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Juniper Networks, Inc. (NYSE:JNPR)

Q3 2006 Earnings Call

October 18, 2006 4:45 pm ET

Executives

Randi Paikoff Feigin - Vice President, Investor Relations

Scott G. Kriens - Chairman of the Board, Chief Executive Officer

Robert Dykes - Chief Financial Officer, Executive Vice President, Business Operations

Analysts

Tal Liani - Merrill Lynch

Nikos Theodosopoulos - UBS Warburg

Jeff Evenson - Sanford C. Bernstein & Company, Inc.

Yoon Yongchul - Lehman Brothers

Mark Sue - RBC Capital Markets

Brantley Thompson - Goldman Sachs

Simon Leopold - Morgan Keegan & Co.

Paul Silverstein - Credit Suisse First Boston

Tim Daubenspeck - Pacific Crest Securities

Presentation

Operator

Welcome to the Juniper Networks third quarter financial results conference call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session.

(Operator Instructions)

As a reminder, this conference is being recorded Wednesday, October 18, 2006. I would now like to turn the conference over to Randi Feigin, Vice President of Investor Relations. Please go ahead.

Randi Paikoff Feigin

Thank you, Gina. Good afternoon, everyone, and thank you for joining us. With me is Scott Kriens, our Chairman and CEO, and Bob Dykes, our CFO and Executive Vice President of Business Operations.

Today, Scott will provide some insight on the trends we have seen and expect to see in the service provider and enterprise markets, as well as discuss the fruits of Juniper’s innovation and, as a result, our opportunity and market position.

Following Scott’s comments, Bob will provide you with the progress we have made on the independent options investigation, some financial statistics for the quarter ending September 30, 2006, as well as outline some of our financial goals for the remainder of the year.

We will then open the call up for questions.

Before I turn the call over to Scott, I would like to remind you that the matters we will be discussing today may include forward-looking statements and as such, are subject to the risks and uncertainties that could cause actual results to differ from those contained in the forward-looking statements, including those risks and uncertainties discussed in our most recent 10-Q filed with the SEC.

We will also be discussing some preliminary non-GAAP financial information but, due to the pending stock option investigation, we are not presenting complete GAAP financial statements, including a reconciliation of non-GAAP to GAAP items.

However, a description of these items excluded in the non-GAAP financial information can be found on our investor relations webpage. Juniper Networks assumes no obligation and does not intend to update forward-looking statements made on this call.

Scott, I will turn it over to you.

Scott G. Kriens

Thanks, Randi, and good afternoon, everybody. Today I will discuss the trends we see in the marketplace, as well as our status in both the service provider and the enterprise markets, and then I will spend some time discussing the announcements we made this morning regarding our carrier ethernet strategy and our new carrier ethernet portfolio, as well as some of the innovations across other areas of the product line. I will then turn it over to Bob to review more of the details of our recent performance and to provide you with guidance for the remainder of the year.

First, to the quarter’s performance, from a financial perspective, we are pleased to have met our targets, with revenues of $573.6 million, reflecting growth of 5% from Q3 of last year and 1% from the previous quarter in 2006, especially given the typical challenges of seasonality during the third quarter. For the first nine months of 2006, our business has grown approximately 15% when compared to the first nine months of 2005.

We are also very pleased with our cash generation of over $166 million during the third quarter, allowing us to build our cash balances to more than $2.4 billion. At the current contribution levels, we are generating over $0.5 billion in cash per year. This makes as strong a statement about the health of Juniper as any, I might add.

This cash has been generated from our success in both the service provider and the enterprise markets, so let’s look first at the service provider, and then we will talk about the enterprise.

We are seeing several trends in the service provider market today. We continue to see growth in IP traffic on service provider networks as a result of peer-to-peer interaction, broadband usage, video, and the increasing reliance on the IP network as a mission critical business tool in the strategies of our service provider customers and of their enterprise customers.

The quality and type of traffic is continuing to change from generic delivery of information to high demand voice and video, where managing traffic characteristics like latency and quality of service become increasingly important and play to the foundation and differentiation of what we can offer.

Just in the last week, with the Google and the YouTube news, we have seen the escalating importance of video on the network experiences of users and service providers.

The evolution of the worldwide demographics for consumer and user driven content, such as MySpace, is extending well beyond the school-aged population, increasing the opportunity for everyone involved.

We could cite other examples, but really the most compelling point is that today, almost no one debates these trends, their potential and their reliance on IP infrastructure for their success. With this assumption safely in hand, we also have a couple of beliefs about the Juniper opportunity and our position.

Our first belief: the service providers network requirements are becoming clearer and therefore, the Juniper solution and the differentiation we provide is becoming more apparent than ever to the marketplace and to our customers. We expect to see a continuing wave of NGN build-outs, with decisions made in favor of Juniper.

Our second belief, which defines the marketplace we are serving and is the basis for the strategy we are following, we define the market as:

  • The IP infrastructure market, and this market includes products and technology at the core for high capacity bandwidth, the edge for business and consumer access;
  • The aggregation layer, which is responsible for aggregating and forwarding traffic for processing;
  • The security to protect users from the inside out and from the outside in;
  • The application awareness and intelligence to optimize the network to meet business and user needs; and finally
  • The management and control of the entire infrastructure.

Today, industry followers measure these segments separately, as if they were standalone markets long-term, which we do not believe they are. They are elements of a single converging market, which we call IP infrastructure, and it is this total solution that will be required to meet customer demand.

To serve this market requires an operating system which can scale to meet capacity and volume of users and traffic, deliver the reliability to be mission critical, the intelligence to handle security and awareness of the traffic being delivered, and the performance to do all of that fast enough to meet the expectations for the experiences users demand when they dial a phone number or click on a movie site.

We rely consistently on our Junos operating system to meet these needs, and this is the power of our differentiation, relative to others, and the key to our opportunity to protect and extend our lead in the market.

