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3Com Corporation (COMS)

F3Q07 Earnings Call

March 22, 2007 5:00 pm ET

Executives

John Vincenzo - IR

Edgar Masri - President and CEO

Don Halsted - CFO

Analysts

Mark Sue - RBC Capital Markets

Scott McCabe - Lehman Brothers

Matt Shimao - Bear Stearns

Manny Recarey - Kaufman Brothers

John Marchetti - Morgan Stanley

Presentation

Operator

Good day and welcome to this 3Com Quarterly Earnings Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to John Vincenzo. Please go ahead.

John Vincenzo

Thank you, and thanks everyone for joining us today to review 3Com's fiscal 2007 third quarter results. Before I turn the call over to CEO, Edgar Masri, I would like to take a second to inform participants on today's call of a couple of key items. First, Edgar will be conducting today's call live from China. With that in mind, I want to mention in advance that there is an outside chance that you may experience a slight delay on occasions. Also during the Q&A portion of our call, there may be a need to repeat a question. We don't anticipate this happening, but we simply ask for your understanding should this occur. With that, let me go through our Safe Harbor statement.

The remarks to be made on this conference call contain forward-looking statements made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. These include forward-looking statements regarding timing of the closing of our announced acquisition to acquire Huawei's 49% ownership interest in H3C, acquisition funding and bank financing plans, H3C integration activities and compensation of employees, leveraging H3C, the purchase accounting impacts of the acquisition, branding plans, strategic initiatives, future financial performance, financial conditions and cash flows, future expense control and savings, product and solution development plans and strategy and market position. These statements are neither promises nor guarantees but involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. These risks include without limitation the risks detailed in the Company's SEC filings.

On this call, we will also discuss several non-GAAP financial measures. The most directly comparable GAAP measures and the required reconciliation can be found in tables at the back of the press release announcing our results or on the IR portion of our website, www.3com.com. The press release is also available on the Investor Relations section of our website.

Now, I will turn the call over to Edgar Masri.

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Edgar Masri

Thank you, John, and thank you everyone for joining us on this call as we review our third quarter results. As John mentioned, I am conducting this call from China. I have been here for almost three weeks working with Dr. Zheng and his team and meeting with customers, partners and employees in the region. This trip has been very productive and I'm more excited than ever about working with H3C as part of the new 3Com.

Before I get into the results for the quarter, let me give you an update on the H3C transaction. I am extremely pleased to report that we are announcing today, that we have received final approval from the Chinese government to purchase Huawei Technologies' 49% stake in H3C for $882 million. This is a significant achievement for us in our efforts to improve our long-term growth profile, and we are excited about reaching this major milestone.

We expect the transaction to close on or around March 29, next week. We'll share specific details of our financing agreement in a separate filing most likely tomorrow. But at a high level I could tell you, we intend to use approximately $470 million of our cash for the deal and fund the remaining $430 million through a senior secured bank loan at the H3C level. I'll give you additional update on H3C, our integration work and H3C management's retention agreement later in my comments.

Now, getting back to this quarter's results. Again, when I joined 3Com as a CEO, I did so because I strongly believed that there was an opportunity to leverage the tremendous assets of the company, including H3C, to improve the overall financial performance and over time create significant shareholder value. The past two quarters and the outlook for the future confirm the reasons I joined the company.

Since we last spoke in December, we have delivered on each of the strategic operational initiatives that I shared with you. And we continue to be highly focused on improving the global execution and financial performance of the company.

I can tell you that we are seeing positive signs across our entire business. To begin, we delivered on our second consecutive quarter of positive operating income on a non-GAAP basis.

Our non-GAAP operating income in the third quarter was $10 million. Our GAAP operating loss compared to last year improved by over 80% to $9 million and our GAAP net loss improved by over 85% to $5 million. Revenue in the quarter was $323 million which is a 6% increase year-over-year on a comparable basis.

Both H3C and TippingPoint delivered a record revenue and the sale of data and voice products within SCN contributed to the profitability milestone through increased gross margin. We also maintained our strict discipline around cost containment within SCN.

Another major achievement from the consolidated 3Com in the quarter is the positive cash flow from operations of $100 million. This was driven by H3C's uniquely strong cash flow from operations of more than $120 million. Overall, there is still a room for improvement, but I am optimistic that the combination of H3C, our product strategy and our improved execution at SCN should help drive meaningful operating profitability and cash flow on a combined company basis.

Now moving on, let's take a look at our specific business units. H3C delivered a record revenue of $195 million, an increase of 3% sequentially which is in line with the guidance we provided last quarter. When looking at this quarter's performance, it is important to note that this growth compares to a very strong second quarter in which H3C grew 12% sequentially. For the calendar year of 2006, H3C's revenue was $711 million, a 40% increase over 2005. All in all, another solid quarter and year for H3C.

