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Polycom Inc. (NASDAQ:PLCM)

Q3 2011 Earnings Conference Call

October 19, 2011 5:00 PM ET

Executives

Laura Graves – VP, IR

Andy Miller – President and CEO

Mike Kourey – CFO

Analysts

Jeff Kvaal – Barclays Capital

Jess Lubert – Wells Fargo Securities

Troy Jensen – Piper Jaffrey

Mark Sue – RBC Capital Markets

Jason Ader – William Blair

Jack Monti – UBS

Joanna Makris – Mizuho Securities

Jim Suva – Citi

Tim Long – Bank of Montreal

Larry Harris – CL King

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Polycom’s Q3 2011, quarterly results conference call. During the presentation all participants will be in a listen-only mode. Afterwards we will conduct a question-and-answer session. (Operator Instructions) As a reminder this conference call is being recorded Wednesday, October 19, 2011. I would now like to turn the call over to Laura Graves, VP Investor Relations, please go ahead ma’am.

Laura Graves

Thank you very much operator. Hello and welcome everyone to Polycom’s third quarter 2011 earnings call. I’m Laura Graves, Polycom’s Vice President of Investor Relations and here with me are Andy Miller our President and CEO and Mike Kourey our Chief Financial Officer.

As the previous quarterly calls, Polycom is again augmenting today’s voice conference with a video webcast. If you would like to receive the full webcast, please open your browser at this time and enter Polycom’s home page which is Polycom.com and click on the Q3 earnings call link. For the analysts participating in the Q&A session, leave your voice call live so that you can use your conference call connection for the Q&A session at the end of our call. Please do note that the Q&A is for financial analysts, we welcome all others to listen into the Q&A session.

Please note that this entire webcast including Q&A will be maintained on Polycom’s website for 12 months from today. Also a link to the call will be provided on Twitter, Facebook and LinkedIn at Polycom.com.

During the course of this conference call, Andy and Mike will make forward-looking statements and present forward-looking visual materials regarding future events, anticipated future trends, future product offerings and the future performance of our company including financial guidance, strategic initiatives and future investments in the business.

We wish to caution you that such statements and visual materials are just predications that involve risks and uncertainties and that actual results may differ materially. We discuss a number of these risks in our business in detail on the company’s SEC reports, including most recently in the company’s quarterly report on Form 10-Q for the quarter ended June 30 2011 and any forward-looking statements must be considered in the context of such risks and uncertainties.

Also please note that Polycom’s application of US GAAP requires disclosures and availability of new products, planned features and upgrades discussed during this call are subject to change or cancellation. In addition, we will be presenting both GAAP and non-GAAP financial measure to you today. Please refer to reconciliation of GAAP and non-GAAP financial measures in today’s earnings release which is also posted on our website. Now with that, let me turn the call over to Polycom’s President and CEO, Mr. Andy Miller. Andy?

Andy Miller

Thank you, Laura and good afternoon everyone. Strategically, this was an outstanding quarter for Polycom as we continued to execute on our five pillar strategy focused on cloud, mobility our UC ecosystem, innovation and our software platform. For example in Q3, we unveiled our software strategy with Polycom’s RealPresence platform. We completed our acquisition of Hewlett-Packard’s Visual Collaboration business, substantially increasing our position in the immersive telepresence space. We launched Polycom RealPresence mobile for Apple’s iPad in the leading android platform.

We announced a new partnership with Jive Software to integrate Polycom HD video into Jive’s social business platform and just earlier this week, we announced the acquisition of ViVu further enhancing our position in the web and cloud-based video collaboration. Financially, we generated solid operating results at both the top and bottom line.

In Q3, we achieved record revenues of $379 million, growing 23% year-over-year and 4% sequentially with non-GAAP operating profit growing 32% year-over-year. Non-GAAP operating margin was 15.2% and non-GAAP EPS was $0.26. We exited the quarter with $205 million in deferred revenues, up 39% year-over-year and 9% sequentially. Finally, we generated $47 million in quarterly operating cash flows.

Looking at the specific dynamics of our third quarter and what we expect in Q4, I’d like to highlight the following

First our strategy of aggressively pursuing emerging growth markets is achieving excellent results. In fact, emerging or growth geographies which includes China, India, Russia, Latin America, Middle East and Africa, grew a significant 58% year-over-year in the third quarter.

Our growth geography strategy is clearly yielding excellent results and now represents 24% of our consolidated revenues. Second, we also noted previously that we are implementing coverage plans to improve our footprint in Central Europe and that is yielding excellent results, especially in the large and important markets of Germany. Third and very importantly, we embarked on a two year journey in 2009 to invest in a US Federal sector through sales coverage, a greatly expanded Washington DC presence, new relationships with the federal systems integrators and the certifications required to participate fully with the DOD agencies.

I’m pleased to report that this is coming to fruition. In Q3 we’ve got the first installment of the market gains and revenue opportunity we expect with this large and important vertical. In fact, US Federal bookings grew 120% sequentially and nearly 40% year-over-year in the third quarter. One key highlight here is, over a $1 million transaction, competitive win of a large US military, forward to four days in Southwest Asia, enabled by our recertification, this organization procured Polycom’s RealPresence platform for their command and control.

Another key highlight is a large US civilian agency with a covenant level department, this agency procured over $1 million of Polycom’s personal UC devices driven by the success with Polycom’s RealPresence platform and integrate with our recent release of our Apple iPad base mobility application. Fourth, even though we only completed the HD visual collaboration acquisition at the end of July, this immersive telepresence offering and managed service is already performing ahead of plan.