Today, we announced another element of that strategy -- the MX960, which expands our Junos footprint into the multi-billion dollar, and rapidly growing, carrier ethernet segment of the IP infrastructure market.

Because the MX960 will run the same Junos operating system that our existing core and edge products run today, the MX960 is proven at scale on the first day it ships, and it joins an installed base of almost 30,000 M and P series routers deployed in hundreds of service providers around the world. Because we designed the MX960 from the ground up, it sets new benchmarks for density and corresponding price performance.

The early response from customers and industry experts has been extremely positive. Today, we change the game in this marketplace. No one has the proven reliability, the scale, the performance, and the integrated functionality we now deliver, and this matters a lot to our customers.

While on the topic of continued innovation, we have also seen very strong customer enthusiasm and acceptance of the E320 broadband services router, due to the recent enhanced capabilities and densities equating to better price performance and setting another benchmark for our customers, and raising the bar for the competition. This is represented by orders of almost 400 E320 units since the product was introduced.

Our next generation silicon, called the i-chip, was delivered in our new M120 router, which provides a denser and more cost-effective system. This is extremely compelling, given it is once again deliver Junos to the market in a smaller and a more competitive form factor.

Evidence of the impact of our innovation has been reflected in many ways. Our partners continue to endorse our approach, and both Siemens and Ericsson each represented greater than 10% of total revenue for the quarter.

Siemens sold our products in over 40 countries to some significant service providers, including DT, or Deutsche Telekom, Telstra, Telecom Italia, and Bell Canada.

Ericsson’s strength came from a wide range of activity across Asia, Europe, and the Americas, with shipments to more than 20 countries during the quarter, including large deployments at China Telecom and China Mobile.

In addition, our ongoing relationship with Lucent and in turn, Alcatel, remains solid and we will continue to leverage our joint capabilities under a recently signed agreement and extension with Lucent.

We continue to be encouraged by the market share, as reported by both Informatics and Synergy Research Group, where Juniper is currently ranked number two worldwide in every major service provider market in which we compete, including total service provider routing, core service provider routing, broadband access, and multi-service edge.

Now, let’s switch gears to the enterprise market. Every day, we gain a clearer understanding of the similarities and the differences between the service provider requirements and those of the enterprises, and we continue to have a significant amount of R&D leverage across both customer segments.

First, to the trends in enterprise and the evolution to what is being call the real-time enterprise. The real-time enterprise faces two critical sets of simultaneous demands on the business. First, agility to meet business requirements, to move the business quickly based on daily economic or other factors, and second, intelligence, or the ability to protect users and information and, at the same time, deliver reliable state-of-the-art services across the enterprise, around the world in real time.

A survey conducted by The Economist recently asked business leaders of more than 4,000 companies in 23 countries to describe how business will change over the next five years and speed of execution was identified as the key management challenge, with more than 80% of the respondents saying that technology will be critical to supporting their company strategy.

Nearly 60% said IT is becoming more of a competitive tool rather than simply a driver of cost efficiency.

The powerful trend we see to deliver this speed of execution is the move by our customers to drive productivity through SOA. According to Gartner, SOA, or service oriented architectures, will provide the basis for 80% of new development projects by 2008 and yet, the interesting statistics provided by CIMI Corporation are that only 20% of enterprises have adequate SOA infrastructure.

So with these trends underway, let’s talk a minute about our beliefs as we pursue this opportunity.

There is an escalating awareness of the importance of the network in the SOA architecture, including performance, scale, resiliency and intelligence, and we believe that all of these attributes must be performed and delivered simultaneously without compromising any of the others. We see this every day.

Needless to say, it is a complex problem which changes quickly and has strategic importance to the business. These requirements are what Juniper has delivered against in response to demand among our service provider customers, and it is again the opportunity to differentiate as we compete in the enterprise market.

This is our sweet spot, and it has been for the last eight years. We believe there is another similarity that is even more powerful in the enterprise market than it has become thus far in the service provider market. There is an increasing value being placed on Juniper integration. This is evidenced by the continued success of our ISG platform, which is a product where we combine firewall and intrusion detection and prevention capabilities, and our SSG products, where we have brought together best-in-class firewall and security technologies with the best WAN routing capabilities.

All this adds up to an opportunity that we define as the power of the portfolio, and its power measured by both the breadth of the offerings, but equally important to our customers is the best-in-class quality of each element, and the integration of those elements.

Finally, they insist on a critical mass of resource and capability in areas like service and support. So when you add it up, Juniper is safer and more scaleable than point product companies, and better than the end-to-end proprietary solutions otherwise available, and this is a powerful and a unique combination.

Returns from the marketplace confirm our approach. We saw a very satisfying quarter from a revenue perspective, with growth of approximately 4% from Q2 of this year, and 13% from the third quarter of last year in our SLT products, which are sold primarily into the enterprise market.

The mix of our enterprise business is similar to last quarter, growing approximately 12% from the third quarter of last year.

Our new and integrated ISG products that I mentioned earlier have allowed us to regain the number one high-end firewall position at 35%, according to Infonetics, and we now have an expanded family of SSG products, which we recently enhanced with nine new offerings at lower price points and with more powerful combinations of highly integrated functionality.

You will see more from us in the area of integration, and we expect the integrated portfolio to become an increasingly larger contributor to revenue over the next several quarters.

Also of note, and for the first time, Juniper has taken over the number two slot in worldwide network security, according to Infonetics, and we remain number one in worldwide SSLVPN markets, with over two times the market share of any other vendor in this space. We moved up a market position with our intrusion detection, or IDP products, as well.

Earlier this week, we also announced several new enterprise data center products. On the WAN optimization front, we introduced the new WXC590 and new versions of our operating and management systems. In addition, we introduced the DX3280 and 3680 platforms, and a new version of the DX operating system, which broadens the suite of products and functionality across the data center application acceleration and load balancing market places.

In addition, we have already seen good interest from the enterprise for our new M120 router, which we believe will further enhance our number two high-end enterprise routing position worldwide, where we currently enjoy 28% market share, according to Synergy Research Group.