Now, turning to another highlight of the quarter, let's look at the security market. The security market continues to be a hot area of growth and our TippingPoint business continues to perform at a high level. While we continue to report security as a combination of sales of security products from 3Com, H3C and TippingPoint, I know one area of investors want to better understand is how TippingPoint specifically is performing.

So, let me give you a little more color on this growth area of our business. Security revenue in the quarter was $31 million, of which $25 million came from the sales of TippingPoint products. TippingPoint revenue grew 10% on a sequential basis. It's the second consecutive quarter of double-digit growth. We are very pleased with this TippingPoint performance in the quarter and the growth potential it shows at the high-end of the market.

While TippingPoint focuses on large enterprise, its IPS and Digital Vaccine technology will be leveraged by 3Com in its mid-market solutions through our soon to be launched 3Com's X-Series of unified security solutions. Being able to leverage TippingPoint with the upcoming X-Series strengthens 3Com's mid-market Secure Converged Networking solution family.

Now, for the data and voice products within our SCN segment, I believe that we are approaching a point of overall stability, and our goal is to return to year-over-year growth in our next fiscal year.

One reason for my optimism is that with H3C, and based on independent industry reports, we have emerged as a clear number two in the switching market share for Total Managed Ethernet ports. We have also seen SCN gigabits revenue increase year-over-year for the first quarter in a year.

Additionally, with voice growth of 13% sequentially, and the IBM relationship having a good six months under its belt, I anticipate seeing continued growth in this fast-growing high-margin markets.

Our objective is to show continued improvement in our operating expense control efforts. For example, let's look at the SCN operating expenses. Our SCN operating expenses decreased approximately $28 million year-over-year due to continued focus on cost containment, and we continue to emphasize the need for intelligent spending. Don will give you a more detailed outlook at the quarter during his comments.

Now, I know that one question on the minds of investors is whether the H3C management team is committed and incessant to continue executing at the high level that has made H3C the global leader it is.

I am pleased to report that H3C's Chief Operating Officer, Dr. Zheng, his direct report and other key members of H3C's senior leadership team, each signed two-year employment contracts. Their compensation includes highly competitive salary, eligibility for annual bonuses, and these bonuses are measured against aggressive financial performance targets for H3C, and for Senior Managers, 3Com equity grants. The agreements also include a strong employee non-compete clause. We are also putting in place, as we speak, a long-term incentive plan that all employees will be eligible for.

Now with the strategic initiative complete, and the integration process underway, I'm pleased to report that Bob Mao is transitioning out of his role as Executive Vice President of Corporate Development to become a member of 3Com Board of Directors.

Bob provided us with invaluable strategic guidance during our negotiations with Huawei. Now that we have ensured a level of management stability at H3C, Bob and the Board agreed that the timing was right for the company to leverage his background, his contact, and expertise in the Asia Pacific region and specifically in China, as a strategic Director and member of our Board.

Our full attention now and focus can be going towards the integration process. So, on this front, the best way to look at the integration is to understand its effect on the overall company, which really falls under three key themes. First, integrating our sales force around the world with an initial focus on our Asia Pacific region. This work began shortly after we announced the results of the auction process. One of the first things we did is appoint Peter Chai as the Regional Vice President for sales outside of China, Japan and Hong Kong.

Peter joined 3Com about a year ago with nearly 25 years of experience in sales in the region. Through the early days of his integration process, he quickly has earned the respect and support of both H3C and 3Com, and I am confident in his ability to build a growing business in the region. Peter is focused on taking the high-end performing people from both H3C and 3Com and leveraging their respective expertise.

Now, in countries where both H3C and 3Com have sales offices, we are merging them under one country manager. This process is well underway with almost all of the leaders already named.

Once this transition is complete, which is most likely in the early April timeframe, the team in APR believes that this more focused approach will help to improve the ability to execute and drive revenue growth at or above market rates during fiscal '08.

Now, from a brand perspective, I know several people have asked questions about which brand we will use in the region, H3C or 3Com. The answer is clear, both. At the product level, both the H3C and 3Com brands are strong. So, we will make them available both to our customers and partners to use where and when it makes sense.

Now, if the H3C brand is stronger in a particular country or enterprise accounts, then the partner can and should use the H3C brand. Where the 3Com brand is stronger, the sales team and partners will use the 3Com brand.

Salespeople will be compensated on selling the dual brands. But over time, there will be an increased focus on making the H3C brand for enterprises and retaining 3Com for the channel in small and medium enterprise markets.

The second theme is really around further leveraging the cost effectiveness of doing business in China and the positive impact H3C has already had on our business.

Now, in a traditional acquisition, you look at the impact of merging two companies. In this case, we have been integrating parts of our business over the three years of the joint venture.

Let me give you an example. From fiscal '05 to '06, 3Com reduced our overall non-TippingPoint R&D expense by 33%. A significant portion of that savings was due to 3Com moving its R&D for switches and routers to the lower cost development found at H3C. We are now selling products sourced from H3C at an annual rate of almost 200 million. This is a significant impact.

