Foundry Networks Q1 2007 Earnings Call Transcript

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Foundry Networks (FDRY)
Q1 2007 Earnings Call
April 26, 2007 5:30 pm ET

Executives

Mike Iburg - Treasurer
Bobby Johnson - President & CEO
Dan Fairfax - CFO

Analysts

Cobb Sadler - Deutsche Bank
Matt Robison - Ferris, Baker Watts Inc.
Mark Sue - RBC Capital Markets
Ken Muth - Robert W. Baird and Co.
Tim Long - Banc of America Securities
Samuel Wilson - JMP Securities
Nigel Frankson - Citigroup
Jason Ader - Thomas Weisel Partners
Munjal Shah - Piper Jaffray & Co.
Tim Daubenspeck - Pacific Crest Securities

Presentation

Operator

Welcome to the Foundry Networks First Quarter Fiscal 2007 Conference. During the presentation, all participants will be in a listen-only mode. Afterwards, you will be invited to participate in a question-and-answer session (Operator Instructions).

And we also ask that you please limit your questions to just one question and a follow up so that everyone has an opportunity to ask, but please feel free to re-queue as many times as you need to for further follow-ups. As a reminder, this conference is being recorded.

I'll now turn the call over to Mr. Mike Iburg of Financial Dynamics. Go ahead, sir.

Mike Iburg

Thank you, and good afternoon, everyone. Thank you for joining us for the Foundry Networks first quarter 2007 revenue results conference call. I am joined today by Bobby Johnson, President and Chief Executive Officer, and Dan Fairfax, Chief Financial Officer of Foundry Networks.

Earlier this afternoon, the Company issued a release reporting its first quarter revenue results. This release can be accessed from our Investor Relations section of Foundry's website at www.foundrynet.com. For reference, we have arranged for a taped replay of this call, which may be accessed by phone. This replay will take effect approximately one hour after the call's conclusion today and will be available for seven days. The dial-in access number for this replay is 402-220-2551. This call is also being webcast live with a Web replay also available. These may both be accessed from the Investor Relations section of Foundry's website.

Before we begin, I would like to make a brief statement regarding forward-looking remarks. Today's call contains forward-looking information regarding future events and the future financial performance of the Company. We wish to caution you that such statements are just predictions and actual results may differ materially as a result of risks and uncertainties that pertain to our business.

We refer you to the documents the Company files periodically with the SEC; specifically, the Company's recent quarterly report on Form 10-Q and annual report on Form 10-K for the year ended December 31, 2005, as well as the Safe Harbor statement in the press release that the Company issued today.

These documents contain important risk factors that could cause actual results to differ materially from those contained in the Company's projections or forward-looking statements. Foundry assumes no obligation to revise any forward-looking statements contained in today's call.

I would now like to turn the call over to Bobby Johnson, President and CEO of Foundry Networks. Bobby?

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Bobby Johnson

Thank you. Good afternoon, everyone. As a point of clarification, that was Mike Iburg of Foundry Networks.

This afternoon, I am very pleased to announce that Foundry started 2007 with continued revenue momentum resulting from continued acceptance of our newer products and an expanded sales presence. For the first quarter, we posted a record quarterly revenue of $135.8 million for the first quarter; an increase of 19% over last year's first quarter. This was our third consecutive quarterly record.

In addition to continued revenue momentum, we had continued momentum in other key financial metrics and key geographic markets during the quarter. This included number one, our book to bill ratio continued to be greater than 1. Number two, our U.S. federal revenues were strong at 18% of revenue. Number three, our North American commercial revenues achieved a new revenue record while representing 55% of revenues. Number four, we generated $11 million in cash for the quarter and ended with a strong cash position of $897 million. The fifth key financial metric was our annualized revenues per employee continued at approximately $645,000 per employee, one of the highest revenues per employee performances in the networking industry.

Underlying our financial successes were key product successes that helped to drive the quarter. This included number one, for the enterprise LAN switching market, all of our newer products did well. Our enterprise chassis family known as the Super X family, led the way as the Company's top revenue producing product family. The Super X is our premier enterprise chassis family supporting both edge and core positioning while providing the right combination of 10 gigabit Ethernet core density and power over Ethernet edge density for both wired and wireless installations. The Super X family's revenues more than doubled from a year ago and was up 46% sequentially.

The second key product success area was in our service provider market sector. We had major wins utilizing all of our Layer 2/3, Layer 4-7 traffic management and MPLS platforms. Our MPLS routers, the Nanor and XMR and MLX continued to gain market acceptance with more than triple their revenue from a year ago, and they were up 12% sequentially over Q4 2006.

Overall, we continue to have continuing new customer wins and existing customer rolloffs in the wired, Wireless cable and content delivery sectors. Applications included Metro, WiMAX, hosting data center, and Internet routing expansions. We announced OC-12, OC-48, and OC-192 WAN capabilities during the quarter and we, indeed, did ship OC-12, OC-48 blades for revenue during the quarter. We sold approximately 345 IP and MPLS routers in Q1.

