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Executives

Kathleen Nemeth -

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

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

Analysts

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

Jason Ader - William Blair & Company L.L.C., Research Division

Brian Marshall - ISI Group Inc., Research Division

Simon M. Leopold - Morgan Keegan & Company, Inc., Research Division

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

Ehud Gelblum - Morgan Stanley, Research Division

Jack Monti - UBS Investment Bank, Research Division

Rod B. Hall - JP Morgan Chase & Co, Research Division

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

Tal Liani - BofA Merrill Lynch, Research Division

Jeffrey T. Kvaal - Barclays Capital, Research Division

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

Mark Sue - RBC Capital Markets, LLC, Research Division

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

Juniper Networks (JNPR) Q3 2011 Earnings Call October 18, 2011 5:00 PM ET

Operator

Greetings and welcome to the Juniper Networks Third Quarter 2011 Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ms. Kathleen Nemeth, Vice President of Investor Relations for Juniper Networks. Thank you, Ms. Nemeth. You may begin.

Kathleen Nemeth

Thank you, operator. Good afternoon and thank you, everyone, for joining us today. Here on the call today are Kevin Johnson, Chief Executive Officer; and Robyn Denholm, Chief Financial Officer. Kevin is joining us today from Hong Kong where he is meeting with customers and partners and attending the All Saints' Day conference. Please remember when listening to today's call that statements made during this call concerning Juniper's business outlook, economic and market outlook, 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 on Form 10-Q filed with the SEC. All statements made during this call today 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, 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 results, 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 and other acquisition-related charges and expenses related to stock-based compensation.

On today's call, Robyn will also be providing forward-looking guidance. As a reminder, guidance is provided on a non-GAAP basis, other than that with respect to revenue and share count. 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 certain charges, which are excluded from the non-GAAP guidance estimates.

Please note that today's call is scheduled to last for one hour. [Operator Instructions] With that, I will now turn the call over to Kevin.

Kevin R. Johnson

Thank you, Kathleen. And welcome, everyone. We delivered third quarter results that were in line with our expectations and the performance benchmarks we articulated on our last conference call. We remain confident in our strategy and our momentum with customers as we execute on the fourth quarter and prepare for 2012.

We achieved solid bookings in the quarter and secured important design wins that support the pipeline of new solutions we are bringing to market. The macro environment remains challenging with many economic indicators becoming more volatile in the recent weeks. In the near term, this environment may make certain customers more cautious in their CapEx spending. However, we believe our broader market opportunity continues to be strong, driven by the 2 key trends of mobile Internet and cloud computing.

In this environment, as we did in 2009, we remained focused on being agile and flexible, while making the right investments for the long-term. Looking at the customer environment, service providers continue to invest in their infrastructure. In Q3, our service provider business grew 8% year-on-year. Year-to-date through Q3, our service provider business has grown 17% year-on-year. The fact that we had solid bookings this quarter, including a number of multi-quarter orders, reflects well on the wins that we have secured for new projects.

We are seeing service providers sequencing these projects over the next few quarters, based on their individual priorities, and we have also been notified of design wins that have not yet translated to bookings. So order flow and investment posture has been pretty healthy, but the timing of spending is being managed closely.

On our Q2 call, we shared the view that large service provider spending for 2011 will be weighted closer to 50% in half 1 and 50% in half 2. That deviates a bit from the normal seasonal trend of higher second half spending that we've talked about in the past. Given the current macroeconomic volatility, we expect that service providers will continue to closely manage their Q4 CapEx investments with an eye on their priorities and financials for 2011 versus 2012.

On the enterprise side, we grew 11% year-on-year. That's a pretty good result, given that the verticals of financial services and public sector, 2 of our largest enterprise sectors, have slowed the pace of new projects as they work through either economic challenges, or in the case of the public sector, a constrained budget environment.

The growth, in spite of these factors, demonstrates the strength of solutions like the EX portfolio and improved performance from SRX. We're also seeing good contributions from our key partners. That said, we expect the near term macro uncertainty to prompt enterprise customers to take a cautious posture on capital spending in the near term.

As we think about Juniper's position and how we manage through near-term uncertainty, we think it's important to keep 3 things in mind. First, beginning 3 years ago, we increased our investment in R&D. 2011 has been a pivotal year in delivering the strongest product portfolio in the history of the company. We remained focused on our strategy of innovation around the market trends of mobile Internet and cloud computing. Second, since 2009, we've managed the company to a set of operating principles that we update annually. A key underpinning of those principles is to remain agile, to invest in our growth and innovation agenda, while prudently managing our operating expense structure. We continue to remain agile through volatile economic periods, while driving our innovation and growth agendas. Third, as we position for the next fiscal year, 2012 is all about converting that innovation to revenue as we move throughout the year. To enable this, we have been prudently investing in our sales and marketing capabilities, within our guiding principle of managing operating expenses carefully.

With the wave of new products coming to market, we continue to be thoughtful about investments in quota-carrying sales professionals, with a focus on near-term return on investment for each new sales headcount we add. As we look at the third quarter results and think about the months ahead, we are executing well. We have built backlog in our current offerings, showing particular strength in the MX and SRX Series. We also continue to create demand and generate design wins that will begin to drive revenue from our new offerings in the data center, enterprise mobility and our Converged Supercore routing technology in 2012 and beyond.