These new data center products and features, coupled with the new M120 router, provides a best-in-class comprehensive solution for enterprise data centers.

As an endorsement of our best-in-class products, coupled with the ability to provide a comprehensive solution, we have repeatedly been listed in Gartner’s leaders quadrant for every security area we focus on, and today, that is five in all -- intrusion prevention, the SSLVPNs, IP sec VPNs, or virtual private network capabilities, enterprise firewalls and, for the first time, they published the WAN optimization leaders quadrant, and we are there as well.

We continue to increase the profitability and penetration, with now more than 10,000 enterprise customers worldwide, and in addition, we now have products deployed in 90 of the 100 largest enterprises, with major wins like the M&J series products recently announced at the Philadelphia stock exchange, and the DX product at Dow Corning.

Our innovation and market momentum have also allowed us to build partnerships with other market leaders, such as Symantec, with whom we announced a key relationship this last quarter. Our joint solutions will be based on open standards and will deliver better security intelligence, faster response for security threats, and comprehensive coverage of the threat landscape.

Since the announcement, we have seen good reception from the market place, and we are working hand-in-hand to capitalize on the opportunities we are seeing. This is the kind of partnership that has the same power to influence our growth as the many successful partnerships we have enjoyed across the service provider marketplace since the early days of Juniper.

In summary, I would like to offer a perspective on both the challenges and the opportunity.

We are very enthusiastic about the opportunities, but with that, there are, of course, some challenges. One is balancing the investment opportunity with the business model. Similar to last quarter, we are currently experiencing a reduction in our operating margins as a result of investment in the enterprise opportunity, but we are a $2 billion company in a $20 billion market, with opportunity everywhere. Some of that opportunity just cannot be ignored.

Also on the enterprise side is the challenge of increasing our visibility with customers, as there are still a significant percentage of enterprise buyers who either have not heard of Juniper, or have heard of us but do not understand that they can get the same reliability and functionality that we build for service providers at price performance matched to enterprise needs.

With service providers, the NGN decision cycle continues to be a factor in the timing of these opportunities, as evidenced by Japan’s continued deliberations, and we continue to work hard there without the immediate realization of the financial opportunities, which we expect longer term.

Finally, the evolution of IPTV and the associated service decisions, including topology and network designs, also affect the timing of our opportunity. Rollouts or trials in Singapore, Hong Kong, India, Korea, Taiwan and Japan are going ahead, but each market is different and each requires a unique approach to service mix and resolution of regulatory issues.

Addressing these challenges is well worth the effort, though, because it positions us for significant opportunity.

First, we remain strategic to our customers, with the right products, the right technology, and subsequently, the right solutions profile for a market which continues to demonstrate demand in the markets we serve.

Secondly, we focused throughout 2006, even with the many obstacles and doubts of others that have been placed in our path. Focus has been applied with execution and demonstrated by the delivery of several system products and, even more important but probably less visible from the outside looking in, several major software releases.

With our execution, our opportunity has improved. We said we would develop an improved edge response, and we delivered significant enhancements to the E320 in areas of capacity, performance, and scale. It is now the highest capacity platform of its type in the marketplace.

We said we would develop ethernet, real ethernet purpose-built for the carrier marketplace, and we have done that already with a family of ethernet interfaces for our M and T series products, and today, we make a dramatic statement on this topic with our new MX960, again the highest capacity platform in its class.

We said we would leverage and integrate our best-in-class security portfolio, and this month, we expanded once more on that deliverable, with the new extensions to the SSG family.

We said we would use our technology differentiation and match it with an unwavering commitment to the enterprise customer and to the go-to-market demands which must be served. Today, we are number two in worldwide security and number two in enterprise routing, also worldwide.

So when you add it all up, here is the bottom line: Juniper has more pure opportunity and a better answer than any company that we see in our market today. Our challenges are all well understood. Our technology and our vision are clear, and are being very well-received by our customers, and our focus and execution will be relentless.

These many successes are only possible with the support of our employees, whose continued commitment and incredible efforts make these results possible, as well as our many partners, our customers, our suppliers, and our long-term shareholders.

I would like to thank you all for your continued support and confidence in Juniper networks.

Bob, I will now turn the call over to you.

Robert Dykes

Thanks, Scott. Before I review our results, I would like to provide a summary of the status of our stock option investigation. As previously announced, our audit committee has reached a preliminary conclusion that the actual measurement dates, for financial accounting purposes, of certain stock option grants issued in the past differ from the recorded grant dates of such awards. Consequently, we will need to restate historical financial statements to record additional non-cash charges for stock-based compensation expense.

We previously announced that we have missed the deadline to file our 10-Q for Q206, and we received a letter from NASDAQ indicating that the company is not currently in compliance with NASDAQ’s listing requirements. There are also implications on our convertible notes due to the delayed 10-Q filing, which I will talk about in more detail when I discuss Juniper's balance sheet.

On September 26, Juniper appeared before the NASDAQ qualifications panel and presented a plan to get back into compliance. The panel has not yet rendered a decision.

Our investigation is ongoing. However, it is our firm intent to file our 10-Q and any necessary restatements before the end of the year. Juniper is committed to resolving these issues as expeditiously as possible.

Similar to the second quarter, Juniper is not in a position to announce detailed financial results for the third quarter. Juniper will not be discussing any GAAP metrics that are affected by stock option expense. Although we are unable to announce these GAAP metrics, we are providing as much information as possible around most non-GAAP metrics.

Please note that these numbers are preliminary and represent our forecast of what we believe the numbers would be without any impact or changes resulting from the stock option investigation.

Now let me get to Juniper's results fort the quarter, which I am pleased to say are in line with the guidance we provided.

As I take you through some of the detailed metrics, please remember that our business will be lumpy across all key metrics, including application, geography, as well as by product mix and market segments.

