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Juniper Networks (NYSE:JNPR)

Q2 2010 Earnings Call

July 20, 2010 4:45 pm ET

Executives

Kevin Johnson - Chief Executive Officer, Director and Member of Stock Committee

Kathleen Bela - Vice President of Investor Relations

Robyn Denholm - Chief Financial Officer, Executive Vice President, Member of Concerns Committee and Member of Stock Committee

Analysts

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc.

Tal Liani - BofA Merrill Lynch

Nikos Theodosopoulos - UBS Investment Bank

Jeffrey Evenson - Bernstein Research

Troy Jensen - Piper Jaffray Companies

Rod Hall - JP Morgan Chase & Co

Jess Lubert - Wells Fargo Securities, LLC

Paul Mansky - Canaccord Genuity

Jeffrey Kvaal - Barclays Capital

Mark Sue - RBC Capital Markets Corporation

Brent Bracelin - Pacific Crest Securities, Inc.

Ehud Gelblum - Morgan Stanley

Simon Leopold - Morgan Keegan & Company, Inc.

Simona Jankowski - Goldman Sachs Group Inc.

Operator

Greetings, and welcome to the Juniper Networks Second Quarter 2010 Earnings Results Conference Call. [Operator Instructions] It is now my pleasure to introduce your host, Kathleen Bela, Vice President, Investor Relations for Juniper Networks. Thank you, you may begin.

Kathleen Bela

Thank you, Joe. Good afternoon and thank you for joining us today. Here today are Kevin Johnson, Chief Executive Officer; and Robyn Denholm, Chief Financial Officer.

A couple of housekeeping items before we begin. First, as a reminder, there is a slide deck that accompanies today's conference call. To access the slides, please go to the IR section of our website at juniper.net. This call will also be available to download as a podcast. For details, visit our website. If you're having any trouble accessing the slides, please try logging out and logging back in to the call and that should bring you back to the section on slides.

With that, I would like to remind everyone that statements made during this call, concerning Juniper's business outlook, economic and market outlooks, future financial operating results and overall future prospects, are forward-looking statements that involve a number of risks and uncertainties. Actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including economic conditions, generally or in the networking industry, changes in overall technology spending, the network capacity requirements of service providers, the timing of orders and shipments, manufacturing and supply chain constraints, variation in the mix of products sold, customer perception and acceptance of our products, litigation and other factors listed in our most recent report filed on Form 10-K with the SEC.

All statements made during this call are made only as of today. Juniper undertakes no obligation to update the information in this conference call in the event facts or circumstances subsequently change after the date of this call. In discussing the financial results today, Robyn will first present results on a GAAP basis. And for purposes of today's discussion, we will also review non-GAAP results. For important commentary on why the management team considers non-GAAP information, a useful view of the company's financial result, please consult our 8-K filed with the SEC today. For the detailed reconciliation between GAAP and non-GAAP results, please see today's press release.

In general, non-GAAP results exclude certain non-recurring charges, amortization of purchased intangibles, other acquisition-related charges and expenses related to stock-based compensation. In today's call, Robyn will also be providing forward-looking guidance. As a reminder, guidance is provided on a non-GAAP basis. All guidance is forward-looking and actual results may vary for the reasons I noted earlier. GAAP guidance measures are not available on a forward-looking basis due to the high variability and low visibility with respect to the charges, which are excluded from the non-GAAP guidance estimates. Please note that today's call is scheduled to last for one hour, and please limit your questions to one per firm. With that, I will turn the call over to Kevin.

Kevin Johnson

Thanks, Kathleen, and welcome, everyone. Juniper had a strong second quarter, including record revenue and operating margin expansion. We're executing well against the 2010 operating principles we outlined at the beginning of the year. As we look towards the second half of the year, we intend to drive our growth agenda and build momentum going into 2011.

I will comment briefly on the current business climate and some progress against our strategic agenda. I will then hand off to Robyn for more details on our results and guidance for Q3.

The global economy continues to recover, yet the pace and trajectory of that recovery varied by geography. A number of economists now expect global GDP to grow in the low mid to single digits this year.

In this economic climate, we have seen growing demand for our products and services and we delivered growth in all three theaters: EMEA, the Americas and Asia Pacific. Economic recovery in Europe continues to lag and the sovereign debt situation in southern Europe added to concerns about the pace of recovery across Europe. The U.S. continues to show modest GDP growth, though experts continue to debate the pace of the recovery.

Asia continues to grow, yet economic recovery in Japan continues to lag. Global demand for networking is increasing as more traffic is being carried over the Internet. Computing is being centralized in massive data centers, and more people and businesses rely on digital devices connected to the network.

Our investment in R&D and expanded routes to market support our growth agenda and position us well for spending cycle in some key scenarios, including mobility, video, security and cloud computing.

We continue to win deals globally as customers embrace our vision for the new network. Our business grew 24% year-on-year, with Service Provider growing 21% and Enterprise growing 31%. We are expanding our footprint with Service Providers, and we are pleased with the growing demand for our MX 3D edge routers and SRX security platforms.

We had a number of key design wins this quarter, including a significant win at Verizon with the MX 3D and SRX. We saw increased growth in our Mobile Secure Solution, based on the SRX platform. And we released Traffic Direct, a mobility solution on the MX 3D.

We are on track for early trial of the second offering from the Falcon project, the Evolved Packet Core, at the end of this year. We completed the acquisition of Ankeena. And we are now securing design wins and generating revenue from both Traffic Direct and the Media Flow Solutions.

We've made good progress globally in the Service Provider segment and I am particularly pleased with our growing relationship with large U.S.-based carriers and cable operators. For example, Comcast continues to expand its relationship with Juniper Networks, deploying Juniper's MX technology and T1600 core routers to support network expansion, including commercial and metro services. Comcast is also utilizing Juniper's EX Ethernet switches for scaling new services.