We have met milestones in shipment schedules for our new products. The QFabric Interconnect and Director have been released. The T4000 is scheduled to ship later this quarter, with Comcast placing one of the first orders. And PTX routers are on the way. At the same time, we've been putting the right organizational structure in place to effectively drive our innovation roadmap and support our customers' next generation networking requirements.

As we announced in July, we have implemented the Platform Systems division and the Software Solutions division. Many of you have gotten to know Stefan Dyckerhoff who heads the platform's Systems division, and oversees our efforts in the data center and core and Edge routing. Bob Muglia officially joined us on October 4 as Executive Vice President of software, responsible for shaping and driving our end-to-end software strategy. I'm confident that Bob's vision, management strength and technical expertise will bring significant value to Juniper.

We are sharpening our focus on systems and software as the 2 core engines of growth for the company. Our software business is already a key differentiator that drives customer adoption of our solutions, including our SRX and virtual gateway security offerings, our MobileNext core for mobile operators, the Junos Pulse mobile security suite for managing devices, and the Junos Space platform for developing and deploying network applications. I'm pleased to welcome Bob to Juniper.

So to wrap up, while we are mindful of the macroeconomic backdrop, our strategy has not changed. We had a strong bookings quarter, we're building backlog, we're driving market interest in our products and we're poised to begin delivering revenue from our innovation roadmap next year.

We have set up 2012 as the year when we will have the strongest product and solutions portfolio in the history of the company. We are being thoughtful as we build the go-to-market capability to drive the success of our new innovations. At the same time, we remain strongly committed to R&D. We're doing all of this with an eye on agility to ensure our approach to spending remains consistent with our stated operating principles. And finally, we're putting a strong organizational structure in place that is aligned with our vision and strategy for success. We look forward to keeping you posted on our progress. Now I'll turn it over to Robyn, for her review of the quarter and our outlook. Robyn?

Robyn M. Denholm

Thank you, Kevin. And good afternoon, everyone. In the September quarter, we achieved our financial objectives and delivered 9% year-over-year revenue growth, an EPS of $0.28, which was in line with our guidance.

While our business in the third quarter unfolded consistent with our view in July, concerns about the macro environment have since increased. We've seen lengthening project cycles and extended delivery of request timelines from some of our customers. Given the volatile economic conditions and the effect they may have on our customers' spending, we continue to balance our investments with careful cost management as we have done in the past.

The underlying fundamentals of our business remain healthy, and we are focused on executing our strategy to address the market trends of mobile Internet and cloud computing. In the coming year, we expect to drive the deployment of our innovative portfolio of new products. Looking at the demand metrics for the quarter, book-to-bill of 1.2 reflects healthy demand for our products. We ended the quarter with strong product backlog, driven primarily by router orders.

Total deferred revenue was $886 million, up $101 million year-over-year. Deferred revenue declined sequentially by $44 million. This included a $29 million decrease in deferred services revenue due to typical seasonality for service contract renewals and a $15 million decrease in product deferrals related to delivery of committed features.

Whilst these metrics demonstrate healthy fundamental demand for our product, we continue to be very cautious in the near term. Total revenues for the third quarter was $1.106 billion, down 1% sequentially and up 9% year-over-year. In the quarter, there were no customers who accounted for more than 10% of total revenue. For the third quarter, GAAP diluted earnings per share were $0.16. Included in the GAAP diluted earnings was a $0.02 charge associated with restructuring actions we took during the quarter.

Non-GAAP diluted earnings per share were $0.28, which reflects a $0.03 sequential and $0.04 year-over-year decrease. Now let me provide some color on revenue by region, business segment and market. In the third quarter, the Americas were approximately 50% of total revenue. EMEA was 28% and APAC was 22%. Americas revenue was down 4% from the second quarter, with the decline in service provider partially offset by good sequential and year-over-year growth in enterprise.

On a year-over-year basis, Americas was up 4%. EMEA revenue was down 5% sequentially, due to declines in Southern and Eastern Europe, partially offset by strength from service providers in Germany and the U.K. Year-over-year, EMEA grew 13%. APAC revenue increased 12% sequentially and 17% year-over-year, primarily due to the recognition of deferred product revenue. We continue to see a challenging demand environment in Japan, and apart from Greater China and Australia, indications of softness elsewhere in the region.

Now looking at revenue by segment, infrastructure revenue was $835 million, down 6% sequentially and up 12% year-over-year. Within this segment, total router revenue was $703 million, down 8% sequentially. Growth of 9% year-over-year was driven by the strength in MX and T Series. Total MX product revenue was $229 million, down 18% sequentially, but up 30% year-over-year. We had very good MX bookings, which are reflected in the strong book-to-bill. We had a strong sequential increase for the T Series, and as planned, we expect to strengthen our core routing offerings with first shipment of the T4000 in fourth quarter of 2011, and the PTX in the first quarter of next year.

Total switching revenue was $132 million, up 7% sequentially and 30% year-over-year. Product revenue, which includes QFabric, was $110 million. This was up 6% sequentially and 13% year-over-year, driven by strength in EX2200 and EX8200 products. In addition, revenue from our wireless LAN portfolio was $12 million.

Moving on to the SLT segment, revenue for the quarter was $271 million, an increase of 15% sequentially and 1% year-over-year. SRX product revenue was strong at $92 million, up $30 million for the second quarter. This was primarily due to growth in our high-end SRX, reflecting our commitment to helping our service provider customers secure their mobile traffic. We are also pleased with the branch SRX growth, which reflects the progress of our channel initiatives in the enterprise market. Pulse continues to expand its success with design wins globally. We expect deployments of these design wins to generate revenue in 2012.