Additionally, we continue to make good progress in product trials in tier 1 service providers. We've had some initial purchase orders from such large environments and we continue to get consideration and trials for new significant opportunities. As stated previously, my expectations for major tier 1 penetration begins in the second half of this year.

In our Layer 4-7 application traffic management arena, our new entry-level traffic management platform, the ServerIron 4G shipped several hundred units while targeting the mid-sized enterprise customer during the quarter. Additionally, our high-end Layer 4-7 traffic management products which are industry performance leaders continue to perform well in both enterprise and service provider markets.

One nonproduct operational highlight for the quarter was particularly good news. This event was a successful broad patent cross license agreement with Alcatel that settled ongoing litigation between our companies. This follows on a similar cross license agreement that we negotiated with Lucent last year. Both of these litigation matters are now resolved.

It is important to focus on these developments for a number of reasons. First, the expense of these matters is now behind us. Second, and equally important, I think that cross licenses are good agreements that promote peace between our companies and validate Foundry's strategy technology and market position.

One more important point to cover is the addition of new Board member, Celeste Ford. Celeste is the founder and CEO of Stellar Solutions, a professional engineering services firm. Stellar Solutions was founded in 1995 and is a leader in critical U.S. government and commercial satellite programs.

Overall, Celeste is a 25 year veteran of the aerospace and engineering services industries. Her extensive experience in the U.S. Federal Government sector complements Foundry's strong federal vertical market presence. Celeste was elected to the Board of Directors at our April 19th Board meeting. The entire Foundry Board of Directors and our entire executive management team welcome Celeste to her new role and I am very happy to have a stronger Foundry team.

I'll now turn the call over to Dan Fairfax, our Chief Financial Officer.

Dan Fairfax

Thank you, Bobby, and good afternoon, everyone. I'll open my comments with a brief status on the Company's restatement. The Company currently anticipates that the restatement of its historical financial statements will be filed with the Securities and Exchange Commission in late May. As we said on the last conference call, the investigation is complete, so the delay and filing with the SEC does not reflect any new findings from the investigation.

Rather, these extra few weeks allow us the time necessary to complete the final stages of our accounting and related disclosures in preparation for filing multiple documents simultaneously with the SEC. The work effort required to process the restatement, which affects eight fiscal years, is very significant. The Company believes that while filing its periodic reports is a matter of urgency, it is also important to exercise due care as we complete the restatement. Foundry and its professional advisers believe the Company will be in a position to file all required periodic reports on or about the end of May.

I would also like to comment on NASDAQ. We previously disclosed that NASDAQ has stayed its delisting proceedings for Foundry and we have provided NASDAQ with an update of our estimated filing timeline. As of this time, we have not been contacted by NASDAQ with any change to the previously announced stay of delisting proceedings. We look forward to issuing the full financial results within the next several weeks and anticipate hosting another conference call to discuss our financial results in more detail and answer questions about our business once our financial statements are published.

Due to the forthcoming restatement of our historical financials, Foundry will not be discussing in any detail our current income statement, balance sheet, or other GAAP financials, including stock based compensation expense, and we will be limited in the types of questions we can answer at the end of the call. However, consistent with last quarter's announcement, we will be presenting select financial results for the first quarter of 2007.

Foundry posted record quarterly revenue for the first quarter of 2007 of $135.8 million. That was compared to $114 million in the first quarter of 2006 and $132 million in the fourth quarter of 2006. This is an increase of 19% over the prior year and an increase 3% sequentially. We believe the momentum that we continue to see in the first quarter of 2007 was primarily due to the impact of our expanded sales force and our fully refreshed line of products. In addition, as Bobby mentioned, a key area of strength was our federal government business, which was up over 10% from the prior quarter.

I would like to point out that we have adjusted our previously announced Q4 2006 revenues from $132.7 million to $132 million to reflect an adjustment related to a newly released product in last year's Q4. The $700,000 is now recognized in our first quarter revenue.

Let me take a minute to break down our Q1 revenue for you. In the first quarter of 2007, sales to the U.S. Federal Government represented 18% of total revenue while sales to North American commercial customers represented 55% of total revenue. Sales to Europe, the Middle East and Africa, our EMEA, represented 13% of total revenue during the period. North American commercial revenue, which includes both enterprise and service provider customers, experienced modest growth during the first quarter, while EMEA revenues experienced normal seasonal weakness.

Sales in Japan this quarter represented 7% of total revenue, a decrease from the prior quarter. We believe we will see recovery in our Japan sales during the second quarter of 2007 despite the softness, which we experienced in the normally strong Q1.

Overall, domestic revenue was 73% of our total business and our international business represented 27% of the total. This compares to 71% for domestic and 29% for international sales in the fourth quarter of 2006. Our enterprise business was, again, our primary source of revenue. Enterprise customers accounted for approximately 79% of total revenue for the first quarter. Revenue from our chassis-based products in the first quarter of 2007 increased slightly compared to the fourth quarter and now represents 72% of revenue.