Relative to the Enterprise, we continue to make headwinds in the segment with an expanded portfolio of offerings. Our comprehensive portfolio of routing, switching and security, all running Junos, and our architectural approach for the data center is resonating with customers. During the quarter, we launched our next-generation data center architecture called 321 that enables customers to connect large numbers of data center servers and storage devices in a way that improved the economics and the performance of these massive data centers.

This is enabling growth in our EX business and positions us to expand momentum with our Stratus project. Our Stratus Project is on track. Earlier this year, we successfully completed first power on. We have fully verified the features in silicon, and we are now moving into the system test phase of the first wave of products coming from the Stratus Project. We expanded roster market in the Enterprise with partners, including IBM, large service providers and now Dell.

Dell began shipping their OEM version of Juniper products, all running Junos, later this month. We are also seeing growing Enterprise opportunity with service providers, who are delivering managed services and on-premise solutions. Both Verizon and AT&T are strong partners, with Verizon recently recognized by us as Partner of the Year at our annual Partner Summit.

In the Asia Pacific region, NEC is proving to be a great partner in the Enterprise segment. These are a few examples of the growing set of partners that are participating in our Enterprise growth agenda.

We are fueling innovation with investment in organic R&D, complemented by an increased focus on M&A that creates customer and shareholder value. Our combination with Ankeena is representative of the type of acquisitions we expect to do more of. This will be combinations that are complementary to Junos and accelerate our vision for the new network.

Looking ahead to the future, we maintain a positive outlook. Revenue momentum is expected to continue in the second half of the year. And we're positioned to take share in both the enterprise and service provider markets.

The foundation is in place, yet we are not taking anything for granted. We have to be focused. We have to execute and we have to stay true to our operating principles. We have very good competitors and the macroeconomic recovery continues to have some twists and turns. We are focused on those investments that deliver long-term customer and shareholder value, while at the same time managing our expenses diligently, maintaining a strong balance sheet and generating healthy cash flows. I look forward to keeping you posted on our progress.

And now, I'm going to turn it over to Robyn to dive into the financial results, as well as our outlook for the next quarter. Robyn?

Robyn Denholm

Thank you, Kevin, and good afternoon, everyone. I'm pleased to report that as a result of strong execution across our business and continued focus on our operating principles, we delivered record revenue and near-record operating profits in the quarter, all about underlying demand metrics was strong. Book-to-bill was well in excess of 1. Our products deferred revenue balance is healthy and pipelines exiting the quarter are robust.

We also expanded operating margins, while continuing to invest in R&D, customer support and sales and marketing. We are well on track to delivering profitable growth in 2010 and making progress against our long-term revenue growth objective while expanding operating margin.

I will provide more commentary on our outlook in a few moments. But first, as a reminder, all numbers include the Ankeena acquisition, which closed on April 19, 2010. We've seen increased customer demand to this technology, and we are very pleased with the way the integration is taking place.

Now a review of the numbers. On a GAAP basis, total revenue for the second quarter was $978 million, up 7% sequentially and up 24% year-over-year. GAAP diluted earnings per share were $0.24 for the second quarter, compared to $0.30 per share in the first quarter of 2010 and $0.03 per share in the prior year second quarter.

Non-GAAP earnings per diluted share was $0.30, an increase of $0.03 sequentially and up $0.11 compared to the prior-year second quarter. Let me now provide you with some color on revenue by region, business segments and markets.

One of our operating principles for the year was that we expect the macroeconomic environment to continue to strengthen throughout the year, and that the price of recovery of standing by our customers will vary by geography. This is proving to be the case thus far, and for the quarter we saw improved levels of spending in both EMEA and APAC, with strong demand indicated in all three regions in both the Enterprise and Service Provider market.

Looking at our revenue by region. For the quarter, Americas was approximately 50% of total revenue, EMEA was 30% and APAC was 20%. Americas revenue increased 1% sequentially and 26% year-over-year. We saw strength in regional service providers, content and cable service providers in the U.S. And in Latin America and Canada, we saw a strong sequential in year-over-year growth.

EMEA revenue was up 10% sequentially and 25% year-over-year due to strength in Western Europe, Russia and the Middle East. APAC revenue increased 22% sequentially and 19% on a year-over-year basis, with sequential growth driven by Japan, Southeast Asia and greater China. From a pipeline perspective, we had significant design wins in Edge and Security with both wireline and wireless carriers in all three geographies. And in addition, we had core design wins in Japan and Southeast Asia.

On a segment basis, total IPG revenue was $720 million, up $0.06 sequentially and 23% year-over-year. Total EX revenue was $92 million, up 20% sequentially. This includes product revenue of $88 million and was another strong proof point of our focused execution.

MX had another strong quarter with product revenue of $149 million, up 7% sequentially. Included in this result is our first full quarter of revenue for the MX 3D at $24 million. This new product has generated increased customer interest and showcases our innovation agenda.

SLT delivered record total revenue of $258 million, which represents an increase of 10% sequentially and 27% year-over-year. SRX product revenue grew 23% sequentially to almost $75 million. We had good mobile security wins in many large wireless carriers in the U.S., EMEA and APAC.

Our strategy is investing in R&D, and our effectiveness in execution on our innovation roadmap has translated into significant revenue growth over the past year. Our most recent product lines, EX, MX and SRX, have generated impressive combined revenues of just over $1 billion in the last four quarters, an 89% growth since Q2 of '09. This is another proof point that our R&D growth agenda is hitting the mark with our customers.

Looking more closely at the markets we address, Service Provider revenue is up 5% sequentially and up 21% year-over-year. This is due to a strong momentum in EX, MX and SRX and solid growth in key products. We now have 35 customers that will provide Juniper-powered managed services. More than double a year ago. This quarter, we saw good customer response with Traffic Direct, after its offering from Project Falcon, reporting our first revenue and a design win with a large mobile carrier in the Middle East.