We are pleased to have this team onboard and look forward to leveraging these managed service capabilities with our cloud partners such as AT&T, Verizon, Telstra, BT and others. Partially offsetting these drivers and our growing leverage through Polycom’s open collaboration network with a lower than expected year-over-year growth in US enterprise.

In our view this was caused by both a mix macroeconomic environment and by some room for improvement in our go to market execution. In the US enterprise, we found that sales cycle for a few key transactions lengthened in Q3, pushing some of these sales into Q4. We have followed these customer transactions extremely closely and we fully expect to close each of them this quarter.

Let me next expand on our key accomplishments over the last 90 days. In Q3, as a next logical step in our strategy of providing those innovative open and interoperable UC solutions in the market. We launched the Polycom’s RealPresence platform formerly known as UC Intelligent Core built on Polycom’s unparalleled software, a RealPresence platform enabled universal video collaboration, video resource management, the only virtualization capability available, universal access and security in video content management.

Polycom’s RealPresence platform serves as a common linkage for IM, Call control web conferencing video collaboration, mobility and social. Importantly we have architect with this UC network infrastructure solution to serve customers of all types, either to the cloud or customer deliveries.

Polycom’s software-based strategy is also enabling Polycom’s broad eco system, the Polycom open collaboration network comprised of key strategic partners such as Microsoft, IBM, Hewlett-Packard, Broadsoft, Juniper, Jive and others. In fact in this third quarter approximately 26% of Polycom’s revenues were generated with the original plus seven Polycom open collaboration network partners alone.

Please note that since this POCM network is evolving rapidly to include mobility partnerships such as Apple, and social collaboration partners such as Jive, we will not be breaking out this POCM percentage going forward. Ultimately, we expect the vast majority of our revenues to be in some way pulled through from one of our cloud mobile social or systems integrator strategic partners.

Of course we will continue to provide color with regard to these partnerships and provide updates as to our successes with each of them. We took Polycom’s RealPresence platform to the next level last week the CTIS Show in San Diego, the world’s premier mobility conference. We announced Polycom RealPresence mobile the first enterprise video software solution for the Apple iPad and the Motorola Mobility and Samsung Tablets.

At my keynote last week, we demonstrated the incredible interoperability in quality of our UC mobile solution across these tablets and integrated with enterprise room and desktop video. I can tell you that through my personal interactions with over 100 customers over the last few months alone, that we are delivering exactly what they are asking for, whether it’s integration with company provided solutions or through a hybrid model that includes BYOD, meaning employee provided devices, enterprises and government agencies are looking for secure video collaboration solutions that span the gamut.

You’ll note that earlier this week, we announced the acquisition of ViVu, even further enhancing Polycom’s web-based high definition video collaboration capabilities. ViVu gives Polycom a fast track to embed video-enabled collaboration software into a wide range of web applications in social platforms. For instance, ViVu has already deployed a video enabled collaboration into TIBCO’s Tibbr social platform and with Thomson Reuters, ViVu powers the video collaboration of the Reuter’s Insider, a real-time finance professionals collaboration application.

This acquisition reinforces Polycom’s software strategy that will serve as a component of Polycom’s RealPresence platform. Next, I’d like to take a moment to look at UC market and discuss what we call the five drivers as a visual mobile society. First is the mobile device proliferation. Smartphones such as the iPhone and the android based devices are being adopted globally at an unprecedented rate.

In fact, IDC estimates there are over 470 million smartphones will ship by the end of 2011 and they expect that number to reach over 980 million by the end of 2015. Tablets particularly well suited for video communications are also exploding on to the scene, especially in enterprise and government applications.

Today, according to Apple, 92% of the Fortune 500 are either testing or deploying iPads across their base of knowledge workers and 90% of these enterprise tablets will be video enabled by 2015. Second is network readiness, whether it’s Wi-Fi, 4G or desktop connection to a room or desktop, the core wired and wireless networks are in place to enable high definition video and voice collaboration anywhere anytime. This applies to internal business-to-business and business to consumer collaboration alive.

Third is cloud delivery, interestingly, according to Gartner 40% of all enterprises worldwide will be cloud enabled by 2012. In fact, cloud delivery already represents a $41 billion market today, according to a market research firm Forrester.

XAAS or anything as a service is emerging as the IT customer adoption method for choice for small to medium business and increasingly larger scale enterprises and government customers as well, coupled with this powerful phenomenon directory services and presence space capabilities are rising to enable full scale voice, video and content communication through standalone applications or when integrated with social collaboration platforms.

Fourth is social networking, collaboration sites such as Jive, Twitter, LinkedIn and others are becoming integral to any knowledge workers’ day-to-day communications. Video chat alone is expected to grow to a 140 million user base in just the next four years. This is a generation raised on video, whether it’s Hulu, iTunes or Youtube, individuals of all generations are fast adapting IP-based video for both entertainment, the news and increase way of daily communications.

Predictably the line between a person’s work place and social life is glorying created the need for common communication platforms that can serve each knowledge worker round the clock. Now with this as a backdrop, let me discuss what this means for Polycom.

Polycom’s vision and value is to make it possible for millions of people to use video collaboration as their preferred method of communicating easily, reliably, and securely regardless of network carrier, protocol application or device. This vision can only be realized through open standards and native interoperability enabling all of these to spirit parts to work together seamlessly and we believe that Polycom is best positioned to capture the video network affect that this brings.