Gross margins for the quarter were slightly below the low end of our target range of 60%. This slight downward shift was due primarily to investment and our service infrastructure and our service to product revenue mix. Product margins were unchanged from a year ago. We believe that this is not a permanent situation and our gross margins will likely be back into our target range in the second half of 2007.

Regarding operating margins, they have moved in conjunction with our gross margins, and also include the effect of the increased expense for payroll taxes and other benefits expense that increase seasonally at the beginning of the fiscal year, and a onetime employee stock purchase plan related bonus paid in the quarter.

Let me now turn to the balance sheet for a look at some select balance sheet items. Cash and investments at the end of Q1 totaled $897 million, which is an increase of $11 million in the first quarter of 2007.

Although we, again, increased our cash position, the increase was offset by certain payments the company made during the first quarter, including a payment to Alcatel and resolution of all outstanding lawsuits with them, the refund of contributions to employees participating in our canceled employee stock purchase plan together with a onetime employee bonus of $4.8 million to compensate employees for the cancellation of the January employee stock plan purchase.

And, in addition, we saw increase in our day’s sales outstanding and accounts receivable from 50 days in the prior quarter to our more normal level of 60 days. The lower Q4 DSO, you will recall, was due to the unusually linear flow of orders in Q4; linearity, which we were not able to replicate in Q1. This, in turn, resulted in our accounts receivable balance returning to a more normal level and a net consumption of cash in the quarter. Without these events, we would have seen greater cash growth in the first quarter.

Regarding the planned use of cash, management's primary focus has been on growth of the company while working to complete the accounting restatement and to be current on our filings. However, in light of the strength of our balance sheet and buoyed by our history of strong cash generation, the Board and our management are actively assessing the cash options available to us. We would anticipate announcing our intentions when management and the Board have completed this assessment.

For the quarter, our book to bill ratio was again, greater than 1. With respect to our personnel, the company added 27 employees during the first quarter, mostly salespeople and engineers. The total number of employees at the end of the first quarter was 843. We expect to continue to grow our personnel with the majority planned for sales and R&D. However, our headcount in all functional areas will grow as the Company continues to scale.

Given our current practice, we will not be providing formal revenue or EPS guidance. We would, however, like to provide qualitative review of the current quarter. Looking at the current period, we believe our North American and European enterprise business will continue to be solid in the current quarter and show stronger growth into the second half of 2007.

Regarding the activity within the federal vertical, while we are expecting some modest seasonal weakness, we believe we have taken steps to mitigate some of the downside risk that affected the second quarter of last year. First, we have a more diversified federal business today, which is less dependent upon the U.S. military. Second, we have a much larger pipeline relative to last year, and finally, our pipeline for the quarter contains more deals based on program spending rather than on operational and maintenance spending.

We are carefully watching the current political environment in Washington for a possible shift of capital away from IT and towards the war effort. This would, obviously, have an impact on our business, but we believe, for the reasons that I've given, that the impact will be less than we experienced last year.

Looking beyond the current quarter, our pipeline of federal business for the second half of 2007 appears robust. Finally, as previously mentioned, we expect Japan to recover in the current quarter due to the timing of several large deals that slipped out of the first quarter of 2007.

With that quick summary, I'll now turn the call back over to Bobby.

Bobby Johnson

Thank you, Dan. The last three quarters have been very positive for Foundry. Our performance reflects the success in our investments in growing our worldwide presence through our branding and expanded sales organization, and the timing and execution of our recent product launches. We have specifically tried to diversify within our U.S. federal vertical, branching out into new agencies while at the same time, diversifying away from our U.S. federal vertical by strengthening our geographic presence worldwide.

Hopefully, over time, all of our markets will produce greater revenue for us with less dependency on any one single market. Our strategy and execution on our major goals continue this year much the same as last year. Specifically, throughout this year, we have three key objectives.

The first objective is that we will continually endeavor to introduce leading edge products in both price, performance as well as feature sets into our targeted and into our adjacent markets.

The second key objective is we will continually endeavor to create an even bigger Foundry brand in the press, and in our customer's minds and networks.

And the third key objective is we will continually endeavor to increase our sales force and sales presence in both established and new territories for Foundry.

We believe that the investments we have made over the last couple of years and that we continue to make in the business will drive improved performance for the second half of this year and establish a stronger foundation for the longer-term.

As a part of our investment strategy, our Board of Directors has been and is continuing to discuss the options available to us and to our shareholders for the best usages of our strong cash position. There have been no decisions, but much deliberation has and is continuing to take place.

And finally, as a part of preparing for the second half of the year, this, the second quarter, is the major tradeshow quarter for us. At Implusai, Las Vegas, in the month of May, we will be debuting three new high-end chassis products.