Our next goal is to find additional cost and expense savings opportunities. Our goal over the next year is to see savings in excess of $30 million on an annualized basis across the company. These savings may be offset in part by some short-term investments in other integration activities.

And now, to the third element of the integration. Third element of this integration is based on something I said during my first call with you as CEO of 3Com and it's by the way, also one of the five milestones that I outlined for you during our last call.

As you may recall, I told you that for 3Com to win long-term, we must change the rules of the game by differentiating our offerings and that will ultimately help us take back market share.

Earlier in the quarter, we took a significant step in that direction when we launched our Open Services Networking or OSN vision as well as initial products. As a background, let me talk a little bit about OSN. OSN is the industry's first open platform that integrates best-of-breed, as well as open source applications into the network infrastructure. It offers organizations in open and through operable architecture to run best-of-breed software application inside the network.

By implementing in OSN platform, we help enterprises do many things. First, protect their network against security threat. Second, enhance their visibility over local and wide area network activity. And third, support the unification of business application, such as voice, data, video, and mobility services.

The first product tied to OSN is the Router 6000 product line with a module that runs Linux-based applications. Eventually, more of the router line will be OSN enabled and we intend to deliver OSN in our switches as well. So, H3C will be the lead provider of the hardware and system platform around OSN, while 3Com will deliver the middleware and drive the partnerships and integration with third party applications. So, there are potential revenues for us within each of the three areas; the hardware, the middleware and the software.

Now, in addition to OSN and the potential it offers us in the mid market, TippingPoint with its Bi-Planar vision is expanding its Network Security Solution for large enterprise customers. Now as I mentioned previously in my calls, in the Bi-Planar network there is a control plane that provides attack control, access control and application control. TippingPoint already, with IPS delivers attack control, and now is expanding its position to include access control or what many in the industry call NAC, Network Access Control.

At the RSA conference in February, TippingPoint unveiled the availability of its fine-grained NAC solution. This offering is based on the technology we obtained in a small but critical acquisition of a company called Roving Planet.

Now, I would like to finish with some high level commentary on our business outlook. Specific to H3C, we currently believe the revenue from this business unit will be around $180 million in our fourth quarter, which is a growth of approximately 15% on a year-over-year basis.

As we pointed out last quarter, we expected our results to be impacted primarily due to the fact that the entire region essentially shuts down for several weeks of the quarter to celebrate Chinese New Year. We also indicated that there would likely be some impact as a result of our working through the common short-term issues associated with merger integration.

With that said, there are a couple of important points to put H3C's outlook in perspective. First, while we expect the top line to decline sequentially due to seasonality, the shut down in the region also should lead to lower operating expenses in the fourth quarter. This should put 3Com in a position to deliver non-GAAP operating profitability in line with what we have seen over the past few quarters.

Second, we anticipate H3C returning to solid sequential top line growth in its quarter ending June 30, 2007.

Finally, let me turn to SCN. We currently anticipate sequential revenue growth in our fourth quarter in that business unit, while continuing to manage expenses carefully.

Now, let me try and summarize. In summary, we are making progress against our key operational initiatives. And following a prolonged period of losses, we anticipate finishing fiscal '07 with three consecutive quarters of positive non-GAAP profitability.

I know that there is still significant room to improve our execution and overall financial performance, but we are confident in our ability to continue improving our efficiency and our long-term position, following the acquisition of H3C.

With that, I will turn the call over to Don. Thank you.

Don Halsted

Thank you, Edgar. As in recent quarters, I will be reviewing 3Com's P&L results, first on a consolidated basis and then the performance of our two operating segments. This will be followed by a discussion of key cash flow and balance sheet items.

Throughout my review, I will be using pro forma and pro forma non-GAAP measures of the historical results of H3C and 3Com as a consolidated entity to calculate comparative values. Absolute values and reconciliation for these values can be found in our press release and on our web page.

Let me start with the consolidated business results. The fiscal third quarter consolidated revenue was $323 million, an 82% year-over-year increase compared to 3Com's historical GAAP results. This increase is explained by the inclusion of H3C's results in the current quarter, partially offset by lower revenue in the SCN segment. The more meaningful comparison is against a pro forma revenue that includes the actual H3C results for the prior year quarter, as if we had consolidated H3C from the beginning of the period. On this basis, the year-over-year revenue growth is about 6%.

Table C in our press release provides geographic and product-based supplementary revenue disclosures. China revenue declined 3% sequentially to $154 million. As a reminder, China sales consists of H3C direct sales, which grew sequentially, as well as OEM sales into Huawei's China-based hub, which declined sequentially.

H3C's direct sales in other Asian regions are included in our APR region, and its sales in Europe are included in our Europe, Middle East and Africa region. Our APR region sales declined sequentially 5% compared to a particularly strong second quarter, which included a large router deal in our SCN segment as noted last quarter.