Looking more closely at the markets we address, service provider revenue was $685 million, down 6% sequentially due to declines in routing, partially offset by strength in security. Service provider revenue was up 8% year-over-year. Enterprise revenue was $421 million, up 8% sequentially, due to the strength in routing and switching, and improvement in security. Enterprise revenue was up 11% year-over-year.

For the quarter, service provider was 62% of total revenue and enterprise was 38% of total revenue. Now moving on to our margins and operating expenses. Non-GAAP gross margins declined slightly from the second quarter to 65.3%, impacted by product mix and higher product costs. Product gross margins were 67.5% of product revenue, down 60 basis points sequentially and 200 basis points year-over-year. Relative to the prior quarter, product gross margin was impacted by a relatively lower volume of routing, partially offset by improved volume of security products.

On the cost side, there were increased inventory carrying costs. Services gross margins were 57.4%, up 170 basis points from the prior quarter, and 270 basis points lower than the prior year. Non-GAAP operating expenses for the third quarter were $501 million, an increase of $8 million from the prior quarter. This reflects our prudent operating expense management as we continue to fund our R&D agenda and increase sales coverage for our new products.

Year-over-year operating expenses increased by 14%. R&D expenses were flat with the prior quarter, and up 9% from last year's third quarter. Sales and marketing expenses were 3% higher on a sequential basis and up 23% year-over-year. G&A expenses remained about 3% of sales and were in line with the prior period at $36 million.

Looking at headcount. We ended the quarter with 9,187 employees, a net decrease of 121 from the second quarter. This includes the impact of actions that we took late this quarter, as reflected in the restructuring charge of $16.8 million. This rebalancing is part of our discipline to ensure that we manage our resources to address the macro environment over the near-term, and the market opportunity to support our growth over the long-term.

Non-GAAP operating margins for the quarter were 20%, down 1.6 points sequentially and down 4.1 points year-over-year. Looking at the operating margin by segment, infrastructure operating margin was 18.5%, 5.2 points lower compared to the prior quarter, and 5.7 points lower compared to the third quarter of last year. Infrastructure operating margin was impacted by the reduced revenue in the quarter, and as a reminder, the results for infrastructure segment includes routers, switchers, MobileNext and QFabric.

SLT operating margin was strong at 24.5%, which was 11 points higher sequentially, and 40 basis points above last year's third quarter. Operating margins in SLT benefited from the strong sequential revenue growth. The GAAP tax rate was 30.9% for the quarter. The non-GAAP tax rate was 27.4%, up slightly from the prior quarter, due to the geographic mix of income.

Looking at the balance sheet, we ended the quarter with net cash and investments of $3.1 billion. DSO was 36 days in the quarter, compared to 39 in the prior quarter, due to better shipment linearity. Q3 cash from operations was a solid $185 million, up $54 million from last year, but down $133 million sequentially. As you may recall, last quarter benefited by the timing of a tax refund related to the 2010 R&D credit.

I am pleased with our strong cash generation again this quarter. During the quarter, we repurchased approximately 8.9 million shares at a weighted average cost of $21.47 per share or approximately $191 million. Our weighted average shares on a diluted basis for the quarter were 536.6 million shares, a decline of almost 10 million shares from the second quarter. CapEx totaled $72 million, up $10 million from the second quarter. And this includes our continued construction costs for our corporate campus here in Sunnyvale -- those buildings are expected to be completed in 2013.

Depreciation and amortization was approximately $43 million, up slightly from last quarter. Now let's discuss our guidance. As a reminder, guidance is provided on a non-GAAP basis, except for revenue and share count. As I highlighted in my opening comments, we believe the long-term fundamentals of our business remain healthy. Demand indicators in the quarter were mixed. Bookings was strong, but the mix of orders requesting delivery beyond Q4, was higher than anticipated. Given this unusual backlog timing, as well as the continued volatility in the macroeconomic environment and its impact on customer CapEx, we remain cautious.

Our guidance for the fourth quarter of 2011 is as follows: we are expecting revenues to range between $1.160 billion and $1.220 billion; gross margins for the fourth quarter are expected to continue in the range of 65% to 67%; operating margins for the fourth quarter is expected to be in the range of 21% to 23%; operating expenses are expected to be up sequentially and lower as a percentage of revenue.

We will continue to focus on balancing the longer-term needs of the business, whilst remaining agile and prudent with our spending in the short term. This is expected to result in fourth quarter non-GAAP diluted EPS of between $0.32 and $0.36 per share, and assumes a flat share count, a tax rate of 27.5%.

In summary, while we continue to see a challenging environment ahead, we remain focused on executing our strategy to capitalize on the market trends of mobile Internet and cloud computing. The underlying fundamentals of our business remain healthy as we bring our innovative products to market in the coming quarters. I want to thank our employees for their continued support, their dedication, innovation and commitment to delivering the new networks, are key to our success. And with that, I'll hand it over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

Just wanted to reconcile a few of the moving pieces as it pertains to your guidance. In particular, as you mentioned, deferred revenue declined by 5% sequentially. That actually was the biggest sequential decline since Q3 of '08, which preceded a couple of subsequent misses. Yet you also commented that book-to-bill was at 1.2, which seems pretty strong, but then at the same time, your guidance is now 10% lower than what we had expected a quarter ago. So can you just kind of put together those moving pieces? And then relative to that lower guidance, can you just be a bit more granular about what drove it relative to either verticals or geographic regions?

