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Plantronics (NYSE:PLT)

F3Q07 Earnings Call

January 22, 2007 5:00 pm ET

Executives

Ken Kannappan - President and Chief Executive Officer

Barbara Scherer - Senior Vice President and Chief Financial Officer

Jon Alvarado - Treasurer and Director of Investor Relations

Beau Wilson - Investor Relations

Greg Tyrrell - European Investor Relations

Analysts

Paul Coster – JP Morgan

John Bright - Avondale Partners

Tavis McCourt - Morgan Keegan

Daryl Armstrong - Citigroup

Manuel Recarey - Kaufman Brothers

Ted Chung - Bear Stearns

Reik Read - Robert Baird

Bill Dezellem - Tieton Capital Management

Jason Ader - Thomas Weisel Partners

Rohit Chopra - Wedbush Morgan

Leo Schmidt – Stubb Corp.

Presentation

Operator

At this time, I would like to welcome everyone to the Plantronics Q3 fiscal year 2007 conference call. (Operator Instructions) I would now like to turn the call over to President and CEO, Mr. Ken Kannappan.

Ken Kannappan

Thank you, Richard. Good afternoon and thank you for attending our conference call. On the line with me are Barbara Scherer, our Chief Financial Officer, Jon Alvarado, our Treasurer and Director of Investor Relations; the other members of our finance and IR team, Beau Wilson and Greg Tyrrell from Europe.

The agenda we will follow today is I will give you a quick synopsis of our results, which you should have all received by now, and a business overview and update. Then, I will turn the call over to Barbara to go through the financial results in more detail. Following that portion of the call, we will open up for Q&A.

I want to remind you that during the course of this conference call we may make certain forward-looking statements that are subject to risks and uncertainties. For further information, please refer to the company's Forms 10-K, 10-Q, annual reports, press releases and other SEC filings.

As we have highlighted in the past, the risk factors discussed in these filings are not standard boilerplate. We update these risk factors every quarter, adding and dropping language and change the order depending upon the timing and potential impact of the concerns that we foresee.

Revenues of $215.4 million for the December quarter were slightly above the high end of the $215 million guidance we provided on October 24, 2006. Consolidated non-GAAP EPS is $0.38, $0.08 above our high end guidance estimate of $0.30, with most of the improvement above the high end driven by non-operating items. In particular, we had a lower tax rate due primarily to the reinstatement by Congress of the R&D tax credit and had an FX gain in other income.

On an operating basis, ACG had a strong quarter with revenues a bit above our internal high end targets, higher gross margin than we planned for, with operating expenses on plan. Operating income was up sequentially and year over year. For the first time ever, over 50% of our ACG revenues were derived from wireless products. We saw growth resume in our wireless office category and had continued growth in our Bluetooth products. The desire for freedom and mobility continues to be the key growth driver for our business, and I believe it will be for many years to come.

The pickup in growth with wireless office systems was concentrated in Europe, and was primarily due to what seems to be an effective marketing campaign. We are also getting positive feedback from our channels on certain of our U.S. marketing programs, and I believe we are making progress there as well.

AEG, on the other hand, delivered revenues in the middle of our internal range. We found it necessary to take significant charges related to canceling purchase orders on its suppliers and for potential excess on-hand inventory, reducing growth and operating margins significantly. The cumulative effect of weaker demand for its products in the six-month period ending December 31 compared to what it had put on order and/or purchased led to this disappointing result.

We had anticipated some sequential improvement in AEG's operating margins, and of course, the actual results were down sequentially. AEG's product pipeline still needs improvement to deliver competitive products at reasonable margins. We are focusing on refreshing and expanding the product line to improve gross margins, and work our way back to the target operating model.

Some of the recently announced products will help move us towards that goal, and we do expect better financial performance in the upcoming quarters than we had this quarter. However, I believe it will take another year from the coming December quarter to get close to the target operating model which will be fall of calendar year 2008.

Earlier this month, I was at the 2007 Consumer Electronics show. It was far and away Plantronics' best ever. Our mobile and B2B product road maps, our products, and our marketing programs received very positive endorsements from our customers. The strength of our portfolio was noted with six Best of CES Design Innovation Awards, including one for Altec; and our Discovery 665 won Best in Show from the Bluetooth SIG. The Discovery 665 combines elegance and performance with our proprietary audio IQ BSB technology. It cuts background sound substantially and also improves transmit clarity.

As previously mentioned, our Altec product announcements were also well received, with particular recognition received from the IM812 wireless home speaker system for the iPod. In addition, Altec benefited from something that didn't happen at CES. As Apple announced the iPhone, we had just finished launching the T515 with Cingular to meet their requirements for a Bluetooth music speakerphone without knowing exactly why. I believe this product development initiative and placement is a significant proof point of our ability to leverage the carrier relationships we have in ACG, as well as the ability to make products which meet the needs of the ever-accelerating convergence between communications and entertainment devices.

Another example of synergy we are creating with Altec is the launch of the IM702, very similar to the Pulsar product we developed last year but under the more powerful entertainment brand of Altec. We believe by leveraging the Altec brand and appealing to music-sensitive buyers, we can increase revenues for this category. We intend to use this strategy in the future as well.

Altec has clearly been under competitive attack, and needs a very strong product to replace the IM3 at the $150 price point. The new IM600 with its striking design and the first integrated radio-MP3 speaker at that price also received a very good response at CES. Altec has seen greater competition and needs to innovate successfully to provide compelling value at the right cost in its key offerings.

It is also clear that Altec continues to have solid channel relationships and a good brand. With the right products at the right cost points, I am convinced Altec will be able to regain share and return to profitability.

Finally, I wanted to tell you that we are in the midst of our annual strategic planning process and look forward to giving you an update on our business model, including growth and profitability targets, when we hold our year end earnings call on May 2nd.

With that, let me turn it over to Barbara.

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Barbara Scherer

Thanks, Ken. I am going to cover the third quarter by segment, starting with a summary of the Audio Communications Group. ACG achieved a new quarterly record with revenues of $176.5 million, up 9.3% or $15 million compared to a year ago and up 8.3% sequentially. The growth was driven primarily by Bluetooth with total mobile revenues growing 44% versus a year ago, and 30% sequentially. Office wireless also recorded strong growth of 28% year on year and up 11% sequentially. These increases were partially offset by a decline in professional grade corded products, 10% year on year and 7% sequentially.