Total reported revenue for Q3 was $573.6 million, an increase of approximately 5% from the prior year, and up slightly from last quarter. Year-to-date revenue is up 15% compared with 2005.

Had we been able to report a full income statement on a non-GAAP basis, and assuming no expenses related to the options investigation, our results are in line with the guidance we provided last quarter of $0.18.

For our infrastructure products, we recognize product revenue of $345.6 million, down slightly from Q2. We recognized revenue on a total of 2,791 infrastructure units this quarter, and we shipped 46,398 infrastructure ports, both up from last quarter.

This quarter, the core represented greater than 50% relative to the edge. We are very pleased with our continued strength in the core. Year-to-date, we have recorded over $400 million in T series revenue, which is up almost 50% from ’05. This represents the momentum of these products, as we support a next generation network build-outs and further reinforces the fact that our customers have accepted the Junos operating system and architecture for scaling the core as the best in the market.

The service layer technology segment performed well. This includes firewall, SSL, IDP, and other security products, as well as J series and application acceleration solutions. Revenue for Q3 totaled $121.7 million, up over 4% versus Q2, due to improved focus of our sales efforts in penetrating the enterprise market and some great new customer wins.

We saw growth in firewall, in particular the SSG product line, and WXNDX products. SSL for this quarter was relatively flat. IDP standalone and J series were down.

Now for some more detail on elements within our business.

Total service revenue was $106.3 million, up approximately 33% from the prior year and 7.8% from last quarter. This increase was due mainly to growth in the contract and stored base.

The total book-to-bill ratio was great than one in the quarter.

We had some very strong contributions this quarter, as Siemens represented 13% and Ericcson 11% of total revenue. We saw particular strength at Deutsche Telekom with Siemens, as well as China Telecom and China Mobile through Ericcson.

From a geographic perspective, we have a healthy mix. The Americas represented 43% of total revenue in Q3, down slightly from Q2. However, Asia increased to 23% from last quarter, and EMEA remained at 34%.

In EMEA, we saw strength in Norway, Poland, and the United Arab Emirates, with particular strength in Germany, Spain, the U.K. and Sweden. In Asia, we saw growth in New Zealand, Korea and Japan, and particular strength in China, given the wins of China Telecom and China Mobile. Asia was still below historical levels, primarily due to the NGN pause, which we have been discussing this year.

With regard to Japan, as we have stated, we expect decisions to be made over the next couple for quarters, with revenue implications for ’07. However, the choice of formal public comment and timing of the network rollout is up to our customers.

We expect to see continued lumpiness by [quarter] as quarterly trends fluctuate.

Revenue through our direct sales was approximately 23% versus 25% last quarter. We are pleased with the expansion and leverage of our channel presence.

Non-GAAP gross margins were up slightly from Q2, which were slightly better than we expected, due to a good mix of products and an increase in service revenue.

Non-GAAP operating expenses in total were up by 4% compared with Q2. On an absolute dollar growth basis, the primary increase was R&D, as we focused on internal innovation. We saw a small increase in sales and marketing as we continue to invest in our global sales force.

Non-GAAP net interest and other income was up about 20% versus Q2. This increase was primarily due to higher interest rates and an increase in our cash position.

As expected, operating income came in as planned, and as a percentage of sales, flat with Q2. I will speak more about our operating income later in my comments.

Now, a few comments regarding the balance sheet. I am pleased with our cash flow this quarter. Cash, cash equivalents, short and long-term investments increased by $167 million to $2.4 billion. With regard to cash, as you know, on our balance sheet, we have $400 million in zero coupon convertible notes. Because we are late in filing our 10-Q, bond totals can, if they choose, call in the bonds if we have not filed the 10-Q by October 24, 2006. At this moment, we do not expect the bonds to be called in, as they are currently trading above par. However, should this happen, Juniper obviously has sufficient funds to pay our bond totals, given our cash position of $2.4 billion.

Net accounts receivable was $285 million, and day sales outstanding was 45 days, compared with 40 days last quarter.

As stated last quarter, we expect DSOs to be in the range of 40 to 45 days, depending on the mix of partners and linearity.

Total deferred revenue was $346 million, compared with $309 million last quarter, mainly due to the increase in service contracts. As a reminder, deferred revenue is made up of service, channel inventory, and product currently unrecognizable for revenue.

Cap-ex was $26.4 million, depreciation was $19.7 million during the quarter.

We ended the quarter with 4,613 in total headcount, up from 4,347 at the end of Q2. The majority of the headcount increase was in sales, service, and R&D, with over 35% of the total increase in the low-cost geographies of China and India.

Now for guidance. The following forecasts and guidance are non-GAAP and forward-looking statements. The actual results can vary for a number of reasons, including those mentioned in our most recent 10-Q filed with the SEC, as well as any impact resulting from the completion of the stock option investigation.

We expect revenue for Q4 in the range of $590 million to $595 million.

We expect stable gross margins in Q4 and expenses to grow in line with revenue.

The expected tax rate remains at 29%.

We expect non-GAAP EPS of $0.19 for Q4.

As discussed previously, in the short- to medium-term, operating margins will be driven below our long-term model of 20% to 30% into the low-20s in order to invest in our growth. The bulk of the investments will be in sales and R&D. We will return to our long-term operating model as a function of significant sustained growth.

As Scott discussed earlier, we are confident of our opportunities in the marketplace and also recognize that there are challenges we face. Juniper is a $2 billion company in a $20 billion market.

On the service provider side, we see the next generation networks and IP video as tremendous opportunities over multiple years. Based on trends in the enterprise, we have a huge opportunity to leverage our strengths in routing, security and application acceleration.

As usual, the GAAP EPS target is not accessible on a forward-looking basis due to high variability and low visibility with respect to the non-recurring charges which are excluded from the non-GAAP estimates.

That concludes my remarks. Now we would like to take questions. Please limit yourself to one question. Thank you.

Randi Paikoff Feigin

Gina, if you could please instruct the audience regarding the queuing process so we can take questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from the line of Tal Liani, Merrill Lynch. Please go ahead.