They are the high-end of the RX, the MLX and the XMR families, with each high-end product capable of supporting up to 128 10-gigabit Ethernet ports at full wire speed. All three products are Layer 2 or Layer 3 capable, and the level of performance doubles to approximately 2 billion packets per second.

The RX platform is targeted at high-end enterprise backbones, high performance cluster computing environments, and datacenter applications. The MLX is primarily targeted at Internet exchanges and metro environments while the XMR is targeted at all areas of the Internet, both Internet edge and Internet core applications.

We have substantial customer interest in all three new products. We do not expect revenues from these new platforms during this, the second quarter. The trials will start during this quarter. Revenue generation is expected on these platforms next quarter.

As we have just completed a successful quarter, I would like to thank all of our employees, partners, customers, and shareholders for their commitment to Foundry. Now I would like to turn it over to Blake for a question-and-answer period.

Questions-and-Answers Session

Operator

(Operator Instructions) It looks like first we will go to the side of Cobb Sadler from Deutsche Bank. Go ahead, please.

Cobb Sadler - Deutsche Bank

Hey, thanks a lot. I had a question on the XMR MLX router. Just make sure I have my numbers right, it looks like it was 19% of revenue this quarter and 13 last quarter, up about 50% quarter on quarter.

Could you talk about what carrier types did the revenue for the quarter address? Is it still tier 2 and below? And also, on the application front, are most of your products shipping with MPLS functionality? Thanks a lot.

Mike Iburg

Cobb, this is Mike. Before Bobby answers the question, I'll provide just a brief clarification on the numbers. We reported 13% of total revenues back in the fourth quarter of 2006, and this quarter, we reported 19% of product revenue. Now, just for everybody's clarification, our service revenues or support revenues from the quarter were about $20.5 million, and obviously, the balance is all product revenue. So when you do the math, what you'll find is that the growth quarter on quarter was about 12%, and the one thing that we've adjusted as well is the fact that last quarter we excluded accessories. And this quarter we've put accessories under the calculation because the accessories are required to make the boxes run.

So now, we believe we have a more comparable set of numbers. It changes the numbers from last quarter from $17 million to $19 million and the number for this quarter is about $21.5 million. So $19 million to $21.5 million should get you about a 12% sequential growth.

Cobb Sadler - Deutsche Bank

Okay, got it. And it will be apples to apples going forward, correct?

Mike Iburg

That's correct.

Cobb Sadler - Deutsche Bank

Okay.

Mike Iburg

And now I will turn it over to Bobby for the positioning.

Bobby Johnson

Okay. First, for the MLX and the XMR, both platforms are MPLS enabled. Not everybody uses MPLS on those platforms. So some people use MPLS from day one. Some people buy it because their MPLS-ready for whenever they need it.

In terms of key verticals and key customers for the XMR MPLS platforms, we have several different verticals and applications we sell into. Let me give you kind of a flavor. We sell into both national and regional backbones.

We sell into Voice over IP providers. We sell into other content delivery providers such as IPTV environments. We sell into cable and MSO environments. We Sell into Metro environments and we do sell into Internet backbone environments.

Some of our customers are tier 1, tier 2 and tier 3, in all environments. We also sell the XMR and the MLX into big universities. We sell them into big enterprises as well. Additionally, the RX family which is not MPLS enabled but it is a very powerful IP router, service providers buy it for V-6 routing because it's less expensive than its cousins, the MLX and XMR if all they ever want is just IP routing. So sometimes we sell the RX into those same applications.

Cobb Sadler - Deutsche Bank

And you were talking in a major tier 1 carrier, the competing box would be a Juniper T-640 type box. Where are you on a pricing level versus maybe not talking about competitor, but generally OC-48 to OC-48. Are you --

Bobby Johnson

If you take a fully loaded box where somewhere probably in the 10 to 25% list price of comparable platforms, from Juniper, we do have trials. We do have initial small PO's. I would say give us a little bit more time before we talk about any real major installs there for, I would say, big tier-1's. We certainly have some tier 1 national customers and we certainly have some brand name Voice over IP and IPTV and cable companies. And we will, over time, release more of those names. I think we've released some in the past.

Cobb Sadler - Deutsche Bank

Okay, great. Last question. Government up about 10% quarter on quarter in a seasonally weak quarter. You must be exposed to some programs that are ramping within the overall federal budget.

I guess in a seasonally weak quarter you are growing the business, I'm just thinking that you've got to be exposed to some particular projects that are outgrowing the overall federal wallet.

Bobby Johnson

As Dan talked about in his part of the presentation or the disclosures, federal was indeed strong. I disclosed that as well. We are still expecting strength for federal in this quarter. We are certainly expecting strength in federal in the second half.

We do believe that we have diversified quite a bit in federal. There is some risk in Q2 over the supplemental, but right at this moment, we feel we have more diversification in federal than we did in Q2 of last year.

