the operating loss level, this decline was more than offset by a net reduction in sales and marketing, research and development, and G&A expenses of $4 million as a result of the restructuring plan and continued cost management focus. We adopted FAS 123 R in this quarter resulting in $3 million of stock-based compensation charges in these lines.

The restructuring cost provision in the quarter was $8 million, almost all related to the restructuring program announced in June. In this period, we also sold our Santa Clara site and this resulted in a gain of $8 million. Since the site availability was the result of restructuring actions, we applied the gain to the restructuring line, resulting in a net benefit in the first quarter of less than $100,000. This is a $3 million improvement compared to the charges in both the fourth quarter and first quarter of fiscal 2006.

The SCN operating segment restructuring plan we announced in our last earnings call is well underway. The clearest sign is in the reduced expenses for sales and marketing, research and development, and G&A expenses in this segment which, as a group, were $85 million for the first fiscal quarter including stock-based compensation cost of $3 million. The comparable expenses in the fiscal fourth quarter were $89 million. This was before the adoption of FAS 123 R but it did include $1 million in stock-based compensation expenses. Therefore, the net reduction in reported expenses of $4 million is comprised of $6 million in operational expense reductions, partially offset by $2 million in increased stock-based compensation costs. Compared to the same period in fiscal 2006, these expenses have declined $24 million or 22% while absorbing the impact of adopting FAS 123 R.

When we announced this restructuring plan last quarter, we expected to reduce the SCN resources by about 250, including actions associated with our Santa Clara facility closure, which have been partially implemented in our fiscal fourth quarter. The SCN headcount at the end of the first quarter was about 1,500, a reduction of 50 from the end of the prior quarter and about 200 from the end of the fiscal third quarter of 2006. On a net basis, this resulted in a sequential improvement in the SCN segment operating loss of $3 million.

The SCN net loss for the first quarter is $23 million, a $19 million improvement over the prior year quarter's 3Com loss of $42 million. These improvements are primarily driven by operating expense reductions, partially offset by $3 million of increase stock-based compensation expenses associated with the adoption of FAS 123 R.

Turning now to the H-3C operating segment, to review H-3C's performance I'm going to compare the reported segment first fiscal quarter financials against non-GAAP pro forma segment financials that reflect the operations of H-3C for the full fourth fiscal quarter of 2006 and stand-alone performance for H-3C in the same quarter of the prior year. These historical values are available in our fourth quarter 2006 press release.

Revenue for the first quarter was $170 million, a 9% sequential and 77% year-over-year improvement. H-3C's gross margin was 47%, down 1% from the prior quarter, but up five percentage points year-over-year. H-3C's direct operational expenses for the quarter were $60 million, an increase over the prior three-month period of $14 million. This increase is primarily driven by headcount increases in the sales and marketing and R&D areas, consistent with the experienced and anticipated growth.

H-3C net income before the Huawei equity charge was $18 million or 11% of sales, including a $9 million non-cash charge for amortization of intangible assets. This is an increase of $18 million over the prior year quarter comparable number, but a sequential decline of about $10 million. Net income after the $9 million Huawei equity charge was $9 million. The primary drivers for the year-over-year improvements are the 77% revenue growth at a higher gross profit margin, combined with the software subsidy that started in our fiscal fourth quarter.

Returning to a consolidated viewpoint, I will now review selected aspect of 3Com's balance sheet. Cash, cash equivalents, and short-term investments totaled $916 million, representing a net increase at $52 million from the balance at the end of the previous quarter. The change includes an increase in cash and cash equivalents of $53 million and a decrease in short-term investments of $1 million. Key components of the change in cash and cash equivalents are as follows:

  1. The sale of our Santa Clara facility, venture funds, and the cash received from the insurance settlement on our UK facility yielded $51 million in cash receipts.
  2. Cash provided by operations was $10 million, including $7 million for restructuring related payments.
  3. Cash used for capital expenditures amounted to $6 million.

The quarter ending cash, cash equivalents and short-term investment balances of $916 million is comprised of $719 million from the SCN segment and $197 million from H-3C. The owners of H-3C, 3Com and Huawei, have agreed on a return of capital of $80 million. This is expected to be complete by the end of the calendar year and will result in an $80 million reduction in the H-3C cash, a $39 million increase in the SCN cash, and a decrease in the minority ownership liability to Huawei.

Other items of note in our consolidated balance sheet includes notes receivable declining $12 million as H-3C reduced the level of bankers acceptances. Inventory increased $23 million, primarily driven by increased inventories in support of certain new products, as well as supplies for certain delayed large deals. Our net property, plant and equipment balance declined due to the sale of our Santa Clara facility and period depreciation charges, offset partially by capital expenditures in the period. Our other asset balance decline to $28 million as a result of the declines for the sale of our venture portfolio and the write-off of our UK facility against the received insurance claims, offset by certain other increases. Accrued liabilities increased $20 million, driven primarily by in-period accruals for certain sales and marketing and employee expenses in our H-3C segment.