Next in order to improve our effectiveness in the America’s enterprise Tracy Newell, our new Executive Vice President of Worldwide Sales is making key few changes. Globally, we are shifting some of our overlay resources to augment our customer high touch model. We’ve also identified opportunities to shift overhead investments into high touch customer engagements as well. In order to capitalize on the growth geographies, Hansjoerg Wagner, our President of Asia-Pacific theater will now have the additional management responsibility, the Latin America growth market as well.

As a result, North America will now have its own dedicated sales management structure. Along these lines we have recruited Dave Rosario our North American President, Dave brings a proven track record from Cisco, where he was Area Vice President responsible for the sales and partnership with AT&T. Previously Dave was Area Vice President for Commercial South, where he achieved number one area Vice President status over multiple years.

David has a consistent track record of overperformance and has worked with Tracy in the past. I believe he is the ideal fit for this role and cannot be more pleased to have David take the range of our largest revenue geography.

Finally Tracy is also assuming direct management authority for telesales, sales operations and worldwide channels. Through these realignments and the addition to Dave Rosario to our management team, I am confident that we can continue to further exploit our success while of course correcting where needed.

Before I turn the call over to Mike, I just want to summarize by saying that I believe the UC market has never been better, driven by the cloud, mobility and Polycom’s unique position in the industry. We do recognize we need to make some adjustments and improvements and we will do so with steel and precision.

Our strategy is on track and we expect to continue to execute, and build upon our market and innovation leadership. The entire management team and I are excited to deliver accordingly.

On that note, let me turn the call over to Mike for a discussion of Polycom’s financial results. Mike?

Mike Kourey

Thank you, Andy. Before I get started, please note that for the financial guidance that we are giving here today, Polycom is not assuming the responsibility to provide any updates regarding this financial guidance, regardless of changes, adverse or otherwise which may occur in the future. Also during this portion of the call, I remind you that we’ll both be making forward-looking statements including guidance regarding our expectations regarding our expectations of future financial execution and performance, which are subject to risk and uncertainties that could cause actual results to differ materially from our expectations.

Moving to a look at our results, as Andy stated earlier, Polycom generated record revenues in the third quarter of $379 million. This represents a sequential increase of 4% and a growth of 23% over Q3 of last year.

Looking at revenue by geography in Q3, America’s grew revenues 4% sequentially and 15% over the year ago period. EMEA revenues grew by 3% sequentially and 23% year-over-year and Asia-Pacific revenues grew 3% sequentially and a significant 41% year-over-year.

Moving to revenue by product line, including the services attached to each, Polycom’s RealPresence platform or UC Network Infrastructure Solutions grew 2% sequentially and 34% year-over-year to $61 million or 16% of revenues.

Revenues for UC Group Systems which includes all of immersive telepresence, group video and group voice systems grew to a record $247 million or 65% of revenues in Q3 increasing by 5% sequentially and by 23% year-over-year.

UC Personal Devices which includes all desktop video devices, desktop voice and wireless LAN products grew to a $71 million or 19% of revenues in Q3 up 2% sequentially and 15% year-over-year.

From a channel standpoint, the revenue breakup for the third quarter is as follows, 28% through value added resellers, 52% through distributors, 8% through service providers and 2% direct.

Note that 4 percentage points of our distribution business in Q3 was driven by the ITSPs, another service provider who sold through distribution, making the total service provider percentage 12% in the third quarter

We shipped 51% of revenues in the last month of the quarter. Polycom’s deferred revenues grew to $205 million in third quarter growing 9% sequentially and 39% over the year ago period.

Moving to the statement of operations, non-GAAP gross margins for the third quarter were 51.1%, down 50 basis points from Q2, as expected due to the inclusion of the HP Visual Collaboration business but up 20 basis points over the comparable period last year. Although we are not changing Polycom’s gross margin model at this time, we do expect a gradual raise in consolidated gross margins over time as Polycom’s RealPresence platform and our software at the edge gain momentum to our brand mobile and embedded applications. Polycom’s non-GAAP operating expenses increased sequentially to fund the growth initiatives as Andy described earlier with non-GAAP operating expenses representing 45% of net revenues in Q3 up slightly from 44.6% or net revenues in the second quarter.

Looking at the specific Q3 non-GAAP operating expense line items on a percent of revenues basis, sales and marketing represented 27.7% of revenues for the period, up slightly from 27.5% in the Q2. R&D closed at 12.9% of revenues, up from 12.5% in Q2 and G&A was 4.4% of revenues, down from 4.6% in Q2.

Moving down the income statement, third quarter non-GAAP operating income was down 2% sequentially but grew 32% year-over-year to $61 million or 15.2% of net revenues. This compares to $47 million in non-GAAP operating income or 15.1% of net revenues in Q3 of 2010, a 110 basis points improvement in operating margin.

As a recap of our performance against our long-term target model, we operated slightly above the midpoint of our target gross margin range of 59% to 63%. Sales and marketing operated at 170 basis points over the high-end of its target range in support of our strategic plan. R&D operated 90 basis points over the high end of its target range and G&A was within its target range.

Other income and expense in Q3 resulted in net other expense of approximately $1.3 million comprised of 400,000 of net interest income and approximately $1.7 million of other expense. Net other expense was primarily driven by non-income related taxes and to a lesser extent net foreign currency losses.