Enterprise revenue was up 12% sequentially and up 31% year-over-year. This strong performance reflects our continued market penetration with our switching, routing and security portfolio. We expanded our switching and routing footprint in the financial services and government verticals.

For the quarter, Service Provider revenue was 63% and Enterprise revenue was 37% of total revenue. On a non-GAAP basis, total gross margin for the quarter was 67.9% of revenue, which is at the high end of our long-term target model range of 66% to 68%.

Product gross margins was 70.2% of revenue, up from 69.3% in the third quarter 2010. And this was due to better product mix and a decrease in manufacturing costs. Service gross margins were 59.3% of revenues, compared to 61% in the first quarter of 2010. This change was due to service mix and [indiscernible] investments in our customer support organization.

Moving on to our operating expenses. For Q2, non-GAAP operating expenses totaled $431 million or 44% of revenue. Relative to the first quarter, operating expenses increased $26 million, a decrease slightly as a percentage of revenue. Year-over-year, operating expenses were up $62 million or $0.17 due to an increase in variable compensation and investments in new product development and expanding routes to market.

R&D expenses were $206 million or 21% of revenue, up $16 million compared to the first quarter. This was due to ramping up headcount and prototype expenses to support key projects, including Falcon and Stratus, which are in advanced stages of development, as well as R&D expense from the Ankeena acquisition.

Sales and marketing expenses totaled $187 million or 19.1% of revenue, a $7 million increase sequentially. As we continue to invest in sales and marketing program to support our go-to-market plan. G&A expenses totaled $38 million or 3.9% of revenue.

Non-GAAP operating margin for the quarter was 23.9%, an increase of 70 basis points sequentially. This reflects continued execution against our operating principle of managing expenses while strategically utilizing resources in key growth areas. I am pleased with our progress towards our long-term operating margin goal of 25% or higher.

Looking at operating margins by segment, IPG operating margin was 25.2% compared to 26% in the first quarter. As a reminder, our investments in both EX and Project Stratus, as well as Falcon, are included within the IPG segment.

SLT operating margin was a record 20.4% compared to 15% in the first quarter. This is the first time we have broken through the 20% level and reflects a fabulous effort by the team. This is a result of efficient R&D execution on the product roadmap and aligning the sales and marketing resources to drive revenue growth.

Turning to the bottom line, Juniper posted non-GAAP net income of $164 million for the quarter, up 12% sequentially and up 58% from year-over-year. The GAAP tax rate for the quarter was 31.1%, the non-GAAP income tax rate for the quarter was 30.2%.

Looking at the balance sheet, we ended the second quarter with approximately $2.7 billion in total cash and investments, which was down slightly quarter-over-quarter. We are pleased with our continued strength in cash generation.

For the second quarter of 2010, Juniper generated cash from operations of $221 million. During the quarter, we also repurchased 6.5 million shares at an average cost of $27.33 per share or approximately $177 million. Our cash flow also reflects $64 million of net cash out in connection with the Ankeena Networks acquisition.

On a housekeeping note, we want to make investors aware that we intend to file a new universal shelf registration of $1.5 billion with the SEC in the next couple of weeks. This filing replaces our prior shelf, which has expired. The filing is consistent with our desire to maintain financial flexibility.

Our weighted average shares outstanding for the second quarter were 539 million shares on a diluted non-GAAP basis, up 2 million shares from the prior quarter. CapEx, consistent with prior quarters, totaled $45 million and depreciation and amortization was $37 million.

DSO improved to 36 days compared to 40 days in the first quarter and well within our normal historical range. Total deferred revenue was a healthy $768 million. Sequentially, product deferred revenue was down 5% or approximately $13 million. As a reminder, product deferred revenue is generally made up of two major elements: Channel revenue deferrals, including other sell-through revenues and future features of projects. For Q2 the future feature balance of deferred revenue was roughly flat with the first quarter.

Services deferred revenue decreased by 2% or approximately $9 million, which is typical for the fiscal second quarter. We ended the quarter with headcount of 7,732, an increase of 279 from the first quarter. This increase was due to investment in R&D, sales and marketing and customer service headcount. We also added approximately 65 new employees from the Ankeena acquisition.

Now let's turn to our guidance. As a reminder, guidance is provided on a non-GAAP basis except for revenue and share count. As we outlined at our financial Analyst Day in February, we are on a multi-year growth agenda. Our investments in R&D, our M&A strategy and our go-to-market plan are all aimed at delivering against our long-term model of 20% or higher revenue growth and 25% or higher operating margin.

As we continue to execute on our operating principles for 2010, we are confident that for 2010, our top line growth will be consistent with our long-term model. For the September quarter, we are expecting revenue of $1.02 billion, plus or minus $20 million.

Gross margins for the third quarter are expected to range between 66% and 68%. We expect operating expenses to remain roughly flat as a percent of revenue, an increase on an actual basis. We will focus our investments in sales and marketing and R&D to support projects that are coming to market soon and to capture the market opportunities ahead. These investments are consistent with the plan we outlined at our financial analyst meeting earlier this year.

Operating margin for the third quarter is expected to be approximately 23.5%, plus or minus 50 basis points. For the full year, we remain committed to growing our revenues faster than our operating expenses, resulting in profitable growth for the company. This would result in the third quarter non-GAAP EPS of between $0.30 and $0.32 and assumes a flat share count and tax rate of approximately 31%.

In summary, I'm very pleased with our results this quarter. We continue to make good progress on our long-term model objective, including revenue growth, improved operating margin and operational excellence. I want to thank our employees for their continued dedication to innovation and our growth agenda. We are confident of capturing the market opportunity ahead of us and delivering profitable growth in 2010.

Now with that, I'll hand it over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Ehud Gelblum with Morgan Stanley.