In summary, operating profit net, non-GAAP and net losses continue to improve, resulting in an EPS loss of $0.04 a share on a GAAP basis. We will continue to drive towards our goal of positive operating profit non-GAAP. As part of this effort we implemented our SCN restructuring plan. We continue to focus on the balance sheet and with the sale of non-core assets have increased our cash and short-term securities of SCN to over $700 million.

Let me turn the call back over to Edgar Masri for comments before opening the call up for questions and answers.

Edgar Masri

Thank you, Don. Operator, we are ready to take questions.

Question-and-Answer Session

Operator

Our first question comes from Long Jiang - UBS.

Long Jiang - UBS

Hi, good evening. My question is relating to the operating structure of the H-3C joint venture. The operating expense kind of fluctuated quite widely from quarter-to-quarter. I am just wondering if you have a target operating margin going forward, considering the revenue growth has increased requirements [inaudible]. Thanks.

Don Halsted

Hello, Long. Thank you for the question. First of all, I would point out that while there was a significant increase in the H-3C expenses, they still had a quarter in which they had a very healthy profit margin on the quarter. So any time you have a business that is growing on a very rapid rate like H-3C is, you are going to end up with period shifts as to the timing of when you have increases of revenue when you have increases of expenses.

If you look at the growth from for them what is the calendar first quarter to the second quarter, they were up about $14 million. That was driven in large part by the increase in the headcount. Not only the increase from the second quarter, but the full quarter effect of the increases in the first calendar quarter.

So it primarily tracks it to the headcount. The direct operating expenses in the quarter at that higher level still is around 35% of revenue, which is consistent with the model that yields a double-digit operating profit prior to the Huawei intangible amortization.

Operator

Our next question comes from Matt Shimao - Bear Stearns.

Matt Shimao - Bear Stearns

Edgar, welcome back to 3Com, I hear you're learning Chinese. That is very good. Edgar, my question is, what do you think are the main strategic factors driving the JV success? Do you see any other companies on the near-term horizon with the potential to threaten the JV success by leveraging a similar strategy?

Edgar Masri

Thank you, Matt. Regarding the JV, its success has been primarily due to taking a comprehensive look at the needs of the Chinese market and then beyond that, Asia. If you look at what they're building, they have built a very, very good platform and then very quickly moved onto solutions whether it is in video security and storage and other related areas. I expect them to continue with this approach because it has the double advantage of leveraging a platform but at the same time, going and pursuing solutions that are critical to their markets.

Matt Shimao - Bear Stearns

The second part, Edgar, are you seeing any other companies on the near-term horizon with the potential to threaten the JV success by sort of leveraging this low-cost R&D strategy they have?

Edgar Masri

It always helps to be paranoid. I think this model can and will be emulated. Just that the momentum of H-3C is such that it will take anybody a couple of years to get closer.

Matt Shimao - Bear Stearns

Thank you very much.

Operator

Our next question comes from Alex Henderson - Citigroup.

Alex Henderson - Citigroup

Thanks. I was wondering if you can give us some sense of what you think the market conditions are looking like in both theaters, i.e., Asia, China region, but also in the US? When you talk to the US, could you address the fairly aggressive marketing program Cisco has been putting in place into the commercial space with this sharp increase in their sales footprint against what has been traditionally your home turf?

Edgar Masri

Thanks, Alex. You have two parts to your question. First is the growth in China. We continue to expect a healthy growth in China as a market. The numbers are showing it. I think it actually applies to a good number of the emerging market countries.

Alex Henderson - Citigroup

The question was really competitive environment.

Edgar Masri

Competitively, we are seeing similar competitors that we have seen for the past year or so. I am not seeing any necessarily price pressure at this juncture. Will it come? Very possibly. But this market is still very hungry to comprehensive product offerings. I would say we have at least a good year of this scenario. We are seeing more requests for features. We are seeing more need for things like IPv6 and other capabilities in routing and switching, as opposed to price pressure.

On the US market, just to make sure I understood your question, you were saying how are we doing and what the competitive market is looking like? We took some pricing action to remain competitive in the switching space. The summer tends to be very good for us because we're strong in the education market. I expect, though, that there will be more demand and expectations around Voice over IP, security and wireless which are looking more for integration as opposed to lower prices.

Alex Henderson - Citigroup

If I could follow up; so you haven't seen any change in trajectory of demand and you haven't seen any pressure resulting from the increase in the commercial sales force at Cisco which is up in excess of 25% in North America?

Edgar Masri

Not directly. I would say looking at this quarter in particular, we have not seen direct pressure on us from those increases that you are referring to.

Alex Henderson - Citigroup

Thanks.