Given the strong showing of our Bluetooth portfolio coupled with resumed growth in office wireless, wireless products crossed through 50% of ACG revenue for the first time and amounted to 53% of total net revenue for the quarter, up from approximately 48% in the September quarter. Contributing approximately $51 million of net revenue, wireless office headsets represented 29% of ACG's segment revenue, and 43% of the office and contact center product group. Net revenues from Bluetooth mobile headsets grew to approximately $37 million, representing 21% of total ACG revenues in comparison to about 15% a year ago. This 60% revenue growth in Bluetooth resulted from our improved product portfolio, expanded customer mix, and increased account penetration. With a full 53% of ACG segment revenue from wireless products, there is another group of cordless office products which represent earlier generations of products prior to the TS50, TS60 launch.

Within ACG international revenues were very strong, up 12% compared to a year ago and 26% sequentially. Domestic was up 7% compared to a year ago, although down 1% sequentially. As a result of the strong growth in EMEA, international grew to 40% to total ACG revenues. OCC revenue was up strongly in EMEA with record revenues in that region, but declined domestically.

International and domestic operated very differently in our OCC business in Q3, with the EMEA growth in part driven by: a successful wireless office campaign, an increase in activities with channel partners, as well as the impact of new products being accepted by the market.

Our OCC corded business was also strong in EMEA, that may in part have been driven by some increased stocking levels on the part of distributors. We had a shortage for a period during the quarter on one popular corded product and distributors reacted by increasing inventories. Therefore, some of the EMEA corded revenue growth was due to distributor inventory growth which we believe also had some effects on the wireless office revenue growth in EMEA as well.

The opposite took place in the U.S. Sell-through was up and distributor inventories were down. Certain campaigns and new marketing tools have not yet hit the street, but should begin to affect demand late this quarter and into the first quarter of fiscal '08. We currently do expect U.S. wireless office revenues to grow in Q4 compared to Q3.

Our sell-through tracking of the U.S. commercial distribution channel for ACG indicates that sell-through increased approximately 2% versus a year ago and 1% sequentially and that inventory in the channel decreased. Please remember that sell-through data is only for a portion of our revenue, U.S.-based commercial distributors, and that this channel represented approximately 29% of the total ACG segment revenue for the December quarter.

ACG non-GAAP gross margin was 44.2% compared to 46.4% a year ago and was better than our internal estimates for the December quarter. Relative to the year-ago quarter, the principal reasons for the decline was the higher percentage of revenue represented by mobile products, which carry lower gross margin than the high value-add OCC category. The 10% decline in OCC corded products compared to a year ago obviously was also unfavorable from a mix perspective.

But significant improvements in manufacturing efficiency offset most of the product mix effect. We also had 0.7 points higher provision for inventory this quarter than in the year ago December quarter, with the net result being the 2.2 point decline in gross margin.

The fact that ACG non-GAAP gross margin was down just 0.1 point sequentially was positive, especially since the December quarter is usually down from the September due to seasonality. We achieved relatively flat gross margin despite incurring higher freight costs in Q3 compared to Q2. In part, this reflects our focus on transformation costs and progress in factory efficiency, and continuing progress on component cost reduction. Due also in part to our inventory management program, we have a lower requirement for inventory provision in the third quarter than we had in the second quarter.

I also want to give a brief update on our progress in China. Our China plant increased its output 37% and is about halfway to breakeven. We continue to believe we will at least achieve breakeven in that plant by the second quarter of fiscal 2008 on anticipated higher volumes of Bluetooth headsets in our China plant. This is the same estimate as we had last quarter.

Turning to operating expenses, on a non-GAAP basis compared to the year ago quarter, ACG operating expenses increased approximately $2 million, due mainly to our expanded sales presence and sales programs. On a sequential basis, non-GAAP operating expenses were up $3.4 million in ACG which was on plan and in line with the guidance we had provided for the December quarter. The increase in ACG was due mainly to additional funding in sales and marketing to fund demand generation campaigns. G&A expense was also up sequentially but nearly flat compared to the same quarter a year ago.

As a result of all the above, ACG's non-GAAP operating margin was 15.2%, down 0.8 points compared to 16% in the year-ago quarter but up 0.2 points sequentially. And non-GAAP operating income was up $1.1 million compared to the year ago quarter, and up $2.4 million sequentially.

Now I am going to turn to the AEG segment summary. AEG revenue was down $22 million compared to the same quarter a year ago. Compared to that record quarter, the portable product line was down 46%, and the powered line down 13%. The cumulative effect of increased competition and loss of market share have been the key drivers of these results. Sequentially, revenue was up $7 million with revenues from the portable line up approximately 34%; while the powered line was up 11%. We understand sell-through has been reasonably good and we believe channel inventories are at normal levels.

Geographically, AEG's revenues were 67% domestic and 33% international, reflecting an increase of 6 percentage points in domestic mix sequentially. A year ago, domestic represented 74% of total revenues and international was 26%. AEG's gross margin was clearly disappointing with a substantial decline compared to a year ago, and down 8 points sequentially on a non-GAAP basis. Sequentially, the 8-point drop from 18.5% to 10.5% was almost entirely due to the unexpected $3 million in charges for potential claims related to canceled purchase orders with its suppliers.

AEG operating expenses were flat compared to the year-ago quarter and down about $500,000 sequentially. That led to an operating margin for AEG of negative 14.9% compared to 15% a year ago. That decline from a year ago was a combination of lower volume, lower price realization and the suppliers’ claims on relatively flat operating expense. Sequentially, operating margin was down 0.6 of a point, with the lower gross margin largely offset by lower OpEx as a percent of revenue, given the 22% sequential revenue increase.

On a consolidated basis below the operating income line we had $1.5 million in other income, mainly due to a foreign exchange gain of $1 million. Last year in the same quarter we had other expense of $600,000, resulting in a net $1.6 million favorable variance compared to the December quarter a year ago.