But we are exposed to growing sectors. I would also say that our extended product family, one of the enterprise customers for some of our MPLS routers that is competing against some of our very worthwhile competitors is, in some of the federal government sectors whereas we have won quite a few MPLS routers for certain defense applications.

That's been very good for us and it would have gone to other worthwhile competitors if we did not have that product family. So that is one of our continued strengths and diversifications into an adjacent market in our federal verticals.

Cobb Sadler - Deutsche Bank

Great. Thanks a lot.

Operator

Our next question comes from the side of Matt Robison of Ferris, Baker Watts.

Matt Robison - Ferris, Baker Watts Inc.

Hey, good afternoon. Looking at your Service Provider business, do you anticipate that growing as fast as enterprise? Sounds like in the second half you may but here in the current quarter and around mid year and is that -- if you do have some surprise on the federal -- downside surprise on the federal side, is it enough to offset?

And then I'm also curious on this settlement you have with Alcatel Lucent, if it's -- how it would compare to the one that you had back in 2004?

Bobby Johnson

Okay, so why don't -- are you comfortable, Dan, with an answer?

Dan Fairfax

Yes. I think on -- let me talk about the Alcatel situation. So we're under restriction or agreement to talk about the details of the transaction. I guess we can get directionally, I think you are referring to the Nortel arrangement, Matt, is that right?

Matt Robison - Ferris, Baker Watts Inc.

Yes.

Dan Fairfax

So our settlement in this situation is much more, a more robust agreement with a lot less cost associated with it and we are really pleased to get the legal drag behind us.

Matt Robison - Ferris, Baker Watts Inc

Okay. And then my cumbersome question about service versus federal and the growth prospects potential to offset there?

Bobby Johnson

Are you talking about general commercial?

Matt Robison - Ferris, Baker Watts Inc

The Service Provider business it sounds like that made this growing off of relatively small numbers and maybe that has faster percentage of growth rates here in the near-term. I don't know if that's true, but it seems like it might be?

Bobby Johnson

That's what, you know, one of our key strategies, our first key strategy years ago was go become a dominant player in the federal vertical.

Our second strategy after we accomplished that was diversify within federal and diversify away from federal. And we're still continuing in those programs. We think we have mitigated our risk. Our Crystal ball is not perfect, but we are feeling more comfortable today than in the past that we have other geographic strengths and that we have diversification within federal and we've diversified away from federal.

Dan Fairfax

I think the other thing we can add is with our support organization, we're looking to make ourselves match up better with the needs of that marketplace in anticipation of growing the business there.

Bobby Johnson

And therefore, that was some of the downward gross margin pressure as we put more support inventory out to support both current and anticipate future clients.

Matt Robison - Ferris, Baker Watts Inc

And then to finish, can you comment on the growth rate in 10 GB ports?

Bobby Johnson

For the quarter, 10 GB was approximately the same as in Q4 of last year, but up 75% from a year ago.

Matt Robison - Ferris, Baker Watts Inc

Okay. Thank you.

Operator

Next we’ll go to the site of Mark Sue from RBC Capital Markets. Go ahead please.

Mark Sue - RBC Capital Markets

Thank you. Bobby, recognizing it's early, any comments on the outlook for growth for this year versus last year? What do you think the industry growth rate is? I get the sense that you are feeling very confident on your ability to accelerate revenues during the back half of the year?

Bobby Johnson

Well, we don't give specific guidance. I would say that our three key objectives on our product family, on our branding and growing our sales force is we are making good progress in those and I think those will and have over a time expanded our revenues. We are on similar goals, similar metrics internally. We certainly are hoping for growth. We certainly believe we will see growth.

There may be the occasional quarter or so of digestion of both new products and new people and new clients, but hopefully, over the last few years, we have rebounded after the Boston and 911 and then we've certainly expanded our presence. We have kept our revenues per employee at or near the top of the networking industry and we are continuing to execute on those same strategies. And we are hopeful for the result.

Mark Sue - RBC Capital Markets

Bobby, do you think mid-teens growth for the industry is a reasonable assumption?

Bobby Johnson

In certain players and certain sectors.

Mark Sue - RBC Capital Markets

And then, can I ask what's your personal preference between dividend payments versus a share repurchase program?

Bobby Johnson

I don't have a personal preference. It's going to be what the Board of Directors collectively views as the best use of cash. Certainly, you've just detailed two of the alternatives that are being considered by the Board and there's other alternatives that are being considered.

Until the restatement is done, and there is more input given by management to the Board of Directors on short-term, long-term prospects, other alternatives, there's no decisions. I would say we certainly are spending more time deliberating and discussing this topic at Board meetings.

Mark Sue - RBC Capital Markets

I see. And is there a base amount of cash you think you would need to be comfortable with on the balance sheet? Is it $500 million? $600 million?

Dan Fairfax

You know, we're looking at that. That's just one more factor as Bobby was talking about, the different possibilities we have going forward. It's one factor we are considering I don't think we would say yes, we have determined exactly what we would like to have for that operating cash balance.