Robyn M. Denholm

In terms of the current quarter and the impact on the guidance for Q4, it's actually quite simple. The movement between Q3 and Q4, in terms of the guidance for the full year, is really the backlog situation, and the unusual nature of that, with a high proportion of the backlog due to delivery in the first quarter of 2012. So that is the sequential change in the guidance. From our perspective, in terms of the deferred revenue, that was anticipated in our guidance for the third quarter. So that was as expected. And in terms of the book-to-bill, we were anticipating a strong book-to-bill, which is what we recorded of about 1.2 for the quarter. So in terms of all of those factors that we've looked at for the guidance as we move forward, clearly we have more visibility to close the closer EMEA for the next quarter. And obviously we take that into account as we're setting guidance. We also take into account the fact that we do have deferred revenue that relates to features that are specified for delivery in terms of the R&D cycles that we have and the features that we're delivering to that R&D cycle. And we also take into account the backlog that we have and our discussions with customers globally.

Simona Jankowski - Goldman Sachs Group Inc., Research Division

And just a quick follow-up there on the weakness incrementally in terms of either EMEA or financial services or public sector. Are you able to allocate how much of the weakness in the guidance versus expectations came from any of those segments?

Robyn M. Denholm

In terms of the weakness in those areas, we actually, as we said in the prepared remarks, had a good quarter in terms of growth rate sequentially on the enterprise side, despite the fact that there is obviously softness in the budgets in the government sector, and also the constraints from the financial services sector. So in terms of the forward-looking part of the enterprise market, we are continuing to see good wins across the board. And that is factored into our guidance. But be assured, we're also taking a cautious view in terms of the market conditions for the fourth quarter as well.

Operator

Our next question is from the line of Tal Liani from Bank of America.

Tal Liani - BofA Merrill Lynch, Research Division

I have a question -- first of all, about the evolution. How should we expect the evolution of revenues for let's say the next few quarters? You have a few products that are kicking in between next quarter and the following 4 quarters. Can you discuss timing? And internal expectations or discuss what should we have for expectations when it comes to timing where the new projects -- or new products -- are hitting the numbers?

Robyn M. Denholm

In terms of the products and revenue and roll out over the next few quarters, obviously we've already released the QFabric products. They shipped in second half of September, so they’re actually already out there. We saw very minimal revenue as expected in the third quarter. And we don't anticipate significant revenue in the fourth quarter either. So we're very pleased with the design wins and Kevin can talk a little bit more about that in a minute. In terms of the evolution of the product roadmap from there, the T4000, as I said in the prepared remarks, is expected to ship in the fourth quarter. We're not expecting revenue in the fourth quarter, that revenue release will start to happen in the first quarter of 2012. We're very pleased with the trials and, as Kevin mentioned, we actually have our first order for the T4000. In terms of PTX, the Converged Supercore, that's scheduled to release in the first quarter of 2012, and obviously revenue will follow that. So, in terms of the progress and the customers' acceptance in terms of the early trials that we've had, I'll let Kevin talk about that.

Kevin R. Johnson

Yes, thanks for the question Tal, just to add to Robyn's remarks, QFabric as Robyn mentioned, we shipped the nodes, QFabric nodes, back in February and, as committed to our customers, we've released the QFabric Interconnect and Director. And we're seeing a lot of very good interest from customers. In fact, we have customers that have selected QFabric, and are in various stages of implementation of their QFabric projects, including customers like Thomson Reuters, Deutsche Boers, Bell Canada. And whether it's large service providers that are building managed services data centers based on QFabric, such as Bell Canada, or it's financial services institutions that are looking at their high-frequency, low-latency trading systems, we're seeing some very good uptick on QFabric. I'll also mention, ACG Research published a white paper where they benchmarked QFabric versus the legacy approach to switching in data centers. And their results show that QFabric was 58% to 75% lower capital expenditures, because we have better scaling and reduced numbers of Chassis and racks. And with reduced number of Chassis and racks, they also found that QFabric consumes 68% to 89% less power. And when you think about the power consumption in these big data centers, that's a huge element of operating expenses. So we're very enthusiastic about QFabric and the implications in the marketplace. And I think as Robyn said, look there's a long sell cycle with these big data centers, but we've got a pipeline, we're getting wins, and we're getting deployments and we're engaged. Certainly as the T4000 releases and the PTX Converged Supercore, I think we're in a position where we've got the strongest product portfolio we've had in the history of this company. And so in many ways we've been engaged with customers already in the discussion around the T4000, and we started taking orders, including the orders from Comcast that we have for the first T4000, and I would expect that as we go into 2012, we will see some early orders for the PTX Converged Supercore as well. But I think both Robyn and I will defer talking about 2012 guidance or expectations until we complete Q4.

Tal Liani - BofA Merrill Lynch, Research Division

Kevin, Cisco recently has been talking about lower growth rates in routing markets driven by pricing pressure, certain geographies. Can you discuss pricing environment, not only current pricing environment, how you see the environment shaping up for the next few years?