Looking forward to Q4 we expect a net other expense of approximately $1 million. Moving to tax, you’ll note that our Q3 non-GAAP effective tax rate was 19.3%. Looking forward to the fourth quarter and beyond, we are now forecasting a 23% effective tax rate based on our geographic mix assumptions and other factors.

Of course our tax rate is subject to change based upon changes in geographic mix, as well as changes resulting from any new U.S. or international regulations or interpretations.

Q3 non-GAAP net income of $48 million increased 1% from Q2 and grew by 43% from $34 million in the comparable period last year. Non-GAAP diluted EPS was $0.26 in Q3 flat with the second quarter but growing by 37% from $0.19 in the year ago period.

GAAP EPS for the quarter was $0.13 per diluted share compared to $0.10 per diluted share in the same period last year. Note that the EPS data for both current and historical periods reflect a two for one stock split that took effect on July 1.

Looking forward to Q4 we expect to continue to benefit from our success in the Asia-Pacific Theater our gains in US Federal, ongoing go to market success in Central Europe and the year-end budget dynamics in global enterprise.

We also anticipated benefit from improved go to market alignment in the US market which should particularly benefit the enterprise segment. Finally we continue to experience positive customer reaction to our innovations and cloud mobility, which we believe will drive broader adoption of our network infrastructure with the service providers, large scale enterprises and government into 2012.

A view of the mix macroeconomic drivers however, we do want to take a conservative stand in the revenue guidance. As a result we are guiding Q4 revenue growth of 5% to 6% from third quarter levels, driven by solid market dynamics and favorable mix expectations, we expect Q4 gross margins to increase by approximately 10 basis points from the third quarter levels.

Of course gross margins in the future maybe higher or lower and resulted to mixed variations and other factors.

Moving to operating expenses in Q4 we expect to benefit from ongoing leverage of the Polycom open collaboration network, sales productivity gains, and other factors. Specifically we expect sales and marketing expenses as a percent of revenue to decrease by approximately 40 to 50 basis points from Q3 levels. We expect R&D to decrease by 80 to 90 basis points from the third quarter and we expect G&A to remain consistent with third quarter levels on an expense basis.

As a result, we expect fourth quarter non-GAAP operating margin to increase by approximately 130 basis points from third quarter representing a 100 basis point improvement over Q4 of last year.

Looking to 2012, we plan to continue to make meaningful year-over-year operating margin improvements in each quarter. That being said we plan to invest in go to market and innovation in order to capitalize on the mounting opportunities in cloud and mobility based collaboration solutions and to exploit Polycom’s unique position in this fast growth market. As such, we expect an operating margin profile of 18% to 20% in each quarter of next year. Please note that our operating margin goal of 20% to 22% over the longer term remains in place.

Turning to the balance sheet, we generated a record $47 million in positive operating cash flow in the third quarter. These operating cash flow results were driven by including profitability and our strong working capital management.

We exited the third quarter with cash and investments of $540 million and the company continues to be debt free. Moving to DSL, the company’s net trade receivables of $206 million resulted in a DSO of 49 days.

Looking forward, we are maintaining our best-in-class DSO guidance of 40 to 50 days. Inventory turns at the end of second quarter were 5.3 turns down slightly from 5.4 in Q2. We continue to be within our target range of 5 to 6 turns.

Regarding expected share count, we expect Polycom’s weighted average shares per diluted EPS to grow by approximately 1.5 million shares in Q4 exclusive of stock repurchases. This is driven by the stock price and other factors.

During the third quarter we purchased 20 million in our shares under our share repurchase program. Looking forward we have $98 million remaining in our share buyback authorization.

Of course in addition to future potential buybacks of our stock, our share count will change based on Polycom’s stock price, any acquisition activity and other factors.

Moving to headcount, Polycom had 3,876 employees at the end of Q3 representing a 7% increase from the end of Q2. These additions are primarily in customer facing and product development roles in support of Polycom’s strategic imperatives as well as headcount associated with our HP visual collaboration acquisition.

At this time, let me turn the call back over to Andy Miller for closing comments.

Andy Miller

Thank you, Mike. In summary, Polycom has clearly emerged as the premier UC provider that provides customers a seamless and secure video collaboration solution, from immersive telepresence to the desktop, to the world’s leading mobile devices. Leveraging the Polycom RealPresence platform we believe we are best positioned to capture the network effect of video communications, being driven by the demand for real-time collaboration in the workplace, vertical industries and social networks.

Our powerful software-based cloud and mobility strategy is beginning to take shape as evidenced by our recent partnership and acquisition announcements. Finally, Mike, I and the entire management team are more excited and committed than ever about the convergence of cloud, mobility and a mounting demand for collaboration within businesses b2b and b2c.

We believe Polycom has an unparalleled offering with immersive telepresence traditional desktop video conferencing, cloud delivery infrastructure and now software and mobility applications available for iPad and android platforms. We plan to use this offering to build an even stronger position in this fast growing market. Couple that with the most powerful partnerships with Microsoft, IBM, Hewlett-Packard and others, we believe Polycom will emerge as the undisputed leader for collaboration solutions that are open secure and the most innovative in the market.

On that note, we would like to open the call to the financial analysts for questions. For all others, we invite you to stay on the call to listen in. Of course as we discussed earlier in the call, many of the statements that we’ve made and we will make during the Q&A period are forward-looking statements which are subject to many risks and uncertainties. Each analyst will be limited to one question and one follow-up. Is the conference call operator available at this time?