Our consolidated effective tax rate for the quarter was 17% compared to 27% in the year ago quarter and to a forecasted tax rate of 25% to 27% in our guidance forecast. The consolidated tax rate was significantly lower than forecast, primarily due to the reenactment of the R&D tax credit. We also had a favorable distribution of taxable income given the strength in EMEA where we have a lower tax rate; and with AEG's losses higher than planned, that also had a tax rate benefit.

As a result of all the above, our consolidated net income for the quarter was $15.2 million or 7.1% of revenues, compared to net income of $25 million or 11.3% of revenues a year ago with consolidated EPS of $0.32 compared to $0.52 a year ago. On a non-GAAP basis, EPS of $0.38 compares to the $0.52 a year ago.

Turning now to the business outlook, we are cautiously providing guidance for the fourth quarter and want to reemphasize the risk and uncertainties which characterize our markets and our business. The volatility of our business does seem to be increasing and with our book and ship business model, things can -- and do -- change rapidly. I also want to remind you that March is an unusually difficult quarter for us to forecast, especially in the ACG business.

Conditions are usually strong in the months of September, October and November, and then weaken in December and January. We usually see a strong pickup in February and March. That is when it is time for us to provide our guidance to you. We have been going through the weakest bookings period of the year and must count on the historical pickup in bookings to recur, and we are counting on such a pickup this quarter.

So with those caveats and a request to please consider the risk factors carefully, we are estimating a revenue range of $190 million to $200 million.

In the consumer segments in both ACG and AEG, revenues in the March quarter are usually down from the December quarter due to seasonal trends, and we expect this to be the case in Q4. In particular, we expect our Bluetooth mobile products in ACG to be down and for AEG to be down in its entirety. Within ACG, we also expect some decline in corded OCC products and a sequential increase in revenues from wireless office products.

In order to accelerate progress on revitalizing the Altec Lansing product lineup, we will be incurring increased marketing and R&D expenses this quarter. We will also face higher costs sequentially and compared to a year ago to complete SOX compliance for fiscal year end, this being the first year that Altec is required to be SOX compliant. In that regard, we did bring them up on Oracle in November, which has contributed to improved financial tools and controls.

We also expect operating expenses to increase in ACG to finish a number of new products and to ready them for launch from a sales and marketing perspective. We will also have higher costs sequentially, given that both CES and CBIT fall in the March quarter.

Given our expectation for lower sequential revenues and the need to increase operating expenses in the key areas I have just discussed, we are currently expecting non-GAAP EPS of $0.22 to $0.27 in the fourth fiscal quarter. We expect equity compensation expense in accordance with FAS 123 R to reduce operating income by approximately $4.3 million, or about $2.9 million on a consolidated after-tax basis and that would translate to about a $0.06 lower EPS than non-GAAP EPS.

Turning to the balance sheet, cash, cash equivalents and short-term investments increased by $8.7 million compared to the prior quarter from $60.1 million at the end of September to $68.7 million. The increase reflects approximately $12.4 million in cash provided by operations, offset partially by $3.1 million used for CapEx and $3.8 million for financing activities. Overall, we believe our financial position remains adequate and in that context, our board of directors declared our eleventh quarterly dividend in the amount of $0.05 per share.

Our accounts receivable balance increased sequentially from $118.6 million to $131.7 million, with ACG receivables increasing by $8.3 million and AEG receivables increasing by $4.8 million, mainly due to the strong sequential revenue growth and some changes in customer mix.

In the December quarter, we had our fifth sequential quarter of record cash collections in the ACG segment, with particularly strong collections in EMEA. Sequentially, our DSO remains flat at 55 days. We believe the net receivable balance is collectible and that we have sufficient reserves to cover our anticipated exposure to bad debt.

We were successful at reducing inventory in the quarter. Compared to the September quarter inventory decrease by $5.2 million to approximately $134 million, and inventory turns improved from 3.4 to 4.0.

Finally, capital spending was $3.1 million in the quarter less than depreciation and amortization of $7.4 million in the quarter. Net property, plant and equipment was down $2 million sequentially, and intangible assets are down approximately $2 million as well. We also had an additional $4.2 million of amortization of equity-based compensation expense. That is $7.4 million in depreciation and amortization in Q3, compared to $7.2 million in both Q1 and Q2.

With that, I am going to turn it back over to our conference facilitator for the Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Paul Coster - JP Morgan.

Paul Coster - JP Morgan

Good afternoon, Ken and Barbara. I am not going to beat around the bush here. Altec Lansing just looks like it has not been a very good acquisition strategically. It doesn't seem to pay off and it doesn't look like there is a huge amount of synergy between this business and your communications group business. What are the strategic options for you here, other than sinking more money into that business?

Ken Kannappan

Well, Paul, certainly to this point in time it's not gone the way that we hoped it would. However, at this point in time our perspective on it is that we haven't really run the course on it. Clearly we are at what we view is a trough point in the business performance and believe that can be turned around.

The basic strategy that we had for that business was that it, in and of itself, had a sustainable model as a consumer electronics business that was comparable to a benchmark of other consumer electronics companies. We recognized at the time we acquired it that it only recently had turned around and needed to do more work on sustaining its business and that work really hadn't been in place. We thought we'd have a little bit more time to put in a stronger portfolio for products; as it happens the competition clearly came quicker than we had before we could get some of those things in place, so the business, as a result, has performed very poorly.

But we still believe that there is a sustainable business model that others in the industry are achieving in the consumer electronics business and with the right set of products, that that can be done.

That was not our reason for buying the business, because in and of itself, the fact that it can achieve products and reasonable margins is kind of a foundation. We were hoping to achieve with that business a combination with our own business in areas where we believe that communications and entertainment were converging.

Frankly we still see those opportunities. Some of those we can't pursue until the base business of Altec is stronger, but we are continuing to get very positive feedback from our channels and customers. Indeed, one of the questions I was asked a number of times was a concern from our customers at CES that they were reading analyst reports and so forth on the Altec business, concerned that we would move from our strategy because they were very bought in.

At this point in time, while we fully acknowledge that the execution of this is way off plan, we believe the execution can be restored and that the strategic logic behind it is continuing to be endorsed.

What are our options? Clearly if we no longer come to the belief that we can in fact improve the execution, then we would have to reassess that. But right now we are not at that conclusion.