Ehud Gelblum - Morgan Stanley

Robyn, in looking at the guidance top line of 10% 20% and then kind of correlating that with your operating margin and EPS guidance, should we be assuming that sequentially, the operating margin clearly sort of is down sort of from where it is here to get into that, call it, $0.31 at the midpoint on that 10% 20% or should we be looking -- if the mix end up being basically roughly, how you think it is similar to this quarter, I was just wondering, how do we get into that range? I would have ended up with a little bit higher of a range given the revenue.

Robyn Denholm

Yes. So the way we are calibrating the operating margin at the high end, we should be roughly flat in terms of operating margin. So with the -- at the 10 40 level, 23.9%, 24% operating margin is what we're expecting at that level. And clearly, we were quite high in our long-term model range for growth margin this quarter. So if you calibrate in terms of 66% to 68%, which is our sort of targeted model for next quarter, then that will help with the model in terms of operating margin.

Ehud Gelblum - Morgan Stanley

Can you give us a hint as to how large Ankeena was this quarter and how much that'll be contributing to Q3 and Q4, was it negligible or something we can just count on two hands?

Robyn Denholm

Yes. So in terms of the overall integration of Ankeena, we're very pleased with the way that has gone. In terms of revenue, it's actually very nominal for the quarter. We are very pleased with the customer dialogue we've been having and in terms of the increased importance of video to a customer conversations and content distribution, et cetera. So it helps with all of those conversations. But in terms of pure revenue, it's very small for the quarter.

Ehud Gelblum - Morgan Stanley

Very small, meaning $5 million or less?

Robyn Denholm

Very small.

Ehud Gelblum - Morgan Stanley

And then finally, and then you said, I just want to make sure I understood you correctly you said 2010 on a revenue model, you said 2010 will be consistent with your long-term model of 20% growth. Given that you've now given guidance for Q3, which comes out to at your midpoint of 10%, 20% comes out to about 23-ish, 23.5 percentage growth. How should we read Q4 that it should kind of flow in such that the full year ends up being consistent with 20%, that will be deceleration from the last two quarters or that we should look at Q4 sort of being continuation off of what we've seen the last couple of quarters?

Robyn Denholm

Yes. I think in terms of the long-term operating model, our target is 20% or higher. And so for this year, we believe we will be in that range, 20% or higher.

Operator

The next question is from Troy Jensen with Piper Jaffray.

Troy Jensen - Piper Jaffray Companies

For Robyn, your gross margin has gone up four consecutive quarters now, at being at 67.9%. I mean, seems like the low end of the range is really unachievable. I mean what would it take for it to get down to that level assuming product mix and is there a point in the future were you guys may reassess your gross margin targets?

Robyn Denholm

In terms of the model range, it's in a good range for us over the last couple of years. I think that is the right range for us. There are very many factors in terms of what goes into the gross margin composition, as you know. And I went through a number of those at the financial analyst meeting. I'm pleased with the execution, both in terms of the sales side and also in terms of the operation group in terms of delivering quarter-over-quarter cost reduction. I'm also pleased with the investments that we're making on the Services side. As that business grows, positioning architecture services and also the state's part [ph] (41:59) to ensure that we have the right resources closest to the customer to ensure that we've got the right customer environment I think is key.

Ehud Gelblum - Morgan Stanley

Was there any 10% customers in the quarter and would you expect to have any in either at the second or any of the remaining two quarters of the year?

Robyn Denholm

So there were no 10% customers in the quarter. And we'll see how Q3 and Q4 pan out in terms of who will be a 10% customer in those periods.

Operator

The next question is from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets Corporation

Can you help us understand the moving dynamics within North American telcos, notably AT&T and Verizon, maybe the trends in business there? Should we factor in sequential growth in the near term with these key customers and then a sharp bounce in the fourth quarter? And also, Robyn, when we factor in your healthy pipeline, are you assuming a similar deal closure rate in 3Q as you did in 2Q and as linearity become more a factor in the third quarter?

Kevin Johnson

I'll take the first question and I'll hand off to Robyn for the second question. Clearly, we're pleased with our relationship with large Tier 1 carriers in North America and the U.S. And certainly, when you look at some of historical patterns, capital spending, in fact, I looked just at, certainly, the top two service providers in the U.S., spending of capital in 2009, range from 53% to 57% of their capital spend in the second half of the year. And so we are -- we do anticipate that there would be, perhaps, some uptick in spending in the second half of the year. But we haven't quantified that. Certainly, our guidance for Q3 reflects the view of what we think will happen. And we are planning for a bigger second half than we had in the first half with the larger Tier 1 service providers.

Robyn Denholm

Yes. And I think in terms of healthy pipeline, the thing that I was pleased about was it's both wireless, wireline content cable service providers. So it's pretty universal, and it's also pretty good across all of the geographies as well. So we conduct our quarterly business reviews, Kevin and I, and it was very good in terms of health of the pipeline.

Mark Sue - RBC Capital Markets Corporation

And closure rate, Robyn?

Robyn Denholm

So our closure rate, varies by geography and the size of the deal. But consistent with our recent past in terms of closure rates, I think it's fair enough.

Operator

The next question is from Nikos Theodosopoulos from UBS.

Nikos Theodosopoulos - UBS Investment Bank

I wanted to ask one question on the deferred revenue. I think you made a comment that, Robyn, you made a comment that Services deferred was down in the second quarter. I don't get a sense that, that's a seasonal trend. So maybe if you can just elaborate on that? And then the second question I have is there's been some concern in general about public sector spending, do you have any comment on whether you're seeing any change in the outlook for that portion of your business and if you can quantify it?