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Jeff Kvaal with Barclays Capital. Please go ahead.

Jeff Kvaal – Barclays Capital

Yes, thank you gentlemen very much. I’m wondering if you could spend a little bit of time talking about what the factors are behind your expectations for the somewhat sub-seasonal early close of the last couple of years, revenue growth heading into the December quarter, if you want to characterize that by type of product or by regions that would be very helpful?

.

Andy Miller

Let me take that. First as it relates to Q4, Mike already gave the guidance in terms of revenue growth. And I also said earlier in the call that we did have several transactions of significance that were delayed in Q3 that have now come into Q4. With that said, we feel very bullish that our growth markets that we described earlier, traditionally known as BRIC and specific and Kvaal we are continuing to be strong going into Q4. We also expect our federal business that we mentioned earlier to continue, even though the buying season traditionally is over September 30, there is still quite a bit of activity in the federal markets in Q4 as well and we also expect frankly a rebound in enterprise. I mean clearly, as we saw in Q3, we did see towards the end of the quarter, some of the deals become delayed and moved into Q4. But it’s very important to note that of those transactions we expect everyone to close within Q4, none of those deals were lost to competition and every one of those deals again will close inside the Q4 timeframe. I also discussed on the call that we expect a combination of Tracy and now our new enterprise leader in North America, Dave to really turbo charge, not only the talent with inside North America enterprise but to be able to drive that with inside the quarter. And therefore we are confident that we’ll achieve Mike’s and myself guidance in Q4.

Operator

Our next question comes from Jess Lubert with Wells Fargo Securities. Please go ahead sir.

Jess Lubert – Wells Fargo Securities

Thanks for taking my question. The question is for Mike, I was just hoping you might be able to walk us through your renewed thinking on operating margins going forward, it seems like getting to 20% was the key goal for Q4 2011 and now it sounds like you are also tampering your enthusiasm for 2012 a bit. So I was hoping to understand how you are balancing growth versus margin going forward and perhaps what level of revenue is needed to get the 20% over time?

Mike Kourey

Sure, good question Jess. Let me turn that over to Andy to start and then I can wrap it up at the end if necessary.

Andy Miller

Sure, clearly Mike and I stated and I accept full responsibility for the 20% operating margins in Q4 and clearly we’ve slightly changed that guidance. It’s very important to understand that in the mid-September timeframe two things happened. One is we started to see several deals elongate and fall into Q4, but more importantly, that my strategic offside, it was very clear that time that the mobility in the social media components of our company were accelerating at a faster rate than even we expected around Motorola, around Apple, around Samsung, Jive many others. At the same time it was very clear at that time, that our investments into IBM, Microsoft and HP from an opportunistic perspective for forward revenue growth opportunities would require investments. Therefore I felt strongly that would be prudent to change our guidance to be between 18% to 20% operating margin, with inside 2012.

Now we commit at Polycom a 100% to get as close as we can to that 20% operating margin in 2012. But what I’m asking for is the elasticity in the year to make investments specifically around IBM, Microsoft, HP, mobility and social media to be able to take that differentiation against the largest competitor and really make that clarity in the marketplace. So we’re sticking with the long term guidance of between 20% and 22% operating margin, but in 2012, we’re looking to be in that range of 18% to 20%. Clearly we are going to shoot for that 20%, but we are not going to do this throughout a specific quarter because of these unique opportunities that we see in the market today. Mike?

Mike Kourey

Yeah, thank you Andy, obviously well said, the only thing I would add to that is, as I mentioned earlier, we do expect to have meaningful year-over-year operating margin expansion each quarter and based on – we won’t make an exact revenue number Jess, but clearly we believe 18 to 20 that we can be at comfortably with reasonable growth rates that we are expecting in revenue for the year.

Operator

Our next question comes from Troy Jensen with Piper Jaffrey. Please go ahead.

Troy Jensen – Piper Jaffrey

Hey Andy, could you tell us how much business do you think slipped into Q4 that you’ve already closed?

Andy Miller

Well, I’m going to let Mike answer that. What I will tell you is that there were deals that I could count on two hands and they would vary between government and enterprise. Really with inside the last three weeks of the quarter, that has slipped into Q4. Some of it was mixed macroeconomic, some of it was execution, some of it was customer conservativeness. As I said before Troy, each of those transactions will close in Q4, none will off the competition.

Mike Kourey

Troy, the only thing I would add to that, although we won’t breakout the exact numbers here, I will say that our bookings activity in Q3 is up materially from last quarter this time. So we have seen a significant pick up in our bookings activity quarter-to-date.

Operator

Our next question comes from Mark Sue with RBC Capital Markets. Please go ahead.

Mark Sue – RBC Capital Markets

Thank you. With the push out in the US enterprise, does that mean video and unified communications is no longer an IT spending priority and become somewhat discretionary and nice to have as opposed to a need to have and maybe you could just on the execution you mentioned and I have a quick follow-up?

Andy Miller

Mark, it’s important to note, I’ve seismically been with over 100 customers, global 1000 customers in Q3 and Q4 today and there is no indication whatsoever that this type of technology collaboration has moved into a discretionary category. If you look at return on investments and travel, if you look at productivity, if you look at a business continuity which is really the three factors in collaboration, they continue to be top of mind for CIOs and CXOs at these global 1000 corporations.