Paul Coster - JP Morgan

The synergies that are expected to emerge between communications and entertainment seems to be realized, others are exploring the hybrid headsets for instance, without having made such a acquisition. I'm thinking here of Logitech on one hand moving into the communication space, and on the other hand, companies like Motorola and Nokia realizing their ability to move into the entertainment space with their Bluetooth solutions. What is it that's different about Plantronics?

Ken Kannappan

Well, it's a fair point. I think a couple of things there. First not every organization is the same or has the same set of needs in terms of trying to meet the long-term opportunities in the market. I think we're at a very, very early stage in terms of assessing who are the winners and who are the losers in this convergence and how effective is each strategy going to be? Separate from that, how effective is the execution relative to those strategies?

Clearly some of the things Motorola, for example, can do are not always to Plantronics with the extent of our leverage and size. But I want to be clear that this is a strategy that is not just directed for us in the initial forays in the consumer and carrier markets, but also we think has applicability in our core B2B market.

Paul Coster - JP Morgan

Barbara, a different subject: it was good to hear that the transformation of products is improving. Can you in any way quantify how much it benefited the gross margins in the Bluetooth segment in particular, but ACG more broadly?

Secondly, when we think about your turnaround and the improvement in that transformation, where are we in terms of the process? Are we halfway through the turnaround? Are we only just starting? Help us think through how that will benefit the margins over the next year or two.

Barbara Scherer

So for ACG, the improvements in manufacturing efficiency versus a year ago actually contributed about 3 points back to gross margin. Very substantial. Quite a bit of that did benefit the Bluetooth P&L, but I actually don't have transformation costs by product family, but I can tell you that the Bluetooth P&L is in the best shape it's ever been. Having said that, it's still not profitable on a fully allocated basis -- so taking all the common costs, G&A costs, facilities costs, fixed costs and allocating them, it doesn't cover all those costs, but it's definitely made a contribution margin in the third quarter larger than it ever has. That was very good news.

I actually think we have quite a long way to go on this transformation cost area, when you consider that our China plant is operating at about, maybe 15% of capacity and we could add capacity to that and that our plant also has the ability to ramp up. We actually have a lot of potential benefit just from scaling up this business on the existing overhead and structure that we have.

But that's not all we're focusing on; we're also focusing on the things we can do in the here and now if revenues go up the normal level. So I think we're early in the journey, but I don't want to pin down the exact amount of the improvements that we could expect over the coming year, though I am willing to commit that we'll factor some update on that into the business model update we'll give on May 2.

Paul Coster - JP Morgan

Last question: to those people who are looking at your two plants both operating under full capacity and they're concerned that maybe the company should just bite the bullet and go for one only, what's the response?

Ken Kannappan

Two things. First, when you add plant capacity you clearly add it in large step functions. The lead time on that is multiple years. I will say candidly that we had expected at the time that we would have greater revenues at this point than we have, and therefore we would be dealing with higher utilization. We still believe that we're in a growth business and this is, therefore, going to happen over time; just not as rapidly.

Two plants for us make sense for many reasons. The [Plymex] facility, of course is world-class in terms of quality beyond, to the best of my knowledge, significantly beyond anything available in our industry; it has excellent cycle time on the high mix and provides the benefit of a lower tax rate to us for the higher-margin B2B products. Our facility in [Suchou] has obviously access to the lowest cost supply base in the industry. Has very, very low inherent labor costs, and we believe can be very effective for the consumer portion of our business. So we see these as naturally aligned infrastructures. We agree that they're not fully utilized. We expect over time that we will be able to improve the utilization and the profitability.

Paul Coster - JP Morgan

Thank you, Ken. Thank you, Barbara.

Operator

Your next question comes from John Bright – Avondale Partners.

John Bright – Avondale Partners

Ken, Barbara, thank you. Good afternoon. Ken, can you talk about the drivers behind the out performance on the top line in the mobile segment? Particularly, in the past we've talked about pricing and bundling by Motorola being pressures on that segment. Are you seeing any product differentiation now from your side of the equation?

Ken Kannappan

Well, it's a hard one to answer. Let me say on the one hand, being an ant very close to the headset ant hill, we see a huge difference between our products and all of our competitors’ products. We continued to believe that the audio performance overall of our products is clearly superior to our competitors in terms of receive and transmit. We believe that we have very, very intuitive, easy to use, easy-to-approach products that are critical for new users. We think our industrial designs overall are the most attractive in the market and urge all on the call to experiment themselves and verify that.

Having said that, we also recognize that some of our competitors have a significantly more powerful brand, particularly in the carrier market space, and there's no getting around the fact that they're also able to put together attractive combined offerings involving their equipment, their brands, the marketing programs that we're not in a position to be able to fully match. So we think on the pure product basis, we have got a very, very good offering. As decided by the customer in a store, who may know another brand better with a certain offering, does it always make us competitive? Not always. I think that the differentiation increases as you move up the price point scale, and you are all the more concerned with the performance of the product.

John Bright - Avondale Partners

We have heard some noise regarding Motorola, a 1,000 day campaign of sorts against you; and GN picking on the Bluetooth mobile side. Your thoughts here? Is it something that you are familiar with? Something you think it may be in year two of three, what are your thoughts there?

Ken Kannappan

Well, I think what you are referring to is something that we have heard, I would say indirectly rather than something that has been officially communicated to us, and therefore I'm not sure that we necessarily know all the nuances. We did understand that there was a campaign to drive us out of the business, so to speak, for a period of time with aggressive pricing and other bundling and other tactics with channel partners and others. It made for us, to the extent that it's true, of course, made for us a hard situation regardless because of the relative competitive strengths of the large players and their tie-ins to phones and so forth perhaps even more aggravated.

Having said that, our focus really wasn't changed. We view it as a product category that we want to succeed in. We believe that it's crucial for us to succeed by providing the best product, because of the players, we have the best and the brightest, in terms of headset design and headset performance and so we've stayed true to that. We believe that our carrier partners wanted to have an independent brand as part of their portfolio, and we have pursued trying to establish with the right positions that we are strong and sustainable in that market.