North America revenue grew 6% sequentially, but declined 4% compared to the prior year period. Consistent with the prior year period, this quarter included the receipt from a revenue sharing arrangement related to the sale of certain intellectual property rights, reported in our CD product area. The value in this quarter for the revenue sharing arrangement is $4 million, which more than offset the continued significant decline in the sales of our Legacy Connectivity products.

The net change in CD revenue contributed 4 percentage points of North America's 6% sequential increase. Sequential increases were seen in key networking, TippingPoint and voice product sales. Our Latin American regional sales declined sequentially 11% and year-over-year 9%. This followed eight consecutive quarters of year-over-year improvements.

EMEA declined sequentially 7%, primarily due to the business alignment work driven by our new EMEA regional manager. The regional profit contribution in EMEA increased on the lower revenue base, demonstrating the focus on delivering more profitable sales in the regions. I expect to see a return to sequential growth in the fourth quarter.

On a product basis, all of our ongoing product areas delivered year-over-year growth. Networking sales more than doubled over the prior year period, driven by the inclusion of H3C's results. On a sequential basis, network sales were down 5%, driven by the lower SCN sales, principally in EMEA.

Security product sales increased by 20% over the prior year period, primarily driven by the inclusion of H3C's security product sales and growth in sales of our TippingPoint products, offset by double-digit declines in sales of our embedded firewall, known as EFW security offerings.

Sequentially, total security declined 3% with declines in EFW product sales more than offsetting a 10% growth in the sale of TippingPoint product and increased China-based security sales. TippingPoint product sales continued to see healthy worldwide expansion and represented about $25 million of the $31 million in security product sales within the quarter.

Voice products increased almost 50% over the prior year period due to the inclusion of H3C and double-digit growth in SCN voice sales. On a sequential basis, voice products increased 13% driven primarily by expanded voice sales in China.

Gross margins improved sequentially 2 percentage points from 45% to 47%. This improvement was driven by SCN's 5 percentage point margin increase, offset in part by a 2 percentage point decrease in the H3C margins.

Total operating expenses increased $3 million or 2%. The change in operating expenses will be explained in the discussion on the operating segment results.

The GAAP operating loss for the third quarter was $9 million, flat to the second quarter of fiscal 2007 and $38 million improvement compared to the same period of fiscal 2006. The $38 million year-over-year improvement is due to $19 million of operating improvements in our SCN segment and $19 million from the consolidation of H3C.

The GAAP operating loss for SCN also includes $2 million charge for in-process R&D associated with the acquisition that Edgar mentioned in his comments.

Also I'd like to point out that H3C's amortization of intangibles from the original acquisition decreased by $2 million in the period as some assets with estimated useful lives of three years became fully amortized.

In the current quarter, we had $5 million of stock-based compensation charges compared to $7 million in the second quarter of fiscal 2007. The sequential decrease was primarily driven by the absence of certain deal related vesting charges that were in our second fiscal quarter.

In the current period, we recognized $2 million in restructuring expense, primarily related to realignments in our EMEA region by our new Regional Manager.

For the past four quarters, management has been reporting 3Com's non-GAAP operating income because we believe that this is the best single measure of operating profitability. This measure excludes unusual expenses as applicable along with restructuring, amortization and stock-based compensation charges. The reconciliation to the GAAP operating income is provided in Table D of our press release.

With this definition consistently applied, I'm pleased to report that for the second quarter in a row, non-GAAP operating income was positive at $10 million, a year-on-year improvement of $38 million compared to a third quarter of fiscal 2006 non-GAAP operating loss of $28 million.

The non-GAAP operating income increase over the prior year period results from the benefit of the consolidation of H3C plus operational improvements in SCN.

Interest income net for the period was $11 million, which was flat sequentially and is a $4 million increase over the prior year quarter. The year-over-year increase is driven primarily by the inclusion of H3C's results in the current period and increased performance of the SCN portfolio.

Other income net for the period was $10 million versus $13 million in the second quarter of fiscal 2007. This decline was due to the absence in the current period of the gain on part of the insurance settlement related to our Hemel U.K. location.

The VAT software subsidy at H3C was flat sequentially at $9 million in the quarter. Provision for income taxes was $1 million for the quarter, which was down sequentially by $1 million due to the current assessment of the SCN provision.

In our third fiscal quarter, we recorded a minority interest charge to our results of $15 million as Huawei's share of the financial performance of the consolidated Huawei, 3Com joint venture for its performance in the period.

The net loss for the third quarter was $5 million or $0.01 per share, of which restructuring, amortization, stock-based compensation expense and in-process R&D represented about $0.05 per share. This is $0.07 per share improvement over the prior year's quarter's net loss per share of $0.08, which had included $0.05 per share for restructuring, amortization, asset impairment, executive transition and stock-based compensation expenses.

The weighted average number of shares outstanding during the quarter was 394 million. This net increase of 1 million shares from the prior quarter primarily reflects the exercise of stock options.