I think one of the things that we saw, frankly, in the quarter and toward the end of the quarter, that some of these deals were on a positive news front, these deals are getting larger in size. In fact, we have more $1 million transactions that we’ve ever had at the company going into Q4. But as we start talking about mobility and social media, these transactions really moved from the VP of IT to the CIO and become a much larger solution, not only in terms of dollar amount but in terms of impact at these corporations.

So, therefore I think that’s the good news becoming more complex, they are becoming larger but they are taking more time in terms of inception to close and I think that there is absolutely a sense of urgency and credibility for these executives to implement collaboration solutions. Personally whether it’s financial services, manufacturing retail, EMEA, APAC, or North America, I think – I’d like to think that I’ve been with more CIOs than any executives in technology and I feel that strongly that collaboration solutions are clearly top of mind and have not fallen into a discretionary bucket.

Mark Sue – RBC Capital Markets

Okay, and a quick follow-up, as we looked at your increase in sales with partnerships, should that have a natural lift to operating margins which should offset some of the investments that you are doing in wireless and mobility? And then along those lines, is HP still kind of $16 million to $18 million for the December quarter?

Andy Miller

Mark, let me split that with Mike, but I think this is a great question and as it relates to operating leverage, we are very early in the relationship with HP in terms of both sell to and in terms of the exclusive arrangement we have with cellular [ph] technology into the other channel into their customer community. The same for IBM as well with inside their organization.

So, there are investments that we do have to make in terms of go to market, marketing and R&D in terms of interoperability with those solutions. So, when I talk about operating margins, we are having to put more in which eventually will get more sell-through and sell to in the forward looking quarters. And yes, that should help our productivity and operating margins as we go forward.

But remember, HP deal was done on June 1st; the IBM relationship and partnership is still in its infancy. And frankly, Microsoft is still early in the link technology. So, I think everybody have to take a deep breath in terms of understanding that we are still very early on with these partnerships. The reason for these partnerships and these investments of operating expenses is to provide a clear differentiator from our largest competitor and I think that story is sticky and it is real. And now is the time that we felt strongly that we have to double down because we see in the after quarters that will payback not only in terms of revenue but in terms of operating leverage.

Mike Kourey

So, thank you, Andy. So on your specific question with HP for Q4, you are correct, that’s the guidance that we gave last quarter. We actually operated ahead of plan in Q3 with HPVC. It’s been an excellent performer and the pipeline is very good for Q4 as well. But at this point, I would not change those expectations. I want to take a conservative stance as I mentioned in the guidance period. But yeah, we expect good things from the HPVC acquisition this quarter as well.

Operator

Our next question comes from Jason Ader with William Blair. Please go ahead.

Jason Ader – William Blair

Thank you. First of all, I was just wondering, Mike and Andy, if you could comment on why you guys didn’t preannounce because you missed by about $10 million, $9 million from the guidance – from the mid-point of the guidance and that’s the first question. Second question, could you talk about the set as a percentage of revenue? I got the numbers on either booking strength year-over-year and sequentially which is pretty impressive, but just any color on a percentage of revenue would be very helpful. And then the final question is just on Microsoft, you commented over the last few quarters on your traction with Microsoft, any additional color on the Microsoft relationship and the tie-ions with link?

Andy Miller

Sure. Let me – again, let me split this with Mike. But let me take the first one because I own it. Yes, we had a 2% topline miss and a penny from the bottom line. So we consider that a slight miss and not require from a materiality perspective of pre-announcing. Mike will cover that in a moment. We also as to the quarter, felt very confident about our quarter. Clearly as I said at the last two-week mark, we started to see some delayed actions in terms of some of our largest customers and partners in terms of the transactions that I spoke about earlier. We also decided later in the quarter that some of the investments required around mobility, social media and our top-three partners were required but I own it; I think we had a very good quarter. We are making the changes that I’ve talked about in my talk earlier around North America and we feel fully confident that that will be – we will see those results in the near future. Mike?

Mike Kourey

Okay, thank you, Andy. I think you answered the pre question appropriately. The fed [ph] as a percentage of sales although we don’t break that out exactly I can’t tell you that in the third quarter like this, especially with these great results, again I don’t want to get overly specific but you can think of it being right around double digits for total worldwide sales as a percent and so I would leave it with that.

Andy Miller

Let me finish the question because we never got to your Microsoft question. The momentum with Microsoft is actually stronger than ever around link. I’m involved in some of the largest link deployments worldwide with the senior executive team in Microsoft. We have completed all the work that we need to do around education, around channel, around the combined sales structure with Microsoft and we have – if we look at salesforce.com, we had to have more influence revenue opportunities with Microsoft Link than we’ve ever had, going into Q4 and even in our out quarters in 2012 Q1 and Q2. So the relationship with Microsoft, the momentum with Microsoft, the differentiation against Cisco with Microsoft is stronger than ever.

Operator

Our next question comes from Jack Monti with UBS. Please go ahead.

Jack Monti – UBS

Thanks for taking the question. I was just curious about the sales mix between service and product it looks like the service mix kind of picked up and I was just curious what we should think about over the longer term for mix in products and service reps. Thank you.

Mike Kourey

Yeah, we’ve been making some great progress in services. I will say though that the number one reason for that in Q3 here was the acquisition of the HP Visual Collaboration business. As you recall they have a, well we now – have a significant portion what is a managed services business. So that’s one of the key drivers there although we did still grow sequentially and year-over-year without that but that was a driver.