We have been trying to work to reduce our cost in what is admittedly a far more competitive and tougher market. We believe we have been making some progress there. Don't think that we're all the way done or that all the battles have yet to unfold. I don't want to claim that. But I do think we are making progress and over time again, maybe starts and stops, but we continue to make progress.

John Bright - Avondale Partners

Barbara, on the Altec side of the equation, I think in the press release you mentioned that you are still targeting the operating model that you'd previously put forth, I think was the 30% to 35% type of gross margins for the Altec operating model. Do you still feel comfortable with that as a long-term goal?

Barbara Scherer

Well, the key to that model is the 5% to 10% operating margin. As Ken said, we did extensive benchmarking on that and it is still the range that you see for consumer audio electronics companies. I have no new information on which to say that shouldn't be the right target. It continues to be what we are benching our strategic plans toward achieving.

John Bright - Avondale Partners

All right. Thank you.

Operator

Your next question comes from Tavis McCourt with Morgan Keegan.

Tavis McCourt - Morgan Keegan

Hi, can you hear me?

Ken Kannappan

Yes.

Tavis McCourt - Morgan Keegan

First, on the mobile strength specifically, you seem to be a little more seasonally strong than even last year. Do you have any feedback on whether the sell-through was that strong, or was there just an exceptional sell-in quarter in mobile?

Ken Kannappan

Well, a couple of things. I think that we had more business in the U.S. this year than we did last year and our market share is stronger in the U.S and so we had a little bit more impact from that. We are launching new products. I do not believe there was a large load effect this quarter. There may have been a little bit more effort to sell this category in the States in the December quarter than we have seen previously.

Barbara Scherer

I want to add on to that because last year we were in such a different position. We had been readying a line of new Bluetooth products in Q2. They were actually late and we didn't get in all the windows, we didn't make all the planogram deadlines, and so we weren't able to actually capture as much business in the December quarter as we were actually qualified for.

This year, besides the strength of the portfolio continuing, we have also been hitting the reset windows much more religiously and so we were positioned from September with placement which we could then deliver into and get the revenue increase. I really think it's been a year-and-a-half journey to the point that we got to in the December quarter.

Tavis McCourt - Morgan Keegan

So with proper execution, this is what a December quarter should look like in mobile?

Ken Kannappan

I lost a couple of words that you said.

Barbara Scherer

That with proper execution, we believe this is what a proper quarter should look like.

Tavis McCourt - Morgan Keegan

A December quarter.

Ken Kannappan

Yes, I say that's true, I would also still say that this is a category that in my opinion is still nascent, and therefore the dynamics are likely to change over time. In particular, to the earlier discussion on convergence, we do think convergence is going to accelerate in this category.

Tavis McCourt - Morgan Keegan

In terms of AEG margins, like you said, if you back out the $3 million charge for the supply order cancellations, pick up about that 18% gross margin levels they've been operating at for three quarters now, inherent in your guidance for next quarter are you expecting any further supply contract cancellation fees, or excess inventory write-offs, or should we have seen the trough of those types of activities?

Barbara Scherer

We are not specifically building in additional, the short hand we use for the makers claims, but we do build in to our forecast estimates for provisions for excess and obsolete inventory because you never know if you will need it. It's not prudent to not include something in the forecast for that.

Ken Kannappan

But in short, we're not expecting anything like the level in the December quarter of adjustments to the standard margin to get the gross margin.

Tavis McCourt - Morgan Keegan

And in terms of the new product cycle this year in both consumer businesses, you mentioned sales and marketing increases next quarter for those product launches. When should we start seeing new revenues from those product launches? Is it next quarter or is it really a Q1, Q2 '08 event?

Ken Kannappan

Well, some of the commentary, just to be clear on the March quarter spending, related to products that we're getting ready to launch and some of them also related to products that are in the early stages of development. So some of those would hopefully result in revenues in the June quarter, but some of them are really targeted for launch in the fall timeframe.

Tavis McCourt - Morgan Keegan

You mentioned the China plant being at about 15% capacity. Looking at it from the other angle, what percentage of your Bluetooth products currently are being manufactured there?

Barbara Scherer

It's still a small percentage but by the September quarter of next year it will be the vast majority of them, although we do use third parties from time to time, as well.

Tavis McCourt - Morgan Keegan

So the big ramp is over the next two to three quarters?

Barbara Scherer

Yes.

Tavis McCourt - Morgan Keegan

And an update Barbara on the tax rate range now given the renewed legislation. What should we look at for a reasonable tax rate quarter to quarter?

Barbara Scherer

On a normalized basis, R&D tax credit usually lowers the dollar amount of our tax expense by let's say $200,000 to $300,000 a quarter. In our outlook, we have got the 18% to 21% tax rate on a consolidated basis. That's really due to the ongoing level of losses in AEG. They have about a 35% plus tax rate, but those losses can be netted for U.S. tax purposes against our profit and so it actually ends up bringing the rate down fairly considerably. So in the outlook for the tax rate, a lot depends on the mix between AEG and ACG.

Tavis McCourt - Morgan Keegan

So as AEG profitability recovers, the consolidated tax rate can move back up?

Barbara Scherer

Yes.

Tavis McCourt - Morgan Keegan

Great, thanks a lot.

Operator

Your next question comes from Daryl Armstrong - Citigroup.

Daryl Armstrong - Citigroup

In terms of the commentary that you guys had about the inventory build of corded devices in the EMEA region, do you have any commentary even anecdotally, in terms of how much build could we see there in terms of weeks of inventory? What would be a normal level of inventories, given this time of the year?

Ken Kannappan

We are actually within the normal ranges of the inventory levels that our distributors like to hold. In general, I would say that many of these guys like to hold in the four to six week range, and it moved up from the four-week range to the six-week range. Part of that was policy decisions on their part, part of it was, in fairness, we did have a few delivery issues here and there and that probably encouraged them to increase their stock levels a bit. But we are actually within the normal levels. They were a little bit on the light side earlier.

Daryl Armstrong - Citigroup

Excellent. In terms of Altec Lansing with the cancellations that you have there, what are your normal policies with your suppliers? Do you give them a rolling forecast, and if so you're only firmly responsible for the next 30 days? Or are the terms a little bit different?