I will now turn to a review of our operating segments. Segment results can be seen in our press release in Table E.

I'll start by reviewing the SCN segment performance. Revenue for the quarter was $157 million, a $9 million sequential decrease and a $20 million decline compared to the same quarter last year, of which the decline in our connectivity products contributed $7 million. The sequential decrease was primarily driven by declines in our EMEA region as discussed earlier.

SCN gross margins increased 5 percentage points sequentially to 41%. This improvement was explained by cost and price improvements, the inclusion in the current period of the revenue sharing arrangement discussed above, and the favorable mix impact of higher TippingPoint sales. Gross margins were flat compared to the prior year period.

We continue to focus on controlling SCN expenses for sales and marketing, research and development and general and administrative expenses, which were $84 million for the third fiscal quarter, including stock-based compensation costs of $5 million.

The comparable expenses in the fiscal second quarter were $86 million, which included $7 million in stock-based compensation expense. Compared to the same period in fiscal 2006, these expenses have declined $28 million or 25%.

On a net basis, this resulted in a sequential improvement in the SCN segment operating loss of $2 million. The SCN net loss for the third quarter is $20 million, a $13 million improvement over the prior year quarters' total 3Com loss of $33 million. This improvement is made up of $22 million in improvements in SCN operating performance and the absence of $9 million minority interest income for H3C as reported in the third quarter of fiscal '06 when we were still reporting H3C on a minority basis.

Turning now to the H3C operating segment, to review H3C's performance I am going to compare the reported segment third quarter financials, which is the quarter ending December 31, 2006, against second quarter financials and the standalone performance for H3C in the same quarter of the prior year, which was prior to consolidation.

H3C revenue for the quarter ending 12/31/06 was $195 million, a 3% sequential and a 35% year-over-year improvement. H3C's sequential overall improvement reflected a decline in China offset by expanded sales of H3C products outside of China.

The sales growth outside of China was primarily through higher 3Com sales of H3C products during the three-month period of October through December of 2006. H3C's gross margin was 46%, down 2 percentage points sequentially and year-over-year. The sequential and year-over-year decline was driven primarily by certain cost provisions recorded in the current period.

H3C's direct operating expenses for the quarter were $64 million, an increase of $3 million sequentially and an increase over the prior year quarter of $12 million. This increase is primarily driven by the experienced growth over the past 12 months. As mentioned in Edgar's comments, I expect to see a sequential decline in expenses associated with the seasonality of the quarter ending March 31.

H3C net income before the Huawei minority interest charge was $30 million or 15% of sales including a $7 million non-cash charge for amortization of intangible assets. This is an increase of $13 million over the prior year quarter's comparable number. Net income after the $15 million Huawei minority interest charges was $15 million.

The primary drivers of the year-over-year improvement are the 35% revenue growth and higher gross profit margins combined with the software subsidy that started in our fiscal fourth quarter 2006 and lower amortization charges.

Returning to our consolidated view, I will now review several aspects of 3Com's balance sheet. Cash, cash equivalents and short-term investments totaled $956 million, which is a net increase of $88 million from the balance at the end of the previous quarter. The change includes an increase in cash and cash equivalents of $314 million and a decrease in short-term investments of $226 million.

Key components of the change in cash and cash equivalents are as follows: One, cash received for the net sale of investments was $226 million, primarily at the SCN level as we prepare for incremental acquisition of H3C. Two, cash generated by operations was $100 million driven by a particularly strong H3C cash flow due to reductions in working capital and strong earnings offset in part by cash consumption and SCN. Three, cash used for capital expenditures and the acquisition of Roving Planet were each approximately $8 million. And four, a $3 million increase due to exchange rates, principally the appreciation of the Chinese Renminbi.

The quarter end cash, cash equivalents and short-term investments balances of $956 million is comprised of $703 million in the SCN segment and $253 million in H3C. As mentioned by Edgar, we will use about $470 million of the SCN cash along with $430 million senior secured loan to finance the purchase of Huawei's share of H3C.

Other items of note compared to the fiscal 2006 year-end consolidated balance sheet include: First, accounts receivable increased $29 million driven by higher levels in H3C based upon increased sales. Second, notes receivable declined $28 million to $36 million. This change contributed directly to the increase in cash in the third quarter. And last, net inventory decreased $24 million driven primarily by continued management effort to reduce inventory in the H3C operating segment.

Before summarizing the quarter, I want to remind investors of expected impacts to our financial results associated with closing the acquisition with the incremental ownership in H3C. As a reminder, these are one, a charge of approximately $60 million to $65 million to H3C for the equity appreciation rights plan or EARP. This is a portion of the employee incentive plan which vests upon consummation of the transaction. This entry will be made just prior to the closing.