Kevin R. Johnson

Yes, I think, first of all, our router product revenue year-to-date has grown 19%. And I think that statement of the momentum that we've gained, whether it's around EMX or T Series or the work that we've done innovating around our routing platforms, I do think that we continue to manage to have our healthy gross margins around those products because they are differentiated. And I think for us, the key is, are we getting the return on investment from R&D to create a differentiated product set in routing. And thus far, I feel very confident that our engineering teams have done a phenomenal job in building fantastic products that deliver great value to customers. So we don't see significant pricing pressure. I will say on the competitive front, there are certain accounts or certain scenarios where, at times, the competition gets intense, and there'll be times where we'll look at surgically focusing on offerings and things that might be more aggressive on price. And then the second comment is 3 weeks ago I was in India and spent a lot of time in India. I'm here in China this week. And so certainly in some of the emerging markets, I think there is potentially different expectations around the pricing. But at a macro level, I don't see that necessarily changing our strategy. Our strategy is to differentiate our product through innovation and ensure that, that innovation translates to customer value.

Operator

Our next question is from the line of Brian Marshall with ISI.

Brian Marshall - ISI Group Inc., Research Division

It looks like we saw some pretty nice improvement on the SRX line. I was wondering if you could talk about, yes, what were the key drivers of this? Was there any lumpy orders there? Do you think this is sustainable going forward? And if it is, looks like that line of business will be 10% of revenues in the not-too-distant future.

Robyn M. Denholm

In terms of the SRX this quarter, we did see good performance on the service provider side, and as I've outlined in previous calls, that revenue will tend to be lumpy as the design wins that we have deployed in the marketplace. So we're pretty pleased with the performance this quarter. As I also mentioned in the prepared remarks, we also saw an improvement in the branch SRX, which is focused at the enterprise side. And we saw that last quarter as well, so I'm very encouraged by that in terms of the go-to-market activities that we're driving around our enterprise security offering as well.

Brian Marshall - ISI Group Inc., Research Division

Okay, so just for clarification, Robyn, so it sounds like these -- this improvement that we saw this quarter, is going to be sustainable going forward in your view?

Robyn M. Denholm

So from our perspective, we're expecting a sequential decline from our SP SRX performance in the fourth quarter, only because of the fact that as I said, we've got other design wins but the deployments of both tend to be lumpy over time.

Brian Marshall - ISI Group Inc., Research Division

Okay. And then with respect to going forward, is it the company's view that we'll continue to see enterprise grow faster than service provider into the new year?

Robyn M. Denholm

So in terms of the guidance from a fourth quarter perspective, we are expecting to see sequential increase in service provider from the third quarter levels. And we're also expecting to see an increase in terms of the enterprise sector as well. So we are expecting growth sequentially in both areas.

Operator

Our next question is from the line of Sanjiv Wadhwani with Stifel, Nicolaus.

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

Robyn, on the backlog, which is really healthy and where you're seeing shipment requests now out into Q1, can you talk about whether that is broad-based? Is it specific to 1 or 2 carriers? And if you can give some geographical information on that, that would be helpful. And then second question on gross margins, you said you had increased inventory carrying costs. Is that related to your backlog? Is that totally unrelated and any clarity on that would be helpful.

Robyn M. Denholm

Yes, let me answer, Sanjiv, the last question first. In terms of the carrying cost, it's totally unrelated to the backlog situation. It is a period cost obviously for the third quarter. We did see some of it in the second quarter as well. And I talked about increased costs in the second quarter. We expect to work that off over the next quarter or so in terms of that increased inventory cost, carrying cost. In terms of the backlog, as I said in my prepared remarks, it is unusual for us to have this higher proportion of backlog that is deliverable outside of the next quarter. We always have some that is deliverable outside of the next quarter, but for this quarter, the proportion is quite high. Having said that, in terms of specificity about customers, it's a handful of customers that are our most strategic customers. And we're embedded in the most strategic projects that they have going forward and in which case that’s how they’ve placed the orders on us. And so we're pretty pleased with that. It obviously gives us some forward visibility. So from my perspective, it's a positive thing.

Operator

Next question comes from the line of Brent Bracelin with Pacific Crest Securities.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

I also wanted to follow up here around this backlog timing and I guess my take here is going to be a little different. As you think about the timing issues here, is this tied to some timing issues relative to internal future deliveries on when you plan on delivering some features and products to these customers? Or is this kind of externally driven by kind of spending plans and maybe architectural implementation by your partners? Again I'm trying to understand, is this your customers that are driving kind of this unusual backlog timing or is it some specific features that you're not going to have until kind of Q1 that's driving the timing here on the backlog?

Robyn M. Denholm

In terms of the timing of the backlog, it's totally unrelated to new product. It is all existing product where we've already -- both for new projects as well as existing projects in the service provider, very strategic service provider customers that we have, so it's not related to future product.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

So would be tied to the -- your strategic partners' planning schedule for the delivery of when they expect this, they want this equipment installed then?

Robyn M. Denholm

Yes, I don't think it's fair to us to talk to our customers' intentions, but I think it's fair enough to draw that latter conclusion that it's more related to the timing of CapEx and the timing of deployments on the service provider side.

Operator

Our next question is from Nikos Theodosopoulos with UBS.

Jack Monti - UBS Investment Bank, Research Division

This is Jack Monti for Nikos. We were curious about 1Q seasonality with strong backlog in bookings and weaker than normal quarter-over-quarter growth in 4Q, we were curious if 1Q will show above-normal seasonality?