Ken Kannappan

Well, it varies a little bit on the particular situation. So for example, certain components we do have to provide hard orders with significant lead times and typically don't really have any significant ability to cancel. With certain other vendors the lead time on the orders is shorter, but we are still obligated for custom components that they need to purchase at lead time, and that's what you see in this situation.

Daryl Armstrong - Citigroup

In terms of the variance of what you were forecasting and what you actually saw in your business, was the variance between the two numbers really more systemic in terms of what you saw in the marketplace or were there any one-time events or competitive actions?

The forecasting error, was that something that you saw pretty much across the board, or were there any special actions or competitive activities or factors that created the variance during the quarter?

Ken Kannappan

Just to be clear, you're referring to the Altec product line?

Daryl Armstrong - Citigroup

Yes, exactly.

Ken Kannappan

In general, the MP3 category was hit harder than was the power category and beyond that, I don't want to go SKU by SKU.

Barbara Scherer

The lead times are long, because they also try to keep the freight costs low and the product is coming from China have four weeks on the water. You do your forecast for the holiday season and get the long lead time on order months and months and months before the actual orders from customers are coming, and it can even be four to five months. So it is a cumulative effect over time, and then you experience your actual demand. When you look at what you've got on order, and that's when they decided to cancel what they have or cancel some of what they have on order, and it's the items within that that are the custom and non-cancelable that they've got this charge related to.

Daryl Armstrong - Citigroup

Thank you very much. That was helpful.

Operator

Your next question comes from Manny Recarey - Kaufman Brothers.

Manuel Recarey - Kaufman Brothers

In the OCC segment, you did go over the inventory build up which helped in Europe. But the rest of the strength, how sustainable is that looking out into the March and June quarter? In the U.S., the OCC it seemed was weak. What are you doing to turn that around?

Ken Kannappan

A couple things. First, we are dealing with fairly small percentage growth rates on a sequential basis over large seasonal fluctuations and so when we block it into particular quarters it is sometimes hard for us to forecast. We actually continue to believe that we are getting what I would call genuine growth in the U.S. markets, that was somewhat masked with the decline in distributor inventories, and in particular, that the critical category of wireless office headsets, which is more mapped to our growth was working and receiving positive feedback on the marketing programs.

Having said that, it's clearly not at an explosive level. Very clearly, we are continuing to try to look at innovations both in terms of product and in terms of marketing that can hopefully break that out more successfully. Obviously intrinsic in our forecast is that we are not expecting that we're going to get that type of substantial break out, at least through the end of this current quarter.

Manuel Recarey - Kaufman Brothers

Looking at the AEG business, the gross margin, taking out the charges in the quarter, I think the gross margin was somewhere around 18%. Just from a modeling perspective, would you expect a typical seasonal decline from the December to the March quarter? Or are there steps that you are taking, where that you won't see that this year?

Ken Kannappan

No, we would still expect to have a seasonal decline.

Barbara Scherer

The volumes will be down and they do have some fixed costs, and the fixed costs will be a larger percentage of the total, and you end up with some compression.

Manuel Recarey - Kaufman Brothers

So it will be down seasonally from that adjusted figure then?

Barbara Scherer

Yes.

Manuel Recarey - Kaufman Brothers

I was just saying that a way to think about it is going to be down sequentially from the adjusted 18% or so?

Barbara Scherer

Yes.

Manuel Recarey - Kaufman Brothers

Thanks.

Operator

Your next question comes from Ted Chung - Bear Stearns.

Ted Chung - Bear Stearns

Just on the seasonality for OCC, I think you mentioned it before. But on the OCC business, would you expect that to increase sequentially? That's what you've been seeing over the past three years.

Ken Kannappan

I don't know exactly what we forecasted that specifically, we are continuing to hope for progress within the B2B side of the ACG business.

Ted Chung - Bear Stearns

Now, given the fact that the cordless overall the Bluetooth handset will decrease, would you expect that gross margin should also decrease for the ACG business sequentially for this quarter?

Barbara Scherer

I'm sorry, the total margin?

Ted Chung - Bear Stearns

Total margin for ACG.

Ken Kannappan

Gross margin.

Barbara Scherer

So we really aren't providing margin forecast quarter by quarter, but frankly it looks very close to flat is our best thinking right now.

Ted Chung - Bear Stearns

Great. Thank you.

Operator

Your next question comes from Reik Read - Robert Baird.

Reik Read - Robert Baird

Hey, good afternoon. Can you guys just talk a little bit about in the office wireless space, can some of the changes that you have made to the marketing programs in the last quarter or two, you mentioned that the European programs were doing well. Can you give us a sense on the U.S. marketing programs? Combined with that, can you talk a little bit about the traction in the CS55 and the CS70, in terms of how those are starting to move forward?

Ken Kannappan

I didn't take notes. I will try to remember all the parts of this question. You know, in general, I would say that our marketing has evolved from what I would call announcement of the category, i.e., there are many people out there that we think have an interest in a wireless headset and do not know a wireless headset exists; to much more specific and targeted marketing on people that we think are potentially interested in this category and providing more interaction with a smaller number of individuals.

It's a slower marketing effort and requires more viral and word of mouth, but we think that overall we are receiving more traction with that approach both in the United States and within Europe. In the United States, a fair amount of our effort is also going to what I would call second tier, i.e. customers of customers, in order to try to improve our information flow to those partners. That has always been a challenge for us to get that information effectively to our second-tier partners.

With the CS55, and I don't want to go into too much detail for everybody on the call, but suffice it to say that this is a very analogous product to our CS50 with some technical differentials. It's really a matter of production cutovers. We are not really having an issue with that rollover, it is just a matter of timing and execution.

With the CS70 is a very different product, it's one that provides, in our opinion, the most attractive office wireless telephone in the market and very well suited for executives. It's also, in our opinion, by far the most comfortable and stable all day wearing over the ear type of wireless product. We historically had slow and steady ramps of these sorts of products. We are getting very positive reception to the product within its target market.

Reik Read - Robert Baird

But you had mentioned earlier in the last couple of quarters that you need to develop more product categories in this segment. Are those two that are helping ramp that up or do you need a lot more beyond that?