Second, the purchase accounting treatment of the acquisition will have the following effects which will be discussed in detail next quarter, an in-process R&D charge, secondly, increased amortization charges based on valuations of the acquired intangible assets, and lastly, the markup of on-hand finished goods inventory to fair value as well as reduced recognition of deferred H3C revenue. Since we are buying 49% of H3C, we will have to book 49% of the inventory markup and the deferred revenue impacts.

Turning to our third quarter, our results that we are reporting today reflect the continued focus on operational improvements in 3Com, which has yielded current quarter and year-to-date positive operating profit non-GAAP as well as current period and year-to-date positive cash flow from operations. In this third quarter H3C's net income before minority interest remained above 15% despite modest revenue growth. And at SCN we've managed the cost and expense structure resulting in improved operating profit non-GAAP contribution.

Let me now turn the call over to the operator to start the questions and answers. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we'll go first to Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets

Good, I hope you are using Skype.

Edgar Masri

Hello Mark.

Mark Sue - RBC Capital Markets

Edgar, maybe if you can just give us a sense of overall enterprise demand in North America, we're getting some mixed signals out there, and also, maybe your reception thus far as an alternative to Cisco?

Edgar Masri

Thank you, Mark. We are, I hope, somewhere on the line using Voice over IP from 3Com. Just to answer your question about North America, the competitive pressure in our market is an ongoing reality. We tend to have a seasonally soft quarter in Q3, even during my earlier days with 3Com, systematically Q3 is the softest quarter and it's softest in North America among other places.

I am though very bullish about the fact that our voice products are getting momentum, specifically with the help of the IBM relationship. And on Gigabit, we have seen, as I mentioned, very healthy growth. And according to various reports we have gained share. The markets outside North America are growing faster and you probably saw from our competition, I guess that the market trends much less than a 3Com trend.

Mark Sue - RBC Capital Markets

Got it. And then Don, how should we model gross margins going forward? I understand the SCN margin improvements. I'm still unclear of the H3C moving parts for gross margins. And longer term, when things stabilize, should the Open Services Network actually help gross margins? Should we connect the two together? Maybe if you could give us a sense of near-term and also longer-term gross margin trends?

Don Halsted

Okay, Mark. Let me answer those in turn, and I'm going to refrain from giving any long-term guidance on the margins. But on the H3C margin, decline of 2%, as I mentioned in the comments, that was in part related to some provisions that were made as a result of what is the end of their fiscal year reviews.

So, as you look at the last two quarters, there is about a 2% difference between 48 and 46. You probably can expect that we're going to land somewhere in between those as we go out, because some of those provisions were based on the full year review.

Mark Sue - RBC Capital Markets

Okay.

Don Halsted

Related to OSN, I think at the moment it's a little premature to predict exactly when that will end up affecting the margins because it has to work-up to a scale size. We have to bring out the more products and bring it to a scale before it really will affect. So, I think it would be premature to be predicting that one.

Mark Sue - RBC Capital Markets

Okay, got it. And lastly, just cash flow from operations maybe for the full fiscal year, any thoughts?

Don Halsted

I'll take this one, Edgar. We're not providing any long-term guidance on the cash flows. A comment I would make on it though, is when you look at the $100 million cash flow that we had, it was contributed to by both the fact that we have positive operating profit non-cash as well as the improvements in the balance sheet.

Longer term, I think the thing to really be looking to is that operating profit non-GAAP which is going to be the primary driver of the cash flows.

Mark Sue - RBC Capital Markets

Okay, that's helpful. Thank you, and good luck gentlemen.

Don Halsted

Thank you.

Edgar Masri

Thank you, Mark. Appreciate it.

Operator

Thank you. We'll take our next question from Scott McCabe with Lehman Brothers.

Scott McCabe - Lehman Brothers

Hey, guys. How are you?

Edgar Masri

Good Scott.

Scott McCabe - Lehman Brothers

You made the comment that with the H3C business, you expect it to grow at least in line with the market going forward after the integration issues are out of the way. What is that end-market growth rate?

Edgar Masri

So again, there are no exact specific numbers. But you have to separate it between the developed world and Mark mentioned a little bit North America versus the rest, and the emerging markets. We see the growth and we are not projecting anything regarding 3Com specifically, but the developed market is growing anywhere between 6% to 8%. The emerging market and the developing market is growing into the mid-teens, may be in some countries in the high-teens and the 20s. We are looking at those as barometers for us to measure ourself against.

Scott McCabe - Lehman Brothers

Okay. And then with respect to the SCN business, it's down 11% year-over-year and I understand it was mostly Europe. But that would imply that you are losing some share. What initiatives are in place to regain share or improve that business in some degree?

Edgar Masri

Yeah. So, let me talk a little bit about EMEA. That's a very good important point. We have put new management under Mike Ansley in Europe and he's making the right changes and focusing on a winning profitable business.

The slowdown in EMEA is in no way a reflection of the demand we are getting, but more of the recent restructuring in the business. Those were very sound decisions and while revenue may be down, our short-term goal is to focus on winning profitable business that contributes to the overall profitability.