Robyn M. Denholm

If I understood your question right, do you mean that because we're calling midpoint of guidance as the represent growth year-over-year for the fourth quarter, is that the question?

Jack Monti - UBS Investment Bank, Research Division

Yes, that's exactly right, kind of weaker than normal we would call it, 4Q growth, and then with the backlog and the bookings being so strong, it seems like that visibility going to the first quarter will be stronger or pretty strong, is that the right way to think about it?

Robyn M. Denholm

I think at this point, it's far too early to talk about the first quarter. We'll give you some insight into the first quarter, what we're expecting for Q1 on the fourth quarter earnings call.

Operator

Our next question is from the line of Jess Lubert with Wells Fargo Securities.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

Question is for Robyn. It sounds like you're continuing to invest in OpEx heading into Q4, despite some signs that end market demand might be slowing. So I guess I was hoping you might be able to help us understand if there is some base level of operating margin you would be looking to maintain if things continue to deteriorate from an end market demand perspective. And then SLT operating margins were pretty strong in the quarter. What drove the strength here? And is this a sustainable level of SLT operating margin going forward?

Robyn M. Denholm

In terms of SLT, the biggest single factor in terms of the sequential strength of the operating margin for SLT was the revenue growth. So the strong sequential increase in SLT's revenue actually translated into a nice improvement on the bottom line. In terms of OpEx overall of the company, we've shown in the past, as we've shown in this quarter in the Q3 OpEx, we are very fiscally responsible in terms of what we're doing from an OpEx management perspective. We’re investing in the things that matter for the long-term, both in terms of R&D as well as sales -- sales and marketing. And we're continuing to be very surgical in how we're placing those investments. And at the same time, we're getting more effective and more efficient across the board from a company perspective. Hence, the rebalancing, restructuring activity that we do in the quarter. And so our view is that we will continue to be as focused on OpEx management as we had in the past. And I think you can see good evidence of that in the quarter.

Operator

Our next question is from the line of Ehud Gelblum with Morgan Stanley.

Ehud Gelblum - Morgan Stanley, Research Division

A couple of questions. First of all, on the -- Robyn,you talked a lot about this large backlog, giving you visibility into Q1, or that's kind of why we're having a below seasonal Q4 and more into Q1 in addition to the macro things Kevin talked about. But 3 months ago when you guided to 12% to 14% for the year versus the 5% to 10% you're guiding now, you clearly thought this backlog was going to land in Q4. And now it's sort of landing in Q1, and turning to backlog in October. What changed or did you always expect it to land in Q1 and you expected other revenue to come in, in Q4? I'm just trying to understand that delta between 3 months ago and now as to what your thought was on -- thought process was on Q4 and what I understood it to be was this backlog, which sounds like it's generally MX bookings. And so what really changed in either carrier plans or carrier thought process or carrier CapEx budgets or whatever between, I guess July and today, to make those MX deals go into Q1 versus Q4?

Robyn M. Denholm

Yes, in terms of the difference, it -- we were anticipating the bookings in the quarter, in the third quarter. But we were anticipating more of them to be deliverable in the fourth quarter. And so that is simply the difference between the 2 metrics from a Q4 perspective. And you can tell by the size of the book-to-bill that it was a significant increase in backlog in the quarter. And I do think that that's reflective of our Q4 guidance. So Kevin, do you want to comment on that as well?

Kevin R. Johnson

Yes, let me just add to Robyn's comments, I think Ehud, the thing that I see has changed slightly from 90 days ago primarily is the implications of the macro level uncertainty or volatility and the implications then on service provider CapEx spending, and how they're being thoughtful about how they're sequencing things on the quarterly boundary. I think the attention that service providers are placing on monitoring their CapEx expenditures quarter by quarter has increased in the last 90 days, relative to what we saw in July.

Operator

Our next question is from the line of Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

Next year if the macro environment doesn't improve, should we take your 10% to 11% revenue growth from this year and then add all the new products? Does that get us back to 20% potentially? Mathematically new products have to contribute about $900 million next year. Is that sort of what you're targeting? And then, Robyn, on gross margins, do these new products carry lower gross margins before the volumes improve and can we potentially get back to 66% to 68%?

Robyn M. Denholm

In terms of the first question, let me go through our process in terms of setting the targets for the fiscal year. So at the beginning of each year, obviously the end of the prior year as we're finalizing our planning, we set up a financial model as well as a set of operating principles on how we plan to manage the company throughout that fiscal year. And that's what we generally share with you at the beginning of each year, and we will do that again for 2012. We started obviously the current year expecting the macro environment to be significantly better by the end of the year. And therefore, how that impacts our end markets, our target markets, obviously routing and switching and security across the service provider and enterprise markets. As Kevin mentioned in terms of our year-to-date growth and how that relates to the market conditions out there, we do think that we're growing faster than the market today. Our view is with the new products that we plan to release, not just the ones that came out in the third quarter, but also those in the fourth quarter and the first quarter of next year, they will enable us to capture again more market share, grow faster than the market over next year. And so that is our approach. We will outline more of the specifics in terms of next year on the call in January. And Kevin did you want to comment on the markets as well?

Kevin R. Johnson

No, I think that you've handled it well, Robyn.

Operator

Our next question is from the line of Rod Hall with JP Morgan.