Robyn Denholm

I'll cover the first part of the question and I'll hand over to Kevin for the second. So in terms of deferred revenue, it was down quarter-over-quarter but it is still a very healthy balance overall. So on the product side, I commented in the prepared remarks that there are basically two parts to the product deferred revenue. The channel and other sell-through revenue, which was actually the piece that was down in the quarter and the future features, which was roughly flat with the first quarter. In terms of Services, the timing of bookings of multi-year deals influences that. And so when I look at that and I look at sequential patterns as bookings in the first quarter, then that is a normal sort of pattern for us in terms of the second quarter.

Kevin Johnson

Nikos, on the second question about concern in public sector, I think the concern is limited to the U.S. public sector. And it's really focused on the fact that U.S. Federal budget approvals and Congress working through getting final approval for that in this quarter. In Q3, it is the fiscal fourth quarter of the U.S. Federal government. And so depending on how Congress and the budgeting decisions unfold in the U.S. public sector, that could have implications on Enterprise revenue in the U.S., of which public sector is a part of. We think in terms of the range of guidance we've provided, we have enough range to reflect the fact that if there's some downside there, we're going to work hard and do what we can but it is a noted risk.

Operator

The next question is from Jess Lubert with Wells Fargo.

Jess Lubert - Wells Fargo Securities, LLC

Two questions. First, are you seeing anything from a gross margin perspective that would suggest the gross margins would be down during Q3? And maybe you can elaborate on whether or not you may use current strength to offer some additional discounts to drive share. And then from an operating margin perspective, infrastructure operating margins, pre-recession, typically stood at 28% to 30%. Is this the right level to be thinking about once revenue for the EX Switch and Project Falcon reach scale? And within SLT, can you help us understand what do you think about as far as the sustainable operating margin go for this business? Can you reach 25%? Or shall we be thinking about current levels as a more sustainable range?

Robyn Denholm

Okay, Jess. I think I can remember most of the parts of the question, but let me go back to the first one which is on gross margin. So the gross margin remains 66% to 68%. That is the range that we've been operating in for some time now. There is various influences on that. I do not see anything at this point that would lead us to believe that we're going to be outside of that range. It will be in that range. That's what we typically see at the beginning of the quarter. So I'm comfortable with that as the Q3 guidance. What was the second part?

Kevin Johnson

The second question, let me take a shot at that. The second question, Jess, was -- I'll paraphrase it as, "Do we believe the 25% operating margin is a sustainable margin to achieve?" And the answer is we do. As we outlined in the financial analyst meeting, we actually gave a range of R&D as a percent of revenue, sales and marketing as a percent of revenue and G&A as a percent of revenue. And that 25% operating margin was kind of in the center of those ranges. If you look at this quarter, R&D as a percentage of revenues is up about 21%, which is probably about two points higher than the high end that we outlined at the analyst meeting. And I think that's because we're in the core of some significant R&D on projects Stratus and the Falcon project, which are significant elements of our growth agenda going forward. So we believe that the investments we're making in R&D are clearly linked to our multi-year growth agenda. Yet getting the margin expansion and certainly sustaining it at the 25% or higher really is a function of us continuing to break through and get the scale economics, which you see us starting to get in the enterprise. And so, look, as we outlined at the analyst meeting, we still got strong conviction that, that is the multi-year plan that we're pursuing. We think 25% or higher operating margins are certainly achievable and sustainable.

Operator

The next question is from Tal Liani with Bank of America.

Tal Liani - BofA Merrill Lynch

I have three quick questions. The first one is about the impact of the euro that was over 10% change versus the dollar. And can you discuss pricing pressure or discounting? The second question is about the impact of the accounting change on deferred revenues. Last quarter, you changed the accounting. I don't know whether it does or it doesn't have any impact from deferred revenues? And the third question is just Europe. Can you discuss the environment in Europe overall? You made some comments about the economy. Maybe you can make some comments about what you're seeing with your customers?

Robyn Denholm

So I'll take the first two parts of the question, and I'll hand over to Kevin for the last. So in terms of the impact of the euro, as a reminder, because we're working through distributors and other partners throughout the world, we actually bill in U.S. dollars in Europe by and large. So at the moment, there is obviously no direct impact from the effect of the euro. Clearly, overtime, if the U.S. stays where it is, we're watching very closely in terms of competitive pressures or anything else in terms of euro, or also whether or not any of the credit crisis over there or sovereign debt actually has an impact on the business. In enterprise, we saw a little bit in terms of demand pausing, if you like, in some parts of Southern Europe. But in the rest of Europe, the business was very strong as you saw, so I was pleased with that. In terms of the accounting change, so as we expected, for the second quarter, the absolute dollar amount was up compared to the first quarter. We were expecting that in terms of what we recognize under the new accounting rules. But the comment that I made in terms of deferred revenue, the only piece that is fixed in terms of deferred revenue on the product side is the future feature area, and that was flat with the first quarter. So really, that piece on the balance sheet is solid. The piece that actually declined was the channel and other filter revenue, which is what you would expect to happen as the business environment improves.

Kevin Johnson

Yes, and on the third element of it, it's a little bit more color on Europe. I was in Europe a few weeks ago with a team calling on customers and visited several countries. And consistent with my comments, I think generally, the economic recovery in Europe is lagging, and it certainly is visible. That said, I think in the quarter, we demonstrated still some strong growth both in service provider and in enterprise segments. Southern Europe, when you look at the sovereign debt situation in Southern Europe, we did have evidence that showed some enterprise customers in Southern Europe where maybe being somewhat baffled or deferring some of their projects, which slowed our enterprise growth in Southern Europe. Our service provider growth though in Southern Europe maintained some strength and with some good relationships with customers and some new design wins there. So it's a little bit of a mixed bag in Southern Europe. Certainly, the question is if I think today, probably there are less concerns about what Europe's going to do about the sovereign debt crisis than there were a couple of months ago, so there's more certainty there. And hopefully, that translates to continued confidence and leads to more signs of economic recovery. That said, we continue to feel like we've got good relationships and a good pipeline on the Service Provider business. We continue to build our Enterprise business in Europe. Yet, I think the European economic situation, that too, should be flagged as a risk.