Operator

Our next question comes from Jeff Evanson - Sanford Bernstein.

Jeff Evanson - Sanford Bernstein

Edgar, I'm wondering how you plan to allocate your time both geographically between China, the US and Europe? Also among the segments, if you think of the segments as H-3C, security and some of the innovations that you talked about on the voice and data switch side at SCN.

Edgar Masri

Thanks Jeff for the question. Clearly, coming into this role I knew and the Board was very clear about the importance of the joint venture in China with Huawei. The growth of this business unit as well as its potential will clearly require, and I'm already to spend about 30% plus of my time in China. It ended up being a case in point, because my first eight days on the job were in China, in Guangzhou as well as in Hong Kong. I do expect though, to spend time here in Marlborough, and spend a lot of time with the SCN Group, which has taken the past four to six quarters to undergo a restructuring. There are a lot of good ideas that I hinted at and I will communicate more about, and provide the direction first and then highlight the leadership and rely on the leadership to go forward. I'm also spending sometime with TippingPoint, but TippingPoint has been very much running autonomously. I just expect to spend probably less time there then in China or here in the Boston area.

Operator

Our next question comes from Manny Recarey - Kaufman Brothers.

Manny Recarey - Kaufman Brothers

Thank you. A question about Heritage 3Com revenue. Looking at the network segment it's been down about three quarters in a row about $100 million now, the way I calculate it. Can you give a little color on what you're going to do as to at least stabilize that? Do you see that continuing to decline for the next several quarters still?

Edgar Masri

Thanks, Manny, this is a very good question. This business has undergone the brunt of the restructuring and you have to keep that in mind. If you are considering that, I am pleased with the performance of this quarter. At the same time, the teams inside this organization have been working very hard on some key initiatives, primarily around unified switching and solutions products we have announced in this area, as well as voice-ready networks. I look at these products to start making a positive impact on this organization and on this business.

While it is early to tell, I am very much looking forward to those results to help with the rest of the situation of this business.

Manny Recarey - Kaufman Brothers

So you expect that in the near-term? The positive impact?

Edgar Masri

Yes. These products are launching this quarter. We should start benefiting from them in Q2 but I expect Q3 will be more a meaningful uptick on those solution and products.

Operator

Our next question comes from Eric Buck - Brean Murray.

Eric Buck - Brean Murray

Thank you. I wanted a clarification from Don, if you would, in terms of the H-3C performance. As I am looking in the press release today, do I interpret this correctly? You're comparing three months ended June with two months ended March?

Don Halsted

That is correct. That is what is in the GAAP tables, Eric. That is why in the comments I looked at what would it be if we were looking at all three months. If you go back to our fourth quarter, we actually listed the pro forma three months for each of the historical quarters. Three months ago, we issued that release.

Manny Recarey - Kaufman Brothers

But your commentary was year-over-year wasn't it?

Don Halsted

Primarily year-over-year. I think I gave a few comments sequentially, but it was mostly on a year-over-year basis.

Eric Buck - Brean Murray

So if we look at that two-month period, it shows $21 million GAAP earnings in the two months versus $18 million GAAP earnings in the more recent three months. Is that a change in the amortization that hit that? Why is it down with the three-month period versus two months?

Don Halsted

The primary reason it is down is two factors. The first is while we had three months of results in this quarter, we also had, as we have discussed earlier, a higher level of operating expenses that we were capturing in that period. And so that was one of the contributors of why the operating profit was in fact down on a comparative basis.

The other thing that is important is that we had a higher subsidy from this software subsidy last quarter. Now that is recorded on a cash basis. So the fact that the subsidy was received in the month of February meant the entire subsidy was captured in our results, even though we were only reporting two months' worth of results. We had a little over a $5 million subsidy; it was received this quarter. That was recorded when it was received but was naturally applied against three. So you also have an extra effect of that in the second quarter.

Eric Buck - Brean Murray

For Edgar, in looking at the joint venture here, I'm kind of curious as to what you consider to be 3Com's contribution to that venture? It seems to be primarily products developed there and sold in China. What do you consider 3Com's contribution and why would Huawei be willing to sell an increased stake of that, since that is clearly the better performing piece overall?

Edgar Masri

This is a great question. There are two phases to the contribution of 3Com. So far 3Com has contributed primarily a channel to market and we represent a good portion of this joint venture. We do sell those products and they have been very successful for us. But if you look at the second phase, now is the opportunity for this joint venture to expand globally. To expand globally beyond China will require branding, selling, recognition of key solutions and key technologies. I mentioned the three of them earlier: Voice over IP, security and wireless.

We have the knowledge. We have the sales mechanism. But more importantly, the marketing and the solution development that will be essential for the joint venture. For them to reinvent that on their own will take longer, primarily because they haven't done it as much. But then second, because the markets in China are not as ready for the solution yet. We look for the joint venture to be successful in western Europe and in the US.