Ken Kannappan

The CS70 does represent somewhat of a new target market profile. The CS55 does not. The CS55 is really a technical improvement on the CS50 and is really reaching out to the same customer base. We do believe that we will need to bring out other products and of course have a number under development that we're intending to launch.

Reik Read - Robert Baird

A question on China. Barbara, can you talk a little bit about the number of new programs that might be slated to ramp up over the course of say the next one or two quarters? I'm asking the question with the understanding that really what's happening is as new products come online, they will initiate their production in China, rather than doing a lot of transfers from Mexico to China. Is that assumption correct? Can you tell me how many new programs are coming online in the next couple of quarters?

Barbara Scherer

That assumption is largely correct. There are some Bluetooth products that we are transferring production from Plymex to China, as well. And it's basically all but one of the new Bluetooth products. I want to say it's on the order of about five new products that are scheduled to ramp-up there in Q1 and Q2. Some this quarter too.

Reik Read - Robert Baird

You mentioned breakeven a year from now. What is the rough estimate of utilization that you need to get to for breakeven?

Barbara Scherer

About 30%, about double from where we are. It's not a year from now, it's the September quarter. They actually should cross through that point in the September quarter.

Ken Kannappan

One other comment if I could on that, that's the breakeven directly related to transformation in the plant. The fact of the matter is by having a facility in China and being able to be on the ground and negotiate prices there, we have already made money from having that facility in China.

Reik Read - Robert Baird

Ken, you talked in a previous question about the behavior of Motorola and what they may trying to do from a pricing and bundling standpoint. Has that behavior changed at all? What is the pricing environment look like in the Bluetooth and the office market at this point?

Ken Kannappan

I don't know that we always know directly how their behavior changes because we see it all through the filter of our customers, the carriers who are aggressive in their own right. From our perspective overall, I don't see a huge difference in the competitive environment in that I continue to see people attempting to be aggressive with respect to price. Plantronics is primarily competing on the basis of having better product performance, better product design, not primarily on the basis of having the lowest price, or the greatest number of things we can bundle into a particular deal. So I don't think our basic positioning relative to the market has changed.

With respect to the office again, we continue to see some level of price competition for sure. That has been in place for some time. But I haven't seen, in my mind, radical changes in pricing from our competitors as yet in either mobile or office from what they have been. We have certainly been concerned that there could be on the office side but as of yet, while it's been competitive, we haven't seen it suddenly as yet get more so.

Reik Read - Robert Baird

Great. Thanks much.

Operator

Your next question comes from Bill Dezellem - Tieton Capital Management .

Bill Dezellem - Tieton Capital Management

We had a couple of questions. The first one relative to the challenges that you are dealing with Altec, when you look at the root cause would you say that it was more in the camp of increased competition, or would it lean towards self- inflicted issues?

Ken Kannappan

It's kind of a combination of the two. I think that at least from our perspective on the outside that Altec had been in a situation as a turnaround, where they had a great opportunity come to them. They were focused very heavily on that, and this turnaround didn't have a lot of resources to devote, or personnel to devote toward how you sustain that. I think as it was selling there is a certain amount of feeling that you have done a great job, which they had to bring that to market, but not necessarily understanding that part of that is being the only game in town and that the competition was inevitably going to arrive. Perhaps not enough alarm to put in place things and understand what was required in terms of customers and the products to meet those. So not enough of that was in place and we were very conscious of that going through the acquisition.

One of the problems we had at that stage is that products are selling, things are going well, what's the problem? And up until the competition arrives and people start to select them, it's not fully clear that you really truly do need to make some changes in order to be more competitive.

So I think it's a combination of competition, seeing an opportunity to provide better products at a value point of the organizations itself not seeing that opportunity was clearly there and therefore heading it off at the pass to a greater degree.

But having said that, everyone being, I think, fairly clear on it now, this is again not an impossible job in our opinion. So it is something that can be executed on.

Bill Dezellem - Tieton Capital Management

That is helpful. As a follow-up, and I'm not even sure if the question is currently relevant because you had mentioned that you viewed the current status of the entertainment business to be really in a trough quarter right now. But with that having been said, would you characterize from a momentum perspective within the entertainment group that it is decelerating and that the momentum is actually improving and that you're beginning to see some light? Or would you categorize it straight up the middle, no real change one way or the other?

Ken Kannappan

Well, I think that the category actually remains very attractive, very vibrant and in fact is opening up in some new ways that are encouraging. I think Altec has great relationships, both with strategic partners and with the channels in order to play this very, very effectively, and in fact, solidified a number of relationships with some of those new players.

Having said that, at this point in time they don't have in place enough of the right products at the right costs to really profit from that and so that has not really changed right away. Again, we think it's going to be some improvement, but to really get close to the model we would like to be at it would probably be a better part of a year-and-a-half to get there.

Bill Dezellem - Tieton Capital Management

Thank you.

Operator

Your next question comes from Jason Ader - Thomas Weisel.

Jason Ader - Thomas Weisel Partners

Yes, thank you. Just a follow-up question that was asked earlier on the ACG gross margins for the March quarter, and why you didn't give specific guidance, you said flattish. I was just wondering in the March quarter you typically have a higher, a better mix of the OCC products. So why wouldn't we see some improvement in the gross margins?

Barbara Scherer

Well, we also have a semiannual cost rolls, very technical accounting conversation to go into, but we roll our costs semiannually and when you're getting cost reductions, you also then need to writedown your inventory and amortize that through, and it's a normal thing, and it happens in the March quarter and in the September quarter. So that should have a bit of a drag on margins, and other things are getting better, and so we think it'll net out about flat.

Ken Kannappan

One other comment. As Barbara mentioned, the revenues will also go down. So the absorption of the facilities and so forth isn't as favorable in the March quarter.

Barbara Scherer

Right.

Jason Ader - Thomas Weisel Partners

Second question is just on the guidance for other income for the March quarter. Is it right to think that we should be modeling it as a negative $1.3 million because of this FX loss? Is that what I am reading from the press release?

Barbara Scherer

No, not a negative, it was a negative swing of that much but from last year, but it's usually -- well actually, yes, it would be a small loss or a small gain. So it will be about $1.3 million, or perhaps a bit more sequentially, yes.

