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3Com Corporation (COMS)
F1Q08 Earnings Call
September 20, 2007 5:00 pm ET

Executives

John Vincenzo - Investor Relations
Edgar Masri - President, Chief Executive Officer; Chief Executive Officer of H3C Technologies Co., Limited
Jay Zager - Chief Financial Officer, Executive Vice President

Analysts

Manuel Recarey - Kaufman Bros.
Long Jiang - UBS
Jeff Evenson - Bernstein
Mark Sue - RBC Capital Markets
Scott McCabe - Lehman Brothers

Presentation

Operator

Good day, everyone, and welcome to the 3Com quarterly earnings announcement conference call. Today’s conference is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to John Vincenzo, Head of Investor Relations. Please go ahead, John