So if I’m not mistaken, it was around 20% of sales I think we would expect now, there is going to be a full quarter impact of that this quarter, so three months and served us two in the sub. So that will continue to be a driver this quarter, as well as frankly a lot of the success that we are having in attaching services for our products now. Because if you think about it, some of the next drivers towards the RealPresence platform a.k.a. the UC network infrastructure as well as some of our immersive telepresence et cetera, you are going to see it has good attach there. And from a benchmarking stand point, we clearly should be in the 20s and although we don’t breakout guidance by service versus products, it’s a reasonable expectation to see us in at least that range for the foreseeable future.

Andy Miller

And I think just to add on to Mike, it’s important that our focus around service has focused on three areas – renewals, attached rate and then frankly our portfolio service offerings. If you go back a year ago we had two service offerings – basic and elite, and we really focused on more defined product menus around implementation, around certification, around deployment of link. So we are starting to see some of the revenue flow in terms of a more enhanced service solution portfolio and inventiveness.

Operator

Our next question comes from Joanna Makris with Mizuho Securities. Please go ahead.

Joanna Makris – Mizuho Securities

Hi, good afternoon. Two things when do you think the OVCC and those initiatives can begin to stimulate your network infrastructure further and then secondly I’m just thinking about how you view market share related to your largest competitor in Q3 obviously last quarter they held their own what are your thoughts on the what happened this quarter particularly as you comment on and improve in their own. What are your thoughts on what happened this quarter particularly as you comment on and improved go to market in the U.S. enterprise. Thanks.

Mike Kourey

Sure, let me take both of those first OVCC for any of the audience forgot the acronym because there are a lot of acronyms in technology is Open Visual Communications Consortium and this is basically an aggregation of the leading service providers in the world to build out the largest public cloud around offering video as a service. So there has been great traction in fact at CTIA last week in San Diego had a very large partner event in Arizona the last two days with 100 of the largest service providers Tier I, Tier III worldwide. OVCC is clearly gaining significant momentum and traction. Now, with any carrier in the service provider space it’s a much longer certification implementing the technology cycle and the ability to draw revenues. So while we are excited about OVCC and well it’s a clear differentiator to our largest competitor it clearly is going to be in 2012 and at the back half of 2012 before we start seeing meaningful revenue in terms of pull through to our RealPresence platform or our network infrastructure that’s the first point. Any comments on OVCC? And the second question was around could you repeat the second question again please? The second part of your question. They may have lost here; we will come back later.

Operator

Ms. Makris, please go ahead with your question.

Joanna Makris – Mizuho Securities

Yeah, I’m wondering how you view market share related to the largest competitor in Q3?

Mike Kourey

Okay great. So in, back half last half of 2010 we actually gained 8 points of market share against Cisco in the first quarter of ’11 we gained 5 points market share. The way that I look at market share and the way we look at market share is not on the quarterly basis but on a year basis. So I think we did a great job in 2010 in terms of gaining market share did a great job in the first quarter of 2011. So I don’t look at it on a quarterly basis because I think it has to be aggregated I want to look at it holistically throughout a year. I believe if you really look at what we are doing in growth markets in federal and brick and APAC clearly the significant market share gains. As I said in the call with a sense of humility we need to do a better job in North America Enterprise and trust me we will be doing that. So I feel very confident as we are going to look at 2011 and going out to 2012 around growing the marketplace faster than our competitor I feel very strongly about that. And it’s very important to understand the things we talked about today mobility, social media, Microsoft, IBM, Hewlett-Packard those are very, very significant differentiators which been our largest competitors. It’s a very different way of doing business if we can execute what we talked about correctly those market share gains will continue and to grow the market at a faster pace than our competitor will be held through as we go into the out quarters.

Operator

Our next question comes from Jim Suva with Citi. Please go ahead.

Jim Suva – Citi

Thank you very much. A question that maybe just because I’m not the smartest one in the call so you can probably help me out here. If Q3 have some order push outs and you have Halo also helping in Q4 and those you mentioned those Q3 order push outs are going to be booked and still you are not going to lose them why are we not seeing a normal or above normal Q4 guidance, is it that the macro environment is that much of a headwind to offset those two positives because it looks like the core Polycom business quarter over quarter both Q3 and Q4 has a bit of a hesitation here.

Andy Miller

I will take that first and I will work with Mike on this. It’s a combination of two things one is we did see some mix economic environments in different parts of our business. We want to make sure that there is we want to make sure we understand what direction those are taking as we also talked about the sense of humility we have seen in North America Enterprise challenges we are going to fix. And we frankly want to be conservative you know the 2% revenue off of consensus doesn’t feel good and we know we are a better company than that. So we are going to be a little bit conservative we are going to make sure that we have extra expectations and we are going to let our North American execution improve and keep an eye out on any of the mixed environments that we feel caused some of the slippage into Q4. No excuses we own it and we intend to fix that but we are going to be slightly conservative on until we get that in line. Mike.

Mike Kourey

I completely agree those are the three drivers and clearly we did wretched up our conservatism as well with this guidance to the reasons that Andy stated.

Operator

Our next question comes from Tim Long with Bank of Montreal. Please go ahead.