Rod B. Hall - JP Morgan Chase & Co, Research Division

I just had a couple. One is, on the MX backlog again or the backlog you guys have talked about. Can you tell us anything about the regional split of that, I mean, is it mostly in Europe or is it spread across all the regions, just be curious to know that. And then I also was wondering about the 0% growth in Q4, the year-over-year growth. Is that -- should we be interpreting that as kind of a negative service provider growth and then low single-digit enterprise growth, can you just give us some idea of what the trajectory of the 2 business types is looking like in Q4? And it'd also be nice to know kind of what sort of visibility you think you got. I mean, have you been seeing order cancellations? Or is it just a push out of orders at this point?

Robyn M. Denholm

In terms of order cancellations and push outs of existing orders, we have not seen that activity. There may have been a small amount of it, but nothing unusual in terms of either canceled orders or any existing orders pushed out. In terms of the backlog itself, we're obviously, that's -- sorry, the geographic split of backlog is obviously with our, as I mentioned before, with our largest, our most strategic service providers that we have. In terms of the growth rate quarter-over-quarter, we're expecting obviously at the midpoint of guidance to grow 7.6% quarter-over-quarter. And we are expecting that to be an increase in service providers, slightly more in terms of percentage terms quarter-over-quarter than enterprise. So we're pretty pleased with the performance in terms of the design wins in both. We're pleased with the year-to-date performance in both sectors.

Operator

Our next question is from Simon Leopold with Morgan Keegan.

Simon M. Leopold - Morgan Keegan & Company, Inc., Research Division

A couple of things I just wanted to drill down on. If we could get an update of the MobileNext product in terms of where you are, trial activity, and your thoughts on how revenue might ramp for the product for the evolved packet core.

Robyn M. Denholm

Kevin, do you want to handle that question?

Kevin R. Johnson

Yes, I'm happy to handle that question. MobileNext is, as you recall, is a software solution that we have created that runs on top of the MX 3D Edge router. And MobileNext, we released the first software offering a little over a year ago called -- something called Traffic Direct, which was the first wave of offering that helped customers redirect bulk Internet traffic around the expensive service complex that some of the mobile traffic -- and allowed them to offload that traffic. We've released the first set of gateways around mobile packet core earlier this year. I think it was in Q2, as we committed to customers, we released that software. And we have a few design wins of some customers -- more of the Tier 2-type customers that we're engaging to now work on the deployment plans and convert those design wins into revenue. We also have a product roadmap where we're continuing to enhance the products set around MobileNext. And so I would expect, as we go into this quarter and into 2012, we'll start seeing some public references of customers that are running MobileNext as their packet core on the MX 3D. In addition, I would also highlight that we continue to have a very strong partnership with Ericsson when it comes to packet core. And the Ericsson packet core solution runs on our M Series router. And they have a market-leading position in packet core and we continue to work very closely with them to ensure that their packet core solution is highly competitive on top of the M Series. And I think this is -- the packet core is one element on the overall end-to-end solution that we're delivering to service providers as they shift from 2G to 3G to LTE. And the timing of these transitions vary by customer, and frankly they vary by geography. And I think from a solution standpoint, we've got a very good platform and a very good solution that we're taking to market. But it’s one that I think will take some time for these design wins and the deployments and to help these customers take advantage of that offering, but I think we're making some very good progress.

Operator

Our next question is from Jeff Kvaal with Barclays Capital.

Jeffrey T. Kvaal - Barclays Capital, Research Division

A couple of clarification, if I may. I think number one, I think, Robyn, you said during your remarks that the MX was down 18% sequentially. Could you talk us through that a little bit?

Robyn M. Denholm

Yes, in terms of the MX, it was down sequentially 18%. But I did note as well that much of the backlog, or the increase in backlog, was primarily routing backlog. So there is a high proportion of that in MX.

Operator

The next question is from Ittai Kidron with Oppenheimer.

Ittai Kidron - Oppenheimer & Co. Inc., Research Division

I wanted to drill into the switching business. Robyn, correct me if I'm wrong. You've talked about revenues of $110 million in products. But that would imply, stripping out the wireless LAN business, that your EX business actually declined quarter-over-quarter. Do I have that correctly? And if so, what's still the challenge over there? And also can you give us some color as to how much of QFabric did you book this quarter? How much do you think you will book next quarter?

Robyn M. Denholm

So let me just clarify EX. So EX was actually up in the quarter sequentially. And the $12 million is on top of the $110 million. So the $110 million was EX and QFabric, and there was a very minimal amount of QFabric in the quarter. In terms of the total revenue, it's $110 million for EX and QFabric, plus $12 million for wireless LAN, and then there's services on top of that to get to the $132 million.

Operator

Our next question is from the line of Ryan Hutchinson with Lazard Capital.

Ryan Hutchinson - Lazard Capital Markets LLC, Research Division

I guess I'm going to ask it a different way. I’m trying to understand the various buckets that drove the midpoint of the guidance down to the levels of about 7.5%, and I understand macro clearly played a role here. But as you dig into the service provider orders maybe, Robyn, if you could just help us quantify how large the orders are, any color around backlog would be helpful. And then what gives you confidence that they'll actually close in Q1? And I know you said there's a number of customers within that, but it seems to be concentrated perhaps in 1 or 2 carriers and if that's the case, just help us understand that as well. And then finally, as relates to seasonality, it was asked, but why wouldn't this positively impact you on seasonality, in the event that these orders were recognized as revenue?