So typically, we have both the low or slow demand that translates into much lower profitability. Here, we have actually improved our profitability in EMEA. I am very, very impressed by what the team has managed to do in very short period of time. And the products continue to be very well positioned to the EMEA marketplace.

Scott McCabe - Lehman Brothers

Okay. Thank you very much and congratulations on government approval.

Edgar Masri

Thank you, Scott. Appreciate it.

Operator

Thank you. We'll go next to Matt Shimao with Bear Stearns.

Matt Shimao - Bear Stearns

Hi, guys. That was a good overview. So, if I could go back to the SCN gross margins where you had some really strong improvements. Just to make sure, I understand how much is sustainable and how much may not be. So, if we look at that rubbish revenue sharing for the connectivity division? It looks like that might have impacted the gross margins by about 2.5% and that might be sustainable. Am I understanding you correctly?

Don Halsted

Let me answer that. Let me try that one, Matt. Within the SCN gross margins, which are about 5 percentage point improvement, the revenue sharing agreement that we had contributes about 1.5 percentage points of that improvement. At 1.5 percentage points, you ought to view as being a non-recurring improvement. Because I do not expect to get the same payment next quarter, these happen from time to time.

Now, the balance of the improvements represents costs and expense or really cost improvements that should be more permanent in nature.

Matt Shimao - Bear Stearns

Great, perfect. My math was a little wrong. Now on the last call you made the point that having a good relationship with H3C is important to Huawei, because H3C is an important OEM supplier to Huawei. So, from that standpoint price is an important factor. Can you characterize the risk to H3C? Do you think Huawei will try to leverage its position as a significant customer to negotiate lower pricing going forward and if, so what kind of impact could this have?

Edgar Masri

Yeah, this is Edgar. Let me take this one, Matt. In the market we are going to constantly expect our partners to come to us and continue negotiating better pricing. So right now we are not seeing that at a point that would get us to revisit or revise our financial model. The other good thing though is with the bigger size that we have as a joint entity, we should be in a much better position to go to suppliers and get better cost down, which would allow us to be more responsive to request some partners for a lower price.

Matt Shimao - Bear Stearns

Got it and just a quick question on the EARP bonus, I think it's around $190 million and is 3Com responsible for paying all of that or will Huawei pay a part?

Edgar Masri

That said, let me try to give you the some high level points about the EARP and then Don will give you more specifics. The good and important point to remember about the EARP is that it is over three years. People will be paid over three years and the employees have to be at the company to benefit from it in the next three years. The $190 million had been accounted for very clearly and I will pass it to Don to give you the specific details of how the first portion will be paid, which was imminently and then how the other portions will be made.

Don Halsted

Thank you, Edgar. And Matt, out of that $190 million, approximately half of that amount is either already recorded and in the books or will be part of that $60 million to $65 million charge that I mentioned. That portion of it from a P&L standpoint will all be subject to a minority share to Huawei. So, from an accounting standpoint, there's a piece that's in there. From a pure cash standpoint, we will end up funding this out of essentially acquired cash, if you will, and there's $253 million from as of 12/31/06 and that really is part of what is the acquired cash. The remaining tail of it, which is over the next three years, is built right into our business cases and the expensing and funding of that is very consistent with the levels that we've had in their operating results up until now. And Matt, I think we've got to move on to the next questioner, if that's answered your EARP question.

Matt Shimao - Bear Stearns

Perfect, thank you very much.

Operator

We'll go next to Manny Recarey with Kaufman Brothers.

Manny Recarey - Kaufman Brothers

Good afternoon and thanks. First, can you talk about the outlook for H3C? I understand there is seasonality but if you look, I think last year it was actually up sequentially and if you go two years ago, it's only down $5 million. So, how much of the $15 million or so sequential decline would you attribute to seasonality as opposed to disruptions due to the acquisition?

Edgar Masri

Hi, Manny. Thanks for your question. A couple of key points: One, last year there were some deferred revenues from Q3 into Q4 that sort of skewed things a little bit. And as I mentioned earlier, the seasonality this year also happened that the New Year was in February, which stretched things more than the year before where it was January and where the team had two more months afterwards to finalize the quarter.

And if you look at it overall, it's important to point out that we expect that we would be roughly equivalent sequential percentage reduction in expenses from Q4 to Q1 calendar. And yes, there is going to be integration challenges. But I am very confident the reason I spent three weeks here, is to monitor how this integration is going, and I feel very good about this. Don, would you like to add anything?

Don Halsted

Yes, thank you, Edgar. Let me just add one or two facts that support the points that Edgar made. The first one is you actually go back two years ago. So, if you look at the quarter ending December '04 to the quarter ending March '05, you are correct, the revenue was down $5 million. But it was a smaller business at that time and that represented about a 6% sequential decline. We are talking about now is about a 7% sequential decline.