Tim Long – Bank of Montreal

Thank you. Two questions if I could first Mike I think pretty specifically you said 18% to 20% off margin in each of the quarters of 2012. So could you just walk us through how operating margin could go up in the first quarter I think that’s what that would imply and then secondly for one or both of you could you talk a little bit about what discounts we lacked in the quarter sounds like Cisco has scratched a jump the pressure I think there is more discounted incentives on video for the Cisco sales force there has been a lot of discussion about quality in Europe. So if you could just touch on those two that would be great.

Mike Kourey

Sure, I can handle the 18 to 20 and then Andy do you want to cover the Cisco question. So on the 18% to 20%, yeah, that’s what we’ve guided here for obviously we would have a slight step up in operating margin between Q4 and Q1. And we are committed to the 18% to 20%. There are some end of year costs that would not have the expected repeat in the first quarter; that would be part of it. And with some of the fruition that we expect to achieve through the realignment of the investments, some further leverage from the PLCM partners, and a variety of factors that we’ve discussed thus far today will contribute what we would expect to achieve in Q1. Clearly, Q1 – you are right from the seasonal stand point – is the weakest from the seasonality perspective but we do expect to hit 18% to 20% each quarter of next year including Q1.

Andy Miller

Let me take the Cisco question and the (inaudible) question and I’ll combine them. So from a discount perspective, we did not see a difference in Q3 than in Q2 or Q1 as it relates to Cisco’s discounting policy. Clearly, in any given quarter, with particular customers, you will see an anomaly in terms of how competitors discount. But there was nothing that took place in Q3 that was any different from previous quarters. Clearly, Cisco has got through some of their challenges earlier in the year as it relates to the channel, as it relates to channel incentives and as it relates to the combination of two sales forces. So I think you are seeing a more assertive competitor and I can tell you that we will be as assertive but we will do it strategically.

But in terms of discounts that had no effect on our win-loss ratio in Q3 nor did it impact any of the transactions that I talked about that have – we will have now in Q4. As it relates to Huawei, we have seen them in both color specifically Brazil and Mexico and we have seen them in Europe specifically in (inaudible) Peninsula, Russia and the (inaudible) countries to a very small degree. In reality, we have some of our largest partners and customers that have done reverse engineering with Huawei and reality is, while it is a lower priced product, there were clear issues that we feel very confident with that we differentiate strongly against some of these new market entrance in terms of integration with Link, ability to have 323 SPC HD65, the whole continuum of mobility and social media.

So we think that based up on some of those inside our competitive intelligence and analysis clearly they are a large player and not to be overlooked, we have to look at them with a sense of healthy paranoia but we feel confident that if we stay our course in a strategic perspective, we will fare well with Huawei. In fact, if you look at China, if you look at our market share against Huawei, I think that’s a great testament in terms of how we compete with Huawei, and the fact that some of the largest financial institutions, second largest in the world, their relationship with Polycom and others in the government I think can speak very well of our ability to compete.

So I hope that covered both of those in detail for you.

Operator

Our last question comes from Larry Harris with CL King. Please go ahead.

Larry Harris – CL King

Yes, thank you and good evening. I was wondering if you could speak more towards how the mobile market would work in terms of the model I believe if I’m not mistaken you are ready on the Apple iPad application location, but I guess to activate it, I assume there would be a license fee, and what type of margins could we see, what types of fee might be generated once this business gets going?

Andy Miller

So the three – actually the four reasons that we entered in mobility marketplace with Polycom’s RealPresence mobile application. Number one is to be a clear differentiator to our competitors. Our competitors have a dedicated tablet device. We have taken it to be agnostic, Android, IOS and other platforms, and we started that with Apple, with Motorola, and Samsung. So one is a clear differentiator. Two is offer a continuum of this technology, so mobility to SMB to enterprise, if we can brand Polycom on that entire continuum, then we can sell as a (inaudible) to CIOs and CEOs a mobile strategy of how to take enterprise video communications out to the mobile work force.

The third is business development relationships with companies like Apple, like Motorola, like Samsung. They all want to enter the enterprise market with these tablets. If we have a right go to market approach in code rending, we can enter accounts just like we are doing with Microsoft Link, IBM same time and others into new markets. And fourthly and probably most importantly from a (inaudible) perspective from a revenue perspective is the pull through revenue for our infrastructure platforms. So we are not as interested in terms of the revenue from download of the app because the basic app is no charge, there is a charge as it relates to the infrastructure software for the more enhanced application on our RealPresence mobile. But the more mobile subscribers that are using Polycom with the carriers, require more infrastructure at the carriers location and more software at the enterprise CPE location. So the pull through of infrastructure, what we call RealPresence platform revenue, will be significant as the numbers I talked about earlier actually become reality in terms of number of pads deployed, number of pads with the video.

So, clear market differentiator, the ability to be able to offer continuum, the ability to go to market with our mobile providers, not only carriers, but also the pad manufacturers. And then, as a revenue perspective, a very significant and material pull through of network infrastructure around the RealPresence platform as we move into 2012. So that and our social media technology that we introduced with Jive and others several weeks back are going to be very important differentiator in a continuum.

Mike Kourey

And then just on (inaudible) to the margin percentage itself, what that typically is, is that RealPresence platform operates at an 800 to 900 basis point higher gross margin than the rest of the product lines of the company.

Operator

As there are no questions at this time, Mr. Miller, I’d like to turn the call back over to you.

Andy Miller

Great. Thank you. So in closing, I’d like to thank you again for your continued support of Polycom and have a great afternoon. Thank you very much.

Mike Kourey

Bye bye.

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