Mark Sue - RBC Capital Markets

That's helpful. And lastly, Dan, just when you said your target gross margins, what would that be again for the second half?

Dan Fairfax

So the Company has been operating with a target range of 60% to 65% and as we talked about, we fell just slightly below that for the quarter. And so our view is that we are still driving the business to perform within that range going forward.

Mark Sue - RBC Capital Markets

That's helpful. Thank you and good luck, gentlemen.
Dan Fairfax

Thank you.

Operator

Next we’ll go to the site of Ken Muth from Robert Baird. Go ahead please.

Ken Muth - Robert W. Baird and Co.

Hi, just quickly follow up on the gross margin, can you just tell us why it fell below 60% or is it going to this quarter? Some just more detail on that?

Bobby Johnson

So really for the shift, as I tried to at least summarize and we won't, on this call, go into any further details, but it really fell out on the service side of our business.

And it was really to expense that we've been looking at putting in place in order to plan for scalability and better match up with the customers we are targeting. Then, as I also mentioned, the product margins were unchanged year-over-year.

Ken Muth - Robert W. Baird and Co.

I guess just one of the concerns, as you ramp these newer products, do these products have at or above where your historical margins may have been or are they below the 60% level in the MLX and the XMR and some of the newer products you are talking about coming out with?

Bobby Johnson

Well, we see some, as we wrap new products and build volumes, we don't see the target margins that we designed the products to until we get volume production. So that will be moving as the volumes increase and there is not every product cost structure is the same, so there is a mix of specific product margins. I don't think on this call we would go into that level of detail.

Ken Muth - Robert W. Baird and Co.

Okay, and then lastly on the service provider vertical, obviously seeing a good ramp up there. Is it because you're also hiring or what percent of your sales force are you hiring for that vertical or how are you getting that vertical so quickly?

Bobby Johnson

Well, we are both hiring there, but we also have established customers from the vertical for a longtime. If we roll back the clock to '99 and 2000, Foundry actually received 65% of its revenues in the year 2000 from the service provider sector. Today, we receive probably 75% of our revenues from enterprise, so we did a complete seat change because of the tech bust at the end of 2000, 2001, 2002.

So we still have legacy customers. We still have very astute sales and support people for that vertical, and as well as we are hiring new SP sales guys. So we are trying to really balance the Foundry business. As I said we're trying to diversify into new geographic markets as well as new product in adjacent markets. So what Foundry is trying to do over time is build a balanced business across multiple sectors, both geographic and vertical market.

We still are smarting as an organization from our concentration in SP's in the year 2000 when the Technology bust came. We did very well on the rebound in 2003 based upon federal. We've had a little bit of a learning experience a year ago when we had a concentration in federal and had some delays, although not lost deals, but delayed deals. So we are continually being aware of the past trying to really diversify across enterprise service provider, across U.S. versus federal versus other geographies.

Operator

Next we’ll go to the side of Tim Long from Banc of America. Go ahead please.

Tim Long - Banc of America Securities

Could you talk a little bit about the -- you mentioned the impact of the sales force. If you could just give us your sense as to how much contribution that relative to just macros having on the growth of the company. And also, deal sizes related to that, that's number one.

And never two, if you could just talk a little bit about the international business. It did -- U.S. growth was very strong in both enterprise and federal. Could you just talk a little bit about why the slower growth in the international. Was there just some timing of contracts that caused that region to grow a little slower this quarter? Thank you.

Bobby Johnson

Let me take the last question first because I remember that one. For us, Europe was more or less flat during the quarter. U.S. federal, U.S. commercial were strong. Northern Asia was a little down, a little weak. In historical past, Japan had usually a more robust calendar Q1. It was their virtual Q4. And part of that was because of some government initiatives on doing capital spending in that quarter in certain sectors.

Now, from what I am being told, is those incentives were not there this past year, I mean this past Q1. So, it's not that we lost deals. It looks like it was a softer capital equipment investment environment in Japan, and we are feeling more confident. We have been told about new wins from the quarter that we should expect purchase orders from this quarter that we've underwent a lot of trials. Obviously, July 19th, my crystal ball being a lot better than it is right now, but so we'll see.

Tim Long - Banc of America Securities

Okay, that's great. And the first one was on just deal sizes and impact to the sales force?

Bobby Johnson

The sales force growth percentage-wise is slightly ahead of our growth rate, because it takes six to 12 months for a new sales team to produce. So we will probably retain 75% of our new sales forces. We will have a 25% or so dropout in those first six to nine months, but it takes six to nine months, so we have to hire substantially ahead of our revenue ramp.

Tim Long - Banc of America Securities

That's great. If I could, just one last clarification here. You talked about the operating margin tracking the gross margins. Could you just remind us of what the operating margin target range is and does that mean that it was slightly below just like the first margin was? That's it for me. Thank you.