Jason Ader - Thomas Weisel Partners

Okay, because you have been running about breakeven at that line, and so I just wanted to make sure that $1.3 million swing meant you meant the breakeven level. It was a $1.5 million in the December quarter.

Barbara Scherer

Breakeven; a $1.3 million swing unfavorable sequentially.

Jason Ader - Thomas Weisel Partners

So maybe we should start at $0.5 million and then swing it down $1.3 million? Is that the right way to think about it?

Barbara Scherer

Let me just use the raw numbers. It was a $1.5 million gain in Q3 and we typically forecast actually a small loss or close to breakeven. So you might go with 1.5 million unfavorable delta.

Jason Ader - Thomas Weisel Partners

For breakeven?

Barbara Scherer

Yes.

Ken Kannappan

From the last quarter, right?

Barbara Scherer

Yes, to breakeven.

Ken Kannappan

To breakeven.

Barbara Scherer

Yes. Okay?

Jason Ader - Thomas Weisel Partners

Wait, wait. Now I'm confused.

Ken Kannappan

Because you guys were speaking in different words the whole time, but just real quickly. What she was saying was going from the gain towards breakeven, not from breakeven to the loss.

Jason Ader - Thomas Weisel Partners

I got you. So we should be modeling the March quarter other interest line at about breakeven?

Barbara Scherer

Right.

Jason Ader - Thomas Weisel Partners

All right. Thank you.

Operator

Your next question comes from Rohit Chopra - Wedbush Morgan Securities.

Rohit Chopra - Wedbush Morgan Securities

Good afternoon. A couple of questions. Could you comment on the price promotion and discounting environment this quarter, compare that to the last couple and then maybe give us an idea of what you expect next quarter?

The second question is, is there a competitive response or have you seen a competitive response from your prime competitor in Europe, as you've made inroads this quarter over there?

Ken Kannappan

In terms of price promotions, I would say there have always been a lot of price promotions. There were some in the December quarter. Overall we didn't think that the level or volume of them changed significantly; bearing in mind, of course that there are certain retailers who do certain things around Black Fridays and so forth and so those happen in the December quarter. But other than that, we didn't see any different characteristic to this December quarter than we would have expected.

Relative to our competitor in Europe, we really don't believe that there have been significant market share swings between us and our competitor within Europe. There are times when one of us seems to go up or down a little bit. But when we bear in mind the explanatory factors of inventory fluctuations and other activities, we really haven't seen significant changes when we look at what's really happening customer by customer. At the end user level if something dramatic is happening and the answer is usually not. Again in this particular last quarter, I don't think that and of course, they haven't reported their numbers yet, but I doubt that we have gained a significant amount of market share in Europe.

Rohit Chopra - Wedbush Morgan Securities

Thanks again.

Operator

Your next question comes from Leo Schmidt - Stubb Corp.

Leo Schmidt - Stubb Corp

Firstly I'd like to go through what you had said earlier and just get a better understanding. You were saying that in the China plant you already have seen a cost benefit from the component cost that has offset the loss in overhead that you have from underutilization? Is that how I am supposed to understand the earlier comment?

Ken Kannappan

That is a true comment, yes.

Leo Schmidt - Stubb Corp

Fantastic. Then you expect to increase utilization from current 15% to 30% by the September quarter?

Barbara Scherer

Yes.

Leo Schmidt - Stubb Corp

Yes. At that point you'll hit breakeven, and that should be then a pretty rapid utilization of overhead?

Barbara Scherer

Well that fully absorbs all of that, so it'll be at a breakeven point.

Leo Schmidt - Stubb Corp

Right. So what I'm getting at is as you cross breakeven and you fill up the plant, that should be pretty good leverage.

Ken Kannappan

Yes, that would be positive.

Leo Schmidt - Stubb Corp

Yes. Are you planning then to move some of the communications products, the Altec Lansing products, over to the China plant as well?

Ken Kannappan

Well, their product is already manufactured in China.

Leo Schmidt - Stubb Corp

But is it in your plant, or in other plants?

Ken Kannappan

It's in another plant.

Barbara Scherer

It's in another plant in a separate province and all of their third party contracting manufacturers are also close by as is their supply chain, which is the nature of things in China where the supply chain gets organized around an industry and a plant. So it probably doesn't make sense to move it. And we don't have any plans to.

Leo Schmidt - Stubb Corp

You seem to be saying you need to add some resources to the Altec design. Maybe it's just transferring internally, but you need new product at better price points?

Ken Kannappan

Yes.

Leo Schmidt - Stubb Corp

You feel that that should happen within the next year and by the time it all ramps up it will be a year-and-a-half before you feel the benefits?

Ken Kannappan

Yes.

Leo Schmidt - Stubb Corp

With the development of Oracle and the Altec Lansing business, typically when that happens the people find all sorts of cost benefits that they didn't realize they could execute on. Have you found any yet, and do you plan to?

Ken Kannappan

Well, if you find things you didn't expect, of course it is hard to have a plan on it. I would say we are early in that ramp-up. We do believe that there are going to be opportunities to provide better service levels that they haven't had, better controls they haven't had. Those are risk, cost avoidance type of stuff. You know, it may be possible to get some efficiency benefits. We don't currently anticipate a large level of actual cost savings.

Leo Schmidt - Stubb Corp

Any shortening of lead times? Because the lead times seem to be one of your problems for this quarter?

Barbara Scherer

Yes, but that doesn't really relate.

Leo Schmidt - Stubb Corp

All right. I'm fishing. I'm hoping for more. It's just usually, it's a nice thing to happen. You had problems, and Oracle can help, so. In your call center business, I am sorry you may have said this, but I didn't quite hear, could you give us the growth rate of the corded and the wireless business?

Barbara Scherer

The corded business was actually down 10% year over year, and 7% sequentially, and the wireless office business was up 28% year over year and up 11% sequentially.

Leo Schmidt - Stubb Corp

Great. Thank you very much.

Operator

There are no further questions.

Ken Kannappan

Richard, thank you very much. I would like to thank everyone for attending our conference call. As always, if you have any further questions, please feel free to call any of us directly.

Operator

Ladies and gentlemen, that does conclude today's Plantronics Q3 fiscal year 2007 conference call.

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