Robyn M. Denholm

Yes, in terms of the backlog affecting Q1, it absolutely could impact positively Q1, but at this point I'm not prepared to call that. It's far too early to call Q1 revenue. They will be delivered in Q1. In terms of the fourth quarter guidance, the movement between our implied guidance for the first -- sorry, for the fourth quarter that we talked about in Q3 earnings -- sorry, on the Q2 earnings call early this quarter, it's primarily that one movement in terms of the small number of customers that have placed orders for -- with us today for delivery in Q1.

Operator

The next question is from Jason Ader with William Blair.

Jason Ader - William Blair & Company L.L.C., Research Division

I want to follow up on Ittai's question. On the switch business, the growth has decelerated pretty substantially over the last few quarters there. I'm just wondering, is this due to competition from a rejuvenated Cisco? And then I was hoping maybe, Kevin, you could comment on Cisco's new product introduction today where they say they can double your fabric for scalability?

Kevin R. Johnson

Yes, let me take that question. Thanks for the question. First of all, the total -- our total switching product revenue, including the wireless LAN, I'll throw that in, has grown -- year-to-date, it's grown 30% year-on-year. And if you look at the analyst reports, just take through Q2, take the Dell'Oro report through Q2, the addressable market for ethernet switching declined by 6% year-to-date through Q2, and we'll see what happens in Q3, but year-to-date, through Q3 we've grown 30%. So we've grown 30% in a market, that addressable market that has declined by 6%. Now your question should be that, "Okay. Well, why has that addressable market declined by 6%?" Well, if you dig into that, you'll actually see the number of ports through Q2 have increased, but the revenue per port or ASP per port has declined. And so then you say, "Okay. Well, there must be some pricing action that's taking place in the switching addressable market." And what we see happening is really a bifurcation of that ethernet switching market. And I'll say in the campus and branch areas, where some customers will look and say, "Okay. Well, a good enough type of switch might be acceptable to them, and you have competitors like an HP or Huawei entering the market with a lower gross margin, lower price. And you see the incumbent having to follow them in terms of price, in a good enough segment of ethernet switching market there is some pricing action that is taking place. Now the second part though is that bifurcation though is the higher end segment of the market where innovation really is differentiated. And that's the segment that we play in. And so when we look at our growth, we've grown in data center, we've grown in campus and branch, but we've grown our business around a value proposition that's enabled by our innovation, whether it's the EX Virtual Chassis feature set, that allowed us to collapse layers in the data center from 3 to 2, or QFabric that allows us to collapse the layers to a single layer of fabric within the data center. Now just remind you, QFabric and that innovation, according to this ACG Research note, allows customers to implement that data center with 58 to 75 lower CapEx and 68% to 89% less power consumption. That's because we changed the architecture. We have a new architecture, new network architecture for QFabric. So at a macro level, I think we've grown quite well with a 30% year-to-date growth in an addressable market that's actually declined. We've grown in the segments of the market where innovation matters and where we have strong differentiation, versus those that I think are fighting more of a commodity battle. We're fighting and really focused on an innovation agenda. Then the second part of your question is around the announcements today. It's early in Hong Kong so I haven't had a lot of time to read them. But what I have read -- fundamentally what they have announced is, products that still utilize the old network architecture. Layers and layers of switches. And what we've done with QFabric is a new network architecture. So I think when it comes to QFabric, certainly Juniper is driving the bus that Cisco is running to catch. And I don't think necessarily what they've announced changes the architecture that they've had at all. It's an old network architecture relative to our new network architecture. That said, I have a lot of respect for Cisco and I think in many ways, this is a competition about old network versus new network. And we're going to continue to play our game and focus on the things that we do well, which is innovate in ways that matter for customers.

Operator

And our final question comes from the line of Alex Henderson with Miller Tabak + Co.

Alex B. Henderson - Miller Tabak + Co., LLC, Research Division

I was wondering if you could talk a little bit about the trajectory into the fourth quarter on a seasonal basis between enterprise and service provider, whether you're expecting a budget plush in the enterprise, within your guidance, or whether the enterprise piece is also going to see a less-than-normal budget plush. What are your assumptions along that piece of the parameter of the guidance?

Robyn M. Denholm

Alex, in terms of the guidance split between service provider and enterprise, we are expecting growth in both sectors, sequentially. And we are expecting service provider growth to be slightly higher than enterprise growth. In terms of normal seasonality, we are not expecting a typical end-of-year spend from either sectors in our guidance so -- that are above the normal purchases within normal quarter as opposed to the end of year quarter. So that's incorporated in our guidance. So Kevin, do you want to add to that?

Kevin R. Johnson

Yes, Robyn. And I would just add a comment, that given the macro level volatility and uncertainty, our expectation is there's much less of any kind of budget surge that you potentially have seen in prior years. I think the pattern that we've seen, whether it's financial services and the enterprise, federal government or service providers, it's much more of a cautionary focus on their CapEx spending in which [indiscernible] of the quarter that's going to happen on and I expect to see that again in Q4. And I think that sets the tone because of the macro environment, I think there should be an expectation that there is less of what I would call a budget surge in Q4.

Operator

Thank you. We have no further questions at this time. I'll just turn the floor back over to management for any closing comments.

Kathleen Nemeth

Thank you, Manny. This concludes our Q3 financial results conference call. Thank you very much for joining us today.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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