Now, if I go back to last year, there was a little bit of an anomaly, and let me explain what that anomaly was. And that was that in the quarter ending 12/31/05, we actually in H3C had to defer about $12 million of revenue for items that they shipped in that quarter. And they could not recognize the revenue until Q1. And the reason had to do with a unique term, a rate of return as a result of a new product feature they had put in, and the product feature by the way related to the IPv6.

So, when you look at that, if you have made the adjustment and moved $12 million, which actually shipped in the quarter ending 12/31, and then moved it out of Q1, what you really would end up with is about an 8% decline from the quarter ending '05 and to quarter ending '06. And I know that requires some normalization to do, but the point of the analysis is that this seasonality that we have experienced has been between 5% and 8% really each of the last three years on a comparable basis.

And just one last note, one of the reasons that we did not talk much about this a year ago right now, is we weren't consolidating the results yet. So, that the revenue was not a part of the 3Com revenue story at that point, it would have just been down in minority interest.

Manny Recarey - Kaufman Brothers

Okay. Thanks for the clarification. But two more quick clarifications. How much revenue from H3C was sold through 3Com this quarter?

Edgar Masri

Don?

Don Halsted

Yeah. In this quarter that number will be for the quarter ending in February, our sale was about $49 million. So, that is the 3Com revenue from products that we sourced from H3C. And interestingly, that revenue was up slightly from about $48 million in the prior quarter.

Manny Recarey - Kaufman Brothers

Okay. And then, one last quick thing. Is there an equity payment that is left to make to Huawei? Wasn't there some type of capital distribution from the joint venture to the two partners or did that occur already?

Don Halsted

Yeah. Actually a very, very good question. Yes we had, it was a shareholder return of capital last November. And in that there was $41 million that had to go to Huawei. And in fact, that $41 million payment had not yet gone to Huawei, and is held in escrow. All the numbers that you have seen and the way we've done the reporting excludes that $41 million. So, the $253 million I talk about for cash is all completely H3C cash.

Manny Recarey - Kaufman Brothers

Okay, thanks.

Don Halsted

Next one.

Edgar Masri

Thank you, I appreciate it.

Operator

We'll go next to John Marchetti with Morgan Stanley.

John Marchetti - Morgan Stanley

Hi, thanks. I've got two quick questions for you. The first is just on the Huawei channel itself, I know it was down this quarter. I was hoping maybe you could just give us a little bit more color as to what some of the puts and takes in that were?

And then secondly, I know in the press release and you mentioned in your remarks, Edgar, you talked about having locked up some of the senior people at the H3C. Just curious if you could comment a little bit on how some of the rank and file sales, marketing, engineering folks are doing? Is the EARP in a sense what you are using to retain them and if morale has improved now with some of the new ownership now more firm?

Edgar Masri

Thank you, John. So, first, let me be clear. Quality is not the reason for the decline in revenue. And actually Huawei continues to perform well as an OEM partner. And Don, could you provide with more specifics on that?

Regarding the employees, of course, the EARP is important. But as Dr. Zheng clearly stated, people are with H3C because they want to build a new and unique company that is winning in the world the same way it has been winning in China.

They of course are looking at EARP, at bonus and compensation. The integration challenges are more common issues that you deal with when you go into one country and you have two country managers, you have to choose one. The good news is almost in all of the ten countries we are dealing with in APR, we've already either identified the party or have made it clear that we are going outside to bring a country manager.

That is making a big difference. Also what is good news is that the teams were already complementary. To give you an example, I was in Korea, I was in Thailand and Singapore. The H3C team has been bringing people that are focused on the enterprise very much to emulate the model that [Ben] has created so successfully in China, and 3Com while having some direct salespeople are still primarily channeling SME.

So, from that point of view people are not looking at it as a threat to their job, but more to complement another team. And from that point of view, it is now with one country manager and one leader making them feel much, much better about the prospects of the future.

Don Halsted

And Edgar, let me add one or two comments if I can on the Huawei OEM question, that John asked. It's interesting if to go to back to the last quarter, which we've reported the quarter ending September 30, sales. About 41% of the H3C revenue in that quarter was Huawei OEM sales. It was a particularly strong quarter.

If we look at this past quarter, the quarter ending 12/31/06, that number dropped back down to about 34%. I think it's interesting. If I go back over the last two years, most of the quarters in the past two years have had the Huawei OEM sales between 30% and 35% of the total sales of H3C. So, what they've done in the last quarter is they've really dropped back into what is absolutely the normal range that they've had over the past two years.

Operator

Thank you. That is all the time we do have for questions today. At this time, I would like to turn the program back over to Edgar Masri for any additional or closing comments.

Edgar Masri

Thank you, Robbie. Thank you very much all. And I am very thankful to you to be on this call and very excited to have shared with you the details of our Q3 results and look forward to continuing the dialogue. Thank you.

Operator

That does conclude today's conference. You may disconnect your line at anytime.

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