Dan Fairfax

Yes, so we've been planning against the 20% to 25% operating margin and this quarter again, without, unfortunately, being able to go into the details, we are below that. Part of it which is this modest change from the gross margin more affected by the payroll tax impact, our operating expenses are significantly in our personnel related to some growth on the sales and marketing expense line.

As Bobby said, we're hiring ahead of the ramp, but really affected by the bonus that I mentioned from the employee stock purchase plan and the payroll taxes being as kind of unusual items that hit the first quarter. So when we report it, it will be lower.

Tim Long - Banc of America Securities

Okay. Thank you.

Operator

(Operator Instructions) Looks like we’ll go next to the side of Samuel Wilson of JMP Securities. Go ahead please.

Samuel Wilson - JMP Securities

I apologize, there's a lot of calls going on, so you may have addressed this. But several large technology companies have sort of indicated that U.S. enterprise acted particularly weak during the month of March. IBM, EMC, Sun, et cetera. And I'm just wondering sort of what you guys saw color-wise during the month of March and sort of just general tone of enterprise IT spending right now. Thank you.

Dan Fairfax

So, maybe I'll grab that, Bobby. So we didn't see that in our business. So we saw March as a strong month and the quarter being good for us.

Samuel Wilson - JMP Securities

Got it. Thank you very much.

Operator

Next we’ll go to the side of Paul Mansky from Citigroup. Go ahead please.

Nigel Frankson - Citigroup

This is Nigel Frankson calling in for Paul. Two quick questions. One, can you give us an idea of what sales from new products versus legacy products were? What percentage of sales?

Mike Iburg

This is Mike, and I'll just jump in and say that if we put together the XMR and the MLX, along with the new enterprise platforms, the RX and the Super X, and then a couple of the new stackables, which we have introduced more recently as well because they're based on some of that same core technology, you're now talking about probably slightly above half -- slightly more than half of the total of product revenue for the Company.

Nigel Frankson - Citigroup

How does that compare to last quarter?

Mike Iburg

It's got to be higher because both the RX and Super X combined are up and the XMR's and MLX's are up as well. I don't have an exact percentage for you, but I can probably dig it up later.

Bobby Johnson

Yes, if I just take a quick look at that, if we talk about products introduced over the last 12 to 18 months, including our newest ServerIrons and Layer 4-7, and our high-end 10 GB ServerIrons introduced last year, if we take service which is approximately 20% of revenue out, that leaves you 80% on hardware, probably 80 to 90% of our hardware revenues were new platforms introduced in the last 12 to 18 months.

Nigel Frankson - Citigroup

And how would that compare to last quarter?

Bobby Johnson

It's up. It's trending strongly up.

Nigel Frankson - Citigroup

Second question is, I've been hearing rumblings about a larger competitor looking to enter the Layer 3 market. I was wondering if you could speak generally. The high-end enterprise, what are the barriers to entry there and if you could identify a couple of those, I would appreciate it.

Bobby Johnson

The barriers to entry deal with several different factors. From a hardware platform, it deals with switching capacity, expandability, port density, port types, do you support Voice over IP in Wireless environments with power over Ethernet capabilities? Do you have a complete to product family? That is, do you offer stackables and edge products as well as beefy core products? Then, there is the whole software suite, which protocols, which multicast protocols do you support? So --

Nigel Frankson - Citigroup

What about as far as actually penetrating the account? Is that particularly difficult? For example, how critical is it that you have reference accounts?

Bobby Johnson

Very critical.

Dan Fairfax

Yes, reference accounts create -- become a cornerstone of anybody's entry into this market. As well as the direct sales, at least it's not a direct sales model, at least a direct touch, so you're going to have to have a direct sales footprint as well.

Dan Fairfax

Okay, Thank you much.

Operator

Next we will go the side of Jason Ader of Thomas Weisel. Go ahead please.

Jason Ader - Thomas Weisel Partners

Thank you. Bobby, I wanted to follow up on a comment you made on the supplemental risks, the risks for supplemental for federal in Q2. Do you have a sense of, at this point, I don't know if you mentioned it or you've mentioned it on previous calls, but what percentage of your business would be exposed to that of the federal -- what percentage of your federal business would be exposed to that kind of ballpark number?

Bobby Johnson

So, the answer to the overall business is a gut feeling of a very small single digit percent. To the federal outlook, it could be maybe a mid-teen size number, if we have any real exposure overall.

Jason Ader - Thomas Weisel Partners

And overall for your federal, would you say that the kind of Armed Forces right now is -- I mean, could you compare that percentage, let's say -- you said you've been able to diversify within federal. Could you compare the percentage to, let's say, Armed Services, Armed Forces in Q1 to like Q1 a year ago? Is there any way you can quantify that?

Bobby Johnson

Well, we probably had a higher exposure in Q1 and Q2 of last year to specifically Army and Army OEM operational and maintenance type versus programs that we have right now. We have more diversification. We have more funded programs today than in the calendar Q2 of last year. So, we are hoping first of all the supplemental gets signed. Second of all, we hope that the exposure is minimal. We hope that the other upside opportunities and diversification within federal takes care of this and we hope that the diversification away from federal takes care of everything as well.