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Tal Liani - BofA Merrill Lynch

Maybe just quick follow up on the deferred revenue question I had. The short-term deferred revenues went down by $75 million, but the long-term deferred revenues went up and recovered about 2/3 of the decline. Can you discuss the differences between short-term and long-term trends?

Robyn Denholm

So short term and long term is purely a mathematical date-driven exercise. So those that we expect to recognize within 12 months from the printed date of the quarter are in short term, and those that are over the 12 months are the long term. It's purely a date-driven exercise.

Operator

The next question is from Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan Keegan & Company, Inc.

I wanted to first ask a little bit about the segment detail because you've given us enough disclosures that process elimination tells us about the E Series, M Series and T products, which look like they were relatively flat sequentially. So I just want to check on what you see going on within those product groups in terms of shifts and mix? I'd presume that the E Series is trending down given the links to Verizon and FiOS but the M Series is probably getting a little bit cannibalized by the MX, but I want to see if those assumptions are correct.

Robyn Denholm

So in terms of sequential growth, which I think was your question, Simon. So EX, MX and SRX obviously, you've got those numbers. T was also up as I mentioned in the commentary. Service was also up and then other, if you net everything else that's in the product categories, they were also up. And so basically, they were all up as a total portfolio. So we think that, that's actually good. The fact that our new products or newer platforms are actually generating $1 billion of revenue in the last four quarters and they're actually growing very nicely year-over-year. They're up nearly 90% as I mentioned in the prepared remarks, and that's a real testament to the value of the R&D that we're doing as we go forward.

Simon Leopold - Morgan Keegan & Company, Inc.

And to follow up, you mentioned in the prepared remarks your expectation that you'd gain market share in both Enterprise and Service Provider. I think the Enterprise, the bar is set pretty low given that you're relatively new to that market. Service Providers seems a little bit more challenging. So if you could maybe give us some more thoughts on how you're going to take that market share with strategy you're using and which products or applications you expect to help you in that?

Kevin Johnson

Yes, thanks for the question, Simon. I think that in the Service Provider segment, certainly, the big trends and things we see are related to mobility and video. And we've seen very strong uptake on Mobile Secure, our security platform in major wireless carriers globally. And that's been a big solution and a big value proposition to them. That combined with the progress that we're making with MX 3D as a unified edge router for both fixed and mobile and the fact that many service providers architecturally are looking to converge those networks to where they're carrying that Internet traffic on a single network. That, combined with the fact that the MX 3D is programmable and the deliverables that we have for the Falcon project is something that, I think, is generating significant interest and dialogue with our customers. So consistent with what we outlined at the analyst meeting, it really is the Junos as a single operating system, programmable operating system running on our platform, but technologies is helping customers, not only change the economics through reducing the cost per bit, but also enabling new business models, and it's delivering a better user experience. And so we continue to focus on that value proposition.

Operator

The next question is from Jeff Kvaal with Barclays Capital.

Jeffrey Kvaal - Barclays Capital

I was wondering if we could delve back into the deferred revenue question for a minute, specifically the channel and sell through. Could you, Robyn, perhaps clarify for us exactly how that process works? And I guess superficially, one could read the lower channel, deferred revenue as better sell through? But on the other hand, maybe we worry the channel is taking less inventory because they're worried about the recession?

Robyn Denholm

Yes, I wouldn't take it as the latter. It's actually because of the fact that there is more demand out there, and that category of revenue is what we do take on a sell-through basis.

Jeffrey Kvaal - Barclays Capital

And then Kevin, for you, I was wondering if you could talk a little bit about what you were seeing in the mobile space? Obviously, that's heated up and the Evolved Packet Core is -- or carriers are making decisions there. If you could give us a little bit of color on how those -- where carriers are in the decision-making process and how your relationship with Ericsson is faring? That would be very helpful.

Kevin Johnson

I guess the first comment I would make is that every wireless provider on a global basis is perhaps in a different stage of the migration from 2G to 3G to LTE and has their own set of business plans in terms of how they're doing that. What is consistent though is that mobile Internet is growing. And it's growing because of the growth in smart phones and certainly, led by the work Apple has done with the iPhone and Google has done with Android and iPad. There's just more of these digital devices driving demand for mobile Internet. That's a very consistent perspective on a global basis. And so number one, we're working with these wireless providers to really help to understand their roadmap in terms of how they're enabling solutions and the ability to carry that traffic economically and provide a great experience for their customer base, and that's number one. Second of all, when you look at Ericsson's GGSN that runs on Junos, it continues to do well in the market, and so we're pleased with our partnership in that regard with Ericsson.

Operator

The next question is from Jeff Evenson with Sanford Bernstein.

Jeffrey Evenson - Bernstein Research

I was wondering if you could give us some color on a couple of your growth initiatives? First, around the managed services. You talked about the number of customers going up to 35. I'd be curious as to what percentage of these or percentage of your financial relationships in these areas are around security? And then for customers who've already sold it, you've already sold to, how they're coming back and reordering the product? And the second area I'd like to hear about is just a little bit of an update on the investment you made in ADVA and where that might go?