Tal Liani - Merrill Lynch

The question I have is one on the quarter, but one clarification on your announcement today with the MX960, so on the quarter, can you describe the trends in routing? You went through all the strong points, but if I look at expectations for routing revenues in the quarter, total revenues are in line to slightly better, but routing revenues are below expectations and SOP and services is above. What is happening within routing where it comes a little bit below expectations?

Second, on the MX960, you spoke about the specs. Would you mind to discuss the gross margin characteristics of this? Will it have any impact on the company or is it going to be at this sort of corporate leverage? Thanks.

Scott G. Kriens

Tal, sort of in reverse order to your questions, the MX960 will generate margins consistent with other products, so we do not see any impact there.

With regard to the trends, the trends that we see I would say are difficult to attach to any given 90-day period in terms of router product revenues. Also, from what we see and from the opportunities around some of these NGN decision criteria, we think this will play very well to the design center of the entire portfolio, and what actually the MX960 represents is another layer in that portfolio, not so much because of its standalone ethernet capabilities, which all by themselves we think are best-in-class, but what it actually does is it changes the market.

What we are really talking about is an infrastructure market for which we now have an aggregation component called the MX960, but it is the same Junos operating system footprint that now goes across the core, across the edge, and now across aggregation as well.

The trends that we see there are what give us the confidence that we have, and also as we watch NGN unfold and the architectural requirements just align so well with what we do, that creates the enthusiasm for the opportunity.

I think the key will not be looking at it over a given 90 days, but watching its impact on our revenue velocity as we watch some of these NGN decisions come to bear, and also as we see the MX product go out into the marketplace.

Randi Paikoff Feigin

Next question, please.

Operator

Our next question comes from the line of Nikos Theodosopoulos, UBS Warburg. Please go ahead.

Nikos Theodosopoulos - UBS Warburg

Yes, can you hear me?

Scott G. Kriens

Yes, go ahead, Nikos.

Nikos Theodosopoulos - UBS Warburg

Thanks. My question is on the services business. Over the last several quarters, this business has been dramatically outgrowing the growth of the product part of the business, so I wanted to see if you could elaborate on why that is happening and if it will continue to happen. As part of that, you mentioned in the dialog that the gross margin was helped by a mix towards services. Historically, this has been a lower margin business versus the product business. Could you elaborate on what you meant about services mix helping the gross margin being up sequentially this quarter? Thank you.

Scott G. Kriens

A couple thoughts, Nikos. First of all, the services business has not really been a margin drag on performance in the past. Maybe we can perhaps clarify that some more offline, but it has been a similar contributor, I would say, so there is certainly not likely to be a dilution as a result of it.

There are a couple of things that drive the services growth. One is we continue to mine the installed base in the enterprise for opportunities to develop our services business and the enterprise marketplace continues to be, and probably will continue to be, a pretty rich source of opportunity for the services business.

But also remember that as we do recognize product revenues in growing the product business, by accounting practices, we have to accommodate services as a component of that, so it will tend to cause there to be strength in the services business, as a matter of categorizing what in many cases are really decisions and wins brought about not only in this quarter, but obviously since it is ratable over time, wins in prior quarters that translate into the distribution of revenues across services in order to remain consistent again with accounting practices.

Some of the services revenue strength that you see coming through the business is a result of the product wins and the decisions that have been made in our favor over the last couple of years, showing themselves in the form of services revenue growth as sort of a distribution consequence, meaning distribution of revenue in the accounting consequence.

Randi Paikoff Feigin

Next question, please.

Operator

Our next question comes from the line of Jeff Evenson, Sanford Bernstein. Please go ahead.

Jeff Evenson - Sanford C. Bernstein & Company, Inc.

You mentioned during the commentary that you recently extended your contract with Lucent. I was wondering if you could give us a bit more color on that, particularly when it was signed and what the relationship entails.

Scott G. Kriens

Sure, Jeff, I would be glad to. We have many common customers with Lucent, obviously not the least of which are companies like BT, or Embark here in the U.S. Significant customers of both Juniper and Lucent, or Alcatel Lucent now.

The extension in the contracts that we have signed over the coming years that have been recently renewed are examples of the commitment that both companies have to providing the service, the support and the system integration to these major customers, as well as continued access and supply of the product to those customers, where that is part of both the contract relationship or the opportunity that we see together.

From out point of view, and I will be careful here not to speak on behalf of Lucent or Alcatel in this, but in our perspective, this continues to be a strong partnership opportunity for us. It is not pure in the sense that it is without some potential overlap, but we are very confident in the strength of our products to win the favor of our customers, and when that happens, we are also very comfortable in working through this relationship on a long-term basis, so the renewal of the contracts simply continues and really reinforces in unambiguous terms to our common customers that the strength of the relationship is intact.

Jeff Evenson - Sanford C. Bernstein & Company, Inc.

Does the contract include going after new customers together?

Scott G. Kriens

Sure. They will have full rights to the product and we will work together in opportunities to continue to sell those products to both existing and new customers, so there are not constraints of any kind.

Jeff Evenson - Sanford C. Bernstein & Company, Inc.

Thank you.

Randi Paikoff Feigin

Next question, please.

Operator

Our next question comes from the line of [Yoon Yongchul], Lehman Brothers. Please go ahead.

Yoon Yongchul - Lehman Brothers

Thank you very much. Can you hear me okay?

Scott G. Kriens

Yes, go ahead.

Yoon Yongchul - Lehman Brothers

Great. I have a question on the op-ex. First, a clarification. I thought I heard, Scott, you mention that the operating margin was lower sequentially than Q2. I also thought I heard Bob said it was sort of flat. Just clarify on that. Going forward, I understand as you invest in different products, making significant investments, but in terms of the timeline, at what point do you think next year in ’07 when they start to see the operating margins start to trend back up to sort of the mid- to high-20s? Thank you.