Jason Ader - Thomas Weisel Partners

And is there any reason to expect that enterprise, broadly speaking, enterprise would not be up in the June quarter based on -- I know you don't give specific guidance, but is there anything you can think of where that this usual seasonal bounce that companies get in the June quarter in the enterprise side wouldn't happen for Foundry this year?

Bobby Johnson

It's very difficult to say. I don't have any particular knowledge of any disaster pending. I would hope that our worldwide Europe and Japan rebound a little bit and that if U.S. doesn't continue to grow, at least it stays flat. But the goal is growth in all sectors.

Jason Ader - Thomas Weisel Partners

Japan, based on your commentary earlier, it doesn't sound like you think Japan necessarily is down in Q2 seasonally. Is that a fair statement?

Bobby Johnson

That's a fair statement of where I sit right now. We'll also be spending some time in Japan later in the quarter, personally; on both product announcements and customer visits and partner visits.

Jason Ader - Thomas Weisel Partners

Okay. Thank you.

Operator

Our next question comes from the side of Munjal Shah from Jefferies. Go ahead please.

Munjal Shah - Piper Jaffray & Co.

This is Munjal for Bill Choi. I have a couple of questions. One, on the router, the XMR and the MLX, do you expect a solid second half ramp? My question was, is that dependent on say one or two customers or is it you think more broad-based with a number of customers? And is that dependent on the new products that you're going to introduce at the Implusai or is it based on the existing products that you have?

Bobby Johnson

It's a broad-base. It's primarily based upon existing products and that the new products that we've just introduced and will be debuting later this quarter for revenue next quarter will be hopefully additive to a broad-base.

Munjal Shah - Piper Jaffray & Co.

And another question on the Layer 4-7. Could you tell us the breakout, as to what percentage that was and could you give us a little bit more color on the traction that you are seeing there?

Bobby Johnson

Okay.

Dan Fairfax

The 4-7 revenue was about 11% of the total revenue.

Bobby Johnson

Is that with support and…?

Dan Fairfax

That's without support.

Bobby Johnson

Okay, so fulfill with the Optix. Yes, right.

Munjal Shah - Piper Jaffray & Co.

11% of total?

Dan Fairfax

Correct.

Munjal Shah - Piper Jaffray & Co.

And just traction with the new products. What are you seeing there in that market?

Bobby Johnson

Well, of the new products, we received revenue on 350 units for the quarter, so the new products seem to be ramping fairly well.

Munjal Shah - Piper Jaffray & Co.

Okay. Great.

Dan Fairfax

Just going back to the router markets just for a second, we have shipped those routers now to over 230 new customers since they began shipment in February of last year. So we're pretty pleased with the broad-base of business that we are seeing in those platforms.

Munjal Shah - Piper Jaffray & Co.

Okay. All right, great. Thanks a lot, guys.

Dan Fairfax

Thank you.

Operator

And we will take our final question from the side of Tim Daubenspeck of Pacific Crest Securities. Go ahead please.

Tim Daubenspeck - Pacific Crest Securities

Thank you very much. Just within the XMR, MLX, you mentioned a lot of customers there. Are there any outsized or unusually large customers? And I think you have mentioned Limelight as a reference customer in the past. Can you give us any more color in terms of the quarterly contribution?

Bobby Johnson

I don't have Limelight's breakout for the quarter. I don't want to get into too much detail, but Limelight is a fairly significant install and we have several key customers, both in SP world, both in the federal world, some large enterprises that do IPTV type things; some large cable and some large national backbone providers that are continuing to do rollouts. And we will disclose more and more names over time. On some of these national rollouts we need to get clearance to use the names.

Tim Daubenspeck - Pacific Crest Securities

Very helpful. And then just in terms of the new products coming in Vegas, can you just give us some general metrics, either 10 gig comparisons to products that are in the market or price per port or just some idea of how it measures up to existing products out there?

Bobby Johnson

Okay, so if we take a look at our two competitors that are larger than us, one is Juniper and one is Cisco. If we take a look at their router families, the Juniper T640 and the Cisco CRS, our existing high-end platforms support approximately double the performance of their existing platforms. So, this new platform doubles our own performance, so of existing other competitors platforms, this could be in the 3 to 4X performance range.

So, in other words, they talk about doing clustered virtual routers. We can do all of that in a single device in much less space, much less cooling, much less purchase price, and with a much better MTBF because ours has a lot less moving parts compared to putting four or more other vendor's products together to equal one of ours.

Tim Daubenspeck - Pacific Crest Securities

Thank you.

Operator

At this point, I'll go ahead and turn the program back over to the management for any closing remarks.

Bobby Johnson

Okay. Thank you, Blake. Now, I would like to thank everybody for taking the time to join us this afternoon. We look forward to updating you in approximately 90 days. Thank you.

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