Operator

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

Jennifer Tennenbaum - RBC Capital Markets

This is Jennifer Tennenbaum for Mark. Just a question also on China, can you talk a little bit about the share shift? How much share do you think you're gaining and who from? Is it Cisco? And then just also a little bit more about what do you think maybe the long-term growth rate would be or sustainable growth rate for the H-3C?

Edgar Masri

I will touch first on the market share gain, I will pass it to Don regarding growth. On market share, H-3C has gained tremendous share over the past two or three years when you look at it. IDC is one of the key firms that tracks that market specifically. And H-3C has moved from the teens to the 30s, primarily at the expense of Cisco. But also against other players who, for a while, were making a dent into that market like Harbor Networks, but that has since evaporated.

We expect the joint venture to continue to gain share, primarily at the expense of Cisco and the Chinese market. I will pass it to Don regarding growth.

Don Halsted

I think there's two types of growth that we need to focus on. First is, if you will, the organic growth of the networking equipment business in China. That is, frankly, the fastest-growing large market in the world. And it really paces, I think, the industrial growth in China, which is growing in the low double-digits range. But no matter how you count it, the growth, the expansion of the networking market is obviously a lot lower than the growth that we have seen in H-3C in the last year or two. So it isn't just having a 10% to 12% growth in the networking business. It is also looking to expand the solutions out into the adjacent market areas in China.

So that the China focus of the business is both participating and growing at least with the market for the networking products, but also looking at expanding into some of the adjacent areas that the networking.

Operator

Our next question comes from Scott MacKay - Lehman Brothers.

Scott MacKay - Lehman Brothers

This is Scott MacKay on behalf of Jung. To go back to the core 3Com business again, obviously it was down fairly significantly quarter-over-quarter although again it's a seasonally soft quarter. But I was hoping you could share a little more insight on how you overall envision strategically it sitting with the JV? How do you separate the go-to-market strategy by geography, by customer segment?

Edgar Masri

Regarding the go-to-market. Until now, it has been made very clear that the JV had exclusive focus on China and Japan and we intend to expand that geographical focus. Outside these countries, 3Com core business, as you called it, was carrying the flag. However, we recognized that it's going to be the mix of product and solutions from both parties that will be required for large enterprise customers.

I can tell you that in Eastern Europe we have already embarked on some cooperative work where the sales representatives from the JV goes and touches the large enterprise opportunity and then very quickly brings in the 3Com partner and the associated channel to complement the solution, primarily for the mid-range access products or solutions like voice when they do not have it. We are looking to expand that model that's cooperative and seems to be working more broadly. But it may take different forms and depending on the country.

Operator

Our next question comes from Jeff Evanson – Sanford Bernstein.

Jeff Evanson - Sanford Bernstein

I noticed that inventories were about 50% greater than cost of goods sold in your fourth fiscal quarter 2006 and are about 8% more than the cost of goods sold in this quarter. What is going on with the inventory equation?

Don Halsted

There are actually a couple of things that are going on. The majority of that increase, but not all of it, the majority of that increase was in H-3C. A portion of that was related to the work they were doing in their pipelines to get compliant with all the RoHS requirements. They really have a pipeline they were working through. The inventory level itself is something, even in H-3C, that is a significant focus within their management team, and our management team, and they are actively working on it. It's one of the balance sheet items that I encourage you to watch as we grow through the next couple of quarters. I think you're going to see the effect of turns starting to improve on that.

The other aspect on there was, there was a couple million dollars of the increase in inventory really was on the SCN side of it. Some of that was a build ahead on a couple of products that, frankly, were delayed out of the quarter and into that next quarter. Those are the primary things. It is something to be watched as we go forward and something we're going to be driving to improve on an aggregate basis.

Jeff Evanson - Sanford Bernstein

What percentage of H-3C sales are in APAC versus EMEA?

Don Halsted

We are not actually going to be breaking down inside of our segments across them. But just like I said in the last quarter, we will get a general guidance. Something well over 85% of the sales are in APAC.

Operator

Our next question comes from Manny Recarey – Kaufman Brothers.

Manny Recarey - Kaufman Brothers

Just one detail question. How much of the JV sales were to 3Com? I think it was $40 million or so last quarter.

Don Halsted

It was actually -- we don't give an exact number -- it was a little less than the $40 million last quarter but still in that higher range than it had been historically. So it was a little less than the $40 million range.

Operator

That will conclude our question-and-answer session. I will turn the conference back over to Mr. Masri for any additional or closing remarks.

Edgar Masri

Thank you, Operator. Thank you very much for joining us on this call. I look forward to continuing the dialogue moving forward. Thank you very much.

Operator

Once again, this will conclude today's conference call.

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Source: 3Com F1Q07 (Qtr End 9/1/06) Earnings Call Transcript (SeekingAlpha)
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