Scott G. Kriens

A couple of things. Certainly as we see the opportunity, there has been a wealth of new products here that have come out in the last three to six months, and as recently as today’s announcement, but nine new products in the area of our secure services gateway, our SSG products, the M120, the E320, the MX960, new chips, new software.

I would not say -- it really is not the case that we just saved it all up, but for some reasons, these things come in clusters and over the last several months, there has been a lot of product rollout.

We certainly expect and are beginning to see the likelihood of those products getting some traction and making some contributions in ’07. It is hard to say exactly when and by how much, and also difficult to say what that would translate to in operating margin contribution as a percentage.

What I would say, and perhaps the best way to describe our priorities here, are to grow revenues, obviously top line, number one. To grow our operating contribution on a dollar basis, to grow absolute operating income, number two. Number three is to grow market share.

We see, and as I went through in some of the numbers, we are very encouraged by our market share position, and by the continuing separation between what I will call the rest of the market and what we see as our opportunity.

As long as we can grow revenue, grow operating income on a dollar basis and grow our market share, we will be serving our priorities in the short- to mid-term. Clearly long-term, an operating model which has operating margins at the 25% or above level, is, has been, and will continue to be a strategic goal of the company’s. It would be something we could achieve in the very short-term, actually. We could do it next quarter, but it would be done at the expense of the market share opportunity and some of the product innovation we have rolled out. Ultimately, that would mean it would come at the expense of the top line revenue growth, or the absolute operating income growth that we see as a $2 billion company in a $20 billion market.

Short- to medium-term, those will be our priorities. Longer term, we continue to be focused on the operating model of the 25% plus, and that continues to be a commitment we have to our shareholders.

Randi Paikoff Feigin

Next question, please.

Operator

Our next question comes from the line of Mark Sue, RBC. Please go ahead.

Mark Sue - RBC Capital Markets

Thank you. Scott, if we exclude NTT’s network upgrade, how would you classify overall router demand? Is it very -- is it selective upgrades? You mentioned the growth in IP traffic. Is it accelerating, and is it necessitating more routers?

Scott G. Kriens

You know, Mark, I think I would say it this way, which is the router demand is improving, or increasing on two dimensions. One is quantity and one is quality. It might be improving or increasing more in the quality dimension, actually, with a couple of wildcards.

Let me explain all that.

Certainly the demand for router or network quality is increasing, probably most of all. In simplest terms, of course, as you know, it translates into meaning high quality video, audio and voice services without interruption, and a lot of the delay sensitive traffic, and also the mission critical business traffic, the secure encrypted traffic, the demand for high quality traffic processing is going up probably more than anything.

What actually drives the quantity demand is going to be very interesting to watch, especially with, for example, the YouTube acquisition, or proposed acquisition being one sort of newsworthy observation of the last week. If you take a lot of video traffic in a network, you already get a big impact on total demand, because it is a huge multiple of e-mail and other traffic we can type at the rate of a character per second. But even more powerfully, from a network design standpoint, if you go to peer-to-peer video, such as YouTube where people are blasting traffic from anywhere to anywhere at video levels on a per image basis, the demand for that traffic changes dramatically in terms of the quantity.

It is kind of like -- a simple example or analogy, it is kind of like a freeway where you did not just get on the freeway going into the city in the morning and going home at night, but you got on it from every on ramp all at the same time going everywhere all at once. Imagine the size of the freeway you would need to do that, and that is exactly what YouTube or peer-to-peer, high volume traffic does to network designs and to capacity requirements.

It is both capacity and quality of traffic, but I would say at this point, we are still watching peer-to-peer video to see how mainstream it becomes, and the traffic quality demands of security and these other delay sensitive services, those are very real and very present today.

I think I would characterize the demand more powerfully on that front, but if it happens in peer-to-peer, watch out.

Operator

Our next question comes from the line of Brant Thompson, Goldman Sachs. Please go ahead.

Brantley Thompson - Goldman Sachs

Scott, if I could just circle back to one of your near-term and medium-term priorities of absolute operating income growth, I know it is difficult to forecast when revenues return, at what rate, these types of things, but a lot of decisions you make around your R&D investments, your beefing up of your sales channels, is something you can have some visibility around.

Is there anyway you can give us a gauge as to whether or not your op-ex increases that we have seen over the last couple of quarters, our rolling run-rate, is going to continue at this run-rate for the next 12 months? Is this the run-rate we should assume is just necessary to sustain the investments, or have we kind of peaked in terms of some of that acceleration and the growth, while it will still be good, it will slow down a little bit.

Could you give us any kind of color around where you see that?

Scott G. Kriens

A little bit, or let me do my best at it. I think that, as I mentioned, the absolute growth is the higher priority to us than the percentage is, but to your point, we would like to see operating expenses grow more in line with revenues, meaning not to outpace them.

The real answer as to whether that will be what happens is a function of the slope of the revenue growth curve. If we see sustained, and particularly if we see increasing rate of growth in revenues, then I think it will be easier to imaging that outpacing the op-ex growth.

If, for whatever reason we did not see that, then I suppose the first thing we would do is go back to our strategy and make sure that we were still seeing the same assumptions and still carried the same beliefs, and that the importance of the IP infrastructure was not something we were overstating, for example, or the security was not becoming less important, or that there were not maybe fewer people getting on the network, or that the network mattered less to business success.

If we saw some of those things happen in contrast to what we believe currently, then we might batten down the hatches here more aggressively. But as long as we see the demand for what we do, and especially across, as we look across the enterprise market, this is probably the interesting thing to us, is it is starting to look more and more like déjà vu all over again.

It is mission critical, scalable, highly reliable, highly intelligent, high performance networks that define the success of the customer. Now, you could insert service provider, customer responding to the Internet demand eight years ago when we first came to market, and that would be Juniper. You could insert the word enterprise before customer in today’s world and the importance of SOA and some of the statistics I mentioned about the migration, the network dependent application development and you have today’s world, but behind that, the infrastructure requirements are the same.

Today, when we walk into an enterprise -- I had this experience in this last quarter actually, in New York. We walked into one of the major financial houses and had a discussion, and they said you need to realize that if we are going to rely on Juniper, that you have to support -- I guess let me not be specific, because it was not a public discussion -- call it hundreds of thousands of employees and so, are you prepared to work at that scale? We said considering it is the same operating system and the same products that support 7 million people in Germany or 8 million people in Korea, we feel pretty comfortable we can commit to hundreds of thousands in your enterprise.

That was quite a powerful statement to be able to make.

I guess just a long-winded way of saying we continue to see compelling alignment between opportunity and capability, and that is going to continue to drive our investment thesis, but it is also fair to go all the way back to your point precisely, it is fair to expect that to translate into revenue growth, and as it does, to be prudent financially in managing our op-ex, and in the process, being mindful of the business model and operating margins, not only operating income on an absolute basis, but also operating margin on a percentage basis.

It is a function of growth and it is something obviously we are going to watch closely here every day.

Operator

Our next question comes from the line of Simon Leopold of Morgan Keegan. Please go ahead.

Simon Leopold - Morgan Keegan & Co.

Thanks. I was hoping we could go back and revisit the Japanese market, and maybe give us a bit more color. Specifically, what I am looking for is whether or not the work you are doing there is in partnership with NEC, who you have worked with in the past, and also if some of the timing of progress in that market is related to the fact that NTT is on an April fiscal year, if that is a boundary condition.

Just real quick, if you could give us an update in terms of the session border control features that came from the Kagoor acquisition. You have talked about integrating those in the past. Just a quick update on where you stand on that, too. Thank you.

Scott G. Kriens

First, to the Japan question, NEC is an extremely important partner of Juniper's, and has been, as you know, for some time, and is going to continue to be. I do not see any correlation between their April fiscal year-end as any kind of a boundary, or even a condition, really. It is driven by -- the opportunities and the timing of these things are driven really by the customers, and I do not see the April fiscal being an issue.

The NGN and the opportunities, and I will be, actually, I think it is two weeks or three weeks, I will be having [tunyaki] in Tokyo, talking about these very things in great detail, so needless to say, we are paying a lot of attention to this.

As I mentioned in the challenges, some of the comments I made about the challenges, it is the challenge that we are not seeing the reportable results appear at the same time as the investments necessary to participate in this market, but Japan alone as a country has approached near 10% of Juniper's revenue in prior periods, and its importance to us really cannot be overstated.

This is an investment decision that we are committed to in a market that we have been and continue to be very successful in with partners like NEC that matter to us a great deal. We are going to stay very focused on that.

To your second question with regard to session border controllers, or SBCs, this is clearly functionality which we see as a feature. It is really not, other than on a niche basis in the short-term, it is really not a product category. It is feature and functionality within the IP infrastructure, and that is our development priority.

I do not think that is different than a lot of what look to be product categories today, but in time actually are not. Word processing looked like a product category or a market not that long ago, and it turned into a feature. I think you are going to see a lot of that happen in networking over the next 12 to 36 months. A lot of what appear as niche products, in fairness, they appear out of necessity, if there is something particular they can offer, but it is just hard to imagine they have any destiny except to become features within the infrastructure.

We have a friend of ours down the street here who exerts a fairly large influence on that marketplace and has the same opinion, so it would be surprising to see any other outcome in the medium- to long-term, and certainly with regard to session border controllers, or session border control technology, it is a feature of the IP infrastructure, in our view.

Randi Paikoff Feigin

Next question, please.

Operator

One moment, please. The next question comes from the line of Paul Silverstein, Credit Suisse First Boston. Please go ahead.

Paul Silverstein - Credit Suisse First Boston

Thank you. Scott, just a couple for quick clarifications. On the last question, on the SBC, have you already integrated that into the router, or is that still to come?

Scott G. Kriens

You know, Paul, as we sit here, I do not know if I can tell you exactly what we have announced, so my comments will be careful at this point. Its functionality we think is very important and its capabilities, which are in the marketplace today, being supported by Juniper in some very important customer situations, and that is clearly going to continue. Its evolution over time is, as I mentioned earlier, functionality within the infrastructure.

Perhaps we can follow up. I am not sure exactly what we have announced, so I will not preclude what we may have said publicly, but if that helps, that is -- it is in existence. It is important. It is supported in customer accounts and it is going to continue to be a function that is important to us.

Paul Silverstein - Credit Suisse First Boston

Scott, to your point last quarter in talking about the shift to integrate, in the enterprise SLT, to integrated platforms from standalone. Can you give us an update? I think you mentioned last quarter integrated was up, standalone was down. Can you tell us where integrated is as a percentage of your total SLT revenues, and what you saw this quarter in terms of those two trends?

Scott G. Kriens

You are making me look bad, Paul. You are asking me all these questions I cannot answer.

I do not know the answer to your question in percentage terms, but I do think, as you mentioned, we commented on this last quarter. It is true again this quarter, that we have seen -- while we saw, for example, SLT or our service layer technology grew about 4% quarter over quarter, our firewall products, our SSL, SSG, these products that integrate intrusion detection, prevention, routing, firewall capabilities, those are all the products that contributed to the growth. For example, our standalone intrusion detection product was the one that was down, and even our J series, although it was partly down because it had a strong quarter last quarter, so some of that is a little bit of a misleading snapshot, but a lot of the growth we have seen in the routing functionality is coming from the SSG products because they integrate state-of-the-art security with wide area routing functionality as opposed to standalone.

I do not know that I have -- I cannot tell you because I do not exactly the percentage distribution of that change, so some of this is more of a comment anecdotally, but clearly, as we look across the demand for the integrated products -- and it is not just the integrated products that we see making up a higher percentage of revenue. If you went through the customer requests and the line item enhancements we call them here, but they are basically when a customer says we want the product to do more different things than it does, if you went through and combed that list of requirements for future development priority, my gut feel is you probably would find 80% of those driven by requirements for integration.

So it is reflected not only in the mix, but it is reflected in what will be our priorities, because those are the inputs we use to make our development decisions. As a result of those deliverables, as they occur over time, I think we will see even more power demonstrated here.

I also think, as probably a final marker to try to find some quantitative evidence, is this quarter we finally took over the number two spot in worldwide security. That is largely due to the fact that have integrated comprehensive solutions and on a comparative basis, relative to a standalone security providers that previously occupied these spots in market share. That is the reason they do not anymore, the integrated proposition.

Paul Silverstein - Credit Suisse First Boston

One more real quick one, Scott. On the MX960, any thoughts in terms of the extent you get your routing business growing again, how much of that growth will come from MX960? What is the timing and scope of that making an impact on your revenues?

Related to that, you mention that you do not look at the business over any 90-day period. I appreciate that, but your routing business now has been down three consecutive quarters. It is almost down 10% from the fourth quarter peak. Is there any larger trend going on? I understand the opportunity that is out there. I understand the 960 fills a big hole, but any insight you can give us on that?

Scott G. Kriens

I think the two things I would say about that, Paul, one, we do see the -- I guess first of all, just some specifics. The MX960 will be eligible for revenue in the first quarter of next year, so it should begin to make contribution at that point.

I am not sure what rate of contribution it will make or how quickly it will do that. We tend to look at the market a little bit differently, because I think we are not in a position to declare this until we watch product shipments and outcomes of decisions materialize.

I actually think that what you will see with the MX960 is far more than just our participation in the carrier ethernet market segment. I think it is going to be the end of the carrier ethernet market segment, because what there is is a market for IP infrastructure, and we have an operating system footprint that runs across the core, the edge, and now the aggregation layer.

I think aggregation will be increasingly driven through ethernet, because it is fast and it is simple and it is cheap, and that is how it has won all of the contests it has entered at 1, 10, 100 megabit, 1 gigabit, 10 gigabit in the past, and it is probably why it is going to be so powerful here.

It is not a segment. It is just a vehicle on which the IP infrastructure, in our case, Junos, gets delivered. So we tend to look at the marketplace as a market for the operating system with delivery vehicles, as opposed to the hardware on which it is delivered.

Then, let’s see, with regard to revenues in total on the routing side, remember the difference between reported revenues and shipments and deferred revenues. What you see on a reported basis, as we talked about, is less than what has been shipped and paid for, by the way, on a recognized plus deferred basis. Would we like to have seen everything grow faster and we would like to see the NGN pause disappear, or the MX products show up sooner, certainly but strategically, I am probably more confident today than I have ever been.

Randi Paikoff Feigin

Gina, we have time for one more question, please.

Operator

Perfect. Our last question comes from the line of Tim Daubenspeck with Pacific Crest. Please go ahead.

Tim Daubenspeck - Pacific Crest Securities

Thank you very much. My question is around the E320. You talked about in the prepared remarks, 400 units shipped. That is a pretty big number, relative to some of the numbers I think you were talking about at Global Com, substantially higher than some of the numbers that you were talking about units shipped at Global Com. Could you just talk about how much of an impact the new ethernet interface upgrade had? When can we start to see really some of the contribution on the revenue side from some of these unit orders? Thank you.

Scott G. Kriens

You know, the interesting thing, Tim, is certainly the new interfaces and the densities have helped, but a lot of those shipments and the impact of those elements has yet to be felt, because we have not been shipping that functionality, either the enhancements to the interface capability or the absolute capacity that now allows us to have the highest capacity platform in the market.

Those are not capabilities that have been shipping for long enough to really be the major drivers behind the units that have been shipped. Now, some of that is a function of people believing those are coming and buying units in advance, knowing those will be made available, so it is not -- that is why it is a little bit hard to be black and white about it.

The shipments have probably I would say not yet really represented the opportunity that exists with the now comprehensive functionality that has been delivered.

There is a lot of demand still worldwide for broadband access, for DSL access and for capabilities that are enabled by the E series products. There is also an installed base out there for us that is quite significant in the many millions of DSL customers we support in these different countries, so that is clearly a driver for some of this as well.

We believe that this E series product line and the 320 in particular, this is a flagship capability for the company, and one which is going to be a significant contributor for many quarters and many years to come and is going to be a very strategic differentiator because of its strategic importance to customers.

I am very encouraged, both by what we have seen and by the potential for what we see going forward.

I guess perhaps this is a summary on the quarter and on the status of what we see in total. It is really I think a reflection -- I made these comments in the scripted remarks, but we have set out through the course of this year to deliver on a number of fronts, and what is being demonstrated here over the last weeks and months are the fruits of that labor in terms of the delivery of those capabilities. Some of it is visible in the form of products that you can touch, platforms like these enhancements to E320, the M120, the SSG products, the MX960. Some of it is not so available to touch but potentially more powerful in the operating system integration and enhancements that run across these, and some of it is probably even less visible from the outside, but at least as compelling from the inside, which is the business practices and some of the organization design, and some of the personnel that we have deployed, and the talent that we have recruited in certain areas and the focus that has given us on the enterprise market.

When I line up all of that, it becomes the source of our enthusiasm for the opportunity. The timing of it all and forecasting of it all and realization of it all in the form of quantifiable results is now our assignment, and that is what we are going to work very hard on over not just the balance of ’06, but it is the focus of planning that is already underway for ’07.

Randi Paikoff Feigin

Great. Well, we would like to thank everyone for your participation today. There will be an audio replay available of this call on the investor relations section of our website. In addition, you can call 800-633-8284 and enter the reservation number 21305676. Again, the phone number is 800-633-8284, reservation number 21305676.

We currently plan to report fourth quarter 2006 results the week of January 29th in 2007. If you have any additional questions, please feel free to call the investor relations department. Again, thank you for your participation on the call today and have a nice evening.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect all lines.

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Source: Juniper Networks Q3 2006 Earnings Call Transcript
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