Kevin Johnson

On the question about managed services, a number of large service providers see this certainly as a growth opportunity for their business, to build out data centers and provide a managed services capability to enterprise customers. It aligns with not only the network infrastructure they have in place but their operational expertise in terms of running large infrastructure-related businesses. And so in our partnership with large service providers, we've got a very specific team and set of resources that are building those relationships with those service providers who are building a managed services business. And that relationship involves us sharing our architecture with them around data center, collapsing layers in the data center going from three to two and to one with Stratus. It involves our technology across routing, switching and security, all running Junos. That involves us helping them find efficient ways to manage the operating expenses using Junos Space. And it certainly also provides them capability to provide user secure SSL VPN with Junos Pulse. And so the relationship is very broad in terms of the product set. And on a consistent basis, these service providers see this as a growth opportunity for them. Your specific question is how many of these relate to security. Well, to have a successful managed services business, you have to have a secure environment or enterprise customers will not turn over their processing and data and connections to run in your managed services. So security is at the heart of being able to be in that business. Regarding the relationship with ADVA and the investment piece, at the analyst meeting, I think Stefan and Pradeep conducted a session where they sort of took you through a view of the role that we saw optical playing in packets switch, what we are looking at with our routing technology. And I think there are many, many players in optical out there and ADVA is one of them, and we're pleased to have a relationship with them. But it relates to the partnerships that we're building in optical as it helps shape our agenda for our routing technology and where that's going in the future.

Operator

The next question is from Brent Bracelin with Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities, Inc.

First, really, is follow up on the service provider demand trends. If I look at your segment, four of the last five quarters, Enterprise has grown faster than the Service Provider business. I guess my question here is as you look at the Q3 pipeline, how would you characterize the Service Provider activity? Is it trending in line with kind of the historical trends that you saw in the past year and through Q3 given the slow, kind of sluggish start to the year? Do you see that the Service Provider pace of order is starting to pick up to maybe above seasonal trends in Q3? Any sort of additional color there would be helpful.

Robyn Denholm

So I think, Brent, in terms of the Service Provider trends, obviously, we saw a good growth this quarter, especially in EMEA and in APAC. And we think that was a good trend, with our Service Provider and our Enterprise customers actually increasing their demand in both geographies. So in terms of going forward, Kevin talked about what we see specifically with our U.S. service provider customers where their CapEx has tended to be more back-end loaded historically. So we don't expect that to be different this year. We are anticipating that in the second half. And our guidance for Q3 reflects, in terms of the range, the difference in what their pattern could be in Q3 or Q4.

Kevin Johnson

Just to add to Robyn's comments, Brent, I think when we look at the second half of 2010, and I think the pipeline and opportunities we see in the service provider are very good. The real question, when you look at Q3, is how much of that pipeline will land in Q3 versus Q4? In 2009, obviously, we had a very big Q4 driven by Service Providers. And there's a question of will that start to smooth out to see a stronger Q3 and still a strong but maybe not as strong as Q4? Can some of that revenue be blended across Q3 and Q4? We'll have to see how that unfolds later in the quarter.

Robyn Denholm

Yes. The one other thing I'd add was in this quarter, particularly in the U.S., we saw a continued spending by the regional carriers and the content and cable sector, which are called out specifically because it is important from a diversification perspective overall in terms of the Service Provider business longer term.

Brent Bracelin - Pacific Crest Securities, Inc.

Then just one clarification. Kevin, at the beginning of the conference call here, you did talk about kind of an increased focus on M&A given the backdrop of a kind of renewed shelf offering. Could you just remind us kind of what type of acquisition that would be ideal that you're looking at? And potentially, would you consider a large acquisition?

Kevin Johnson

Yes. First of all, I would say that we will consider a range of things. But the ones that are preferred, the ones that are really sort of on the radar screen, I would characterize as very similar to Ankeena. There are things that are based on intellectual property and talent that's complementary to Junos, that helps us accelerate our vision for the new network, things that we believe we can do a good job of integrating and managing the integration and things of that will translate to revenue and revenue growth fairly quickly. So that said, I think the best way to characterize it is just point to Ankeena as one example, and of what I think is probably the more likely scenarios to expect.

Operator

The next question is from Paul Mansky with Canaccord Adams.

Paul Mansky - Canaccord Genuity

I wanted to talk a little about EX, specifically kind of expectations as you go on to the back years, you have the second of your two major OEMs looking like they're prepared to launch?

Kevin Johnson

And so the question is in the second half of this year or longer term, Paul?

Paul Mansky - Canaccord Genuity

Second half of this year. Specifically, I just wanted to get, I think, kind of get the sense vis-a-vis cadence in or around that ramp of those OEM relationships?

Kevin Johnson

Yes. I think certainly, we had achieved some revenue on the EX through the OEM relationships, but we still -- I wouldn't discount all the relationships that we have with partners that are reselling EX. So let me just talk about EX as a total product offering whether it comes through OEM or through resale. Number one, I think the portfolio that we've assembled, routing, switching, security, running Junos, the role of Junos Space and the role of Junos Pulse, the data center architecture of 321, that value proposition is one that we are communicating more broadly to more enterprise customers and it's one that's resonating. Our job is to help make sure that we've done the right job on R&D to create the right solution set and that we create demand in the market. And that's what we've been very focused on doing. And in doing that, that creates more opportunity for our partners to then sell into that demand that we're creating, and as they do that creates more demand and more awareness. And so I think we are executing against our plan to continue to do that. I think that we continue to make good progress relative to that plan. My expectation is as we do that, we continue to reach a point where we hit a tipping point where then awareness hits a certain point and that demand creation part has taken place, and then there's just a lot of partners fulfilling opportunity. I don't think we've hit that tipping point yet, but I do think we're a step closer. I look at the design wins, I look at the level of dialogue we're having, I look at the energy behind our partners, I participated in the Americas Region Partner Summit this last quarter, and there's just a lot of energy from our partners: Dell, IBM, Verizon and many, many other partners on a global basis. So look, our long-term growth agenda, we've got to grow the Enterprise, I think, at the analyst meeting, we've got to grow our Enterprise segment 25% plus higher over this period to drive that. Certainly, the EX plays a big part of that, and so it is core to the growth agenda.

Operator

The next question is from Sanjiv Wadhwani with Stifel, Nicolaus.

Sanjiv Wadhwani - Stifel, Nicolaus & Co., Inc.

Robyn, in terms of when you gave guidance for Q2, you had mentioned that the swing factor over there was going to be timing of service provider orders. Given that you came in at the high end of your guidance, can you talk about whether this was one or two carriers coming in or was it multiple carriers? And then second question on the head count, you had a pretty steep ramp even if you x out Ankeena, about 215-odd people, were they skewed on the R&D side or sales and marketing? Any color there would be helpful.

Robyn Denholm

So on the carrier spending, when we gave the guidance for Q2, we were expecting that range to be variable with service provider spending. So in terms of how the quarter unfolded, it did unfold as we expected. Obviously, we overachieved relative to our guidance. But in terms of service provider, it was within the range that we gave you on the Q1 call. So in terms of headcount, yes, the headcount was up. The main areas, as we said, they're about at the 65 headcount as a result of Ankeena, approximately 65. And then the rest were primarily R&D for the projects that we've talked about in terms of R&D, plus customer service and support. So those are the three categories. There was a little bit in sales and marketing, but it was still mainly the other categories.

Operator

The next question is from Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc.

Just a question on margins. Your product gross margins are now at the highest level in the last two years and at the same time, we've seen fiscals margins decline in the last couple of quarters. So just curious if you can walk us through some of the reasons for that expansion? How much of that has been cyclical versus structural, and in particular, are some of the newer products like the SRX or the MX 3D higher margin? And is that also the case for things like Falcon and Media Flow? And is that contributing to the expansion?

Robyn Denholm

So in terms of the overall product margin, we were very pleased with the rate of growth margin on products. In terms of product mix, the security products had very good margins relative to the range of margins that we have. So obviously, that helps. You've seen how SLT has become profitable and now has broken through the 20% level. Their gross margin structure is very healthy. So in terms of other areas, yes, the MX 3D is a higher gross margin product for us. It's our silicone, our IP. So obviously, that contributes to favorable gross margin in terms of mix. In terms of structural areas, the operations team has been doing a very good job in terms of continuing, just grinding away at the cost. And as I mentioned at the financial analyst meeting, there are two sides to the equation on the gross margin side, and cost is definitely an area that the team's very focused on driving.

Kevin Johnson

Yes, let me just add one or two other comments to what Robyn said. I think certainly, our investments in silicone, I think is significant in terms of the value it creates for customers and for shareholders. And that the value for customers is being able to solve these kinds of networking problems at scale that we think is unique, and that we have differentiated position in the market, which allows us to have higher gross margins in some of those areas. The second piece is we're building out software businesses. You asked the question of Media Flow and Falcon. If I look at Media Flow, that's a software business. If I look at Falcon, it's a software business. If I look at Junos Space, it's a software business. If I look at Junos Pulse, it's a Software business. These software businesses have much higher gross margins, certainly, than our Systems business. And we love our Systems business, but we're going to complement our Systems business with the Software business. Certainly, the revenue for Media Flow was immaterial this quarter, but over time, as we're successful building these software businesses, that should also be something that provides us some lift or ability to improve product gross margins as that mix shifts.

Simona Jankowski - Goldman Sachs Group Inc.

I guess, Robyn, for you on deferred revenue. I want you to zero in on the product deferred revenue that's related to the future features and projects and that was flat in the quarter. Why would that be flat when you're continuing to grow on a sequential basis going forward? And in particular, how should we think about that when your book to bill was well over one?

Robyn Denholm

So in terms of future features, so in terms of the stuff that has been on the balance sheet under the old rules, over the next four to six quarters, we expect that to actually be recognized. So that is normal flow of future feature activity. In terms of the stuff that's being put onto the balance sheet, that is the change. So under the new rules, the deferral still happens, the amount of the deferrals on 100% of the activity, it is the amount that's represented by the features that we have yet to bring to market. So but net-net in the quarter, I want to be very clear, that part was flat. So there was no reduction in the deferred revenue associated with future features, even though the right at which we were putting it on was at a lower percentage of the total deal. So that does actually explain, in terms of the increased activity, you are seeing that because the amount was flat in the quarter. And we expect that to be the case over the next four quarters.

Simona Jankowski - Goldman Sachs Group Inc.

Is there a way to quantify that? I think last quarter was about $25 million that would have been part of deferred under the old rule. Should we think about it as a similar amount this quarter?

Robyn Denholm

No. I did say in the prepared remarks that it was actually higher this quarter. When we publish the 10-Q, we're going to give you quite a bit of detail in terms of the various components and that type of things. But the amount in absolute dollars was actually higher the last quarter, which is what we were expecting.

Operator

Our next question is from Rod Hall with JPMorgan.

Rod Hall - JP Morgan Chase & Co

Just quickly, can you guys comment on component shortages, whether that's expected to affect your ability to deliver in the next couple of quarters? Just real quickly since a lot of other people are talking about that. And then just big picture on the 20% growth target, can you give us some idea what the plus or minus range on that is, in your own minds? And also just clarify whether that's an organic growth target?

Robyn Denholm

So I'll handle the component question. So in any quarter, you always have various components that might be in higher or lower demand situations. There's no question, our operations team, they're doing a phenomenal job in an environment where our demand has upticked. They've actually been able to meet that demand. So we're very pleased with what we've been doing in that area.

Kevin Johnson

Yes, just let me add on the components piece. It's also fair to say that in the industry in 2009, a lot of the suppliers had reduced inventories and reduced manufacturing capability. Now as demand is returning, we do think that the industry is seeing some pressure on suppliers for those components. We work very hard to ensure that the component shortages don't affect our ability, but we acknowledge that in our discussion with suppliers and doing that work, clearly, there is some pressures in the industry, overall, on components.

Kathleen Bela

And that is all the time we have today. We'd like to thank you all for joining our conference call and we look forward to updating you next quarter. Thank you.

Operator

This concludes today's teleconference. You may disconnect your lines. Thank you for your participation.

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Source: Juniper Networks Q2 2010 Earnings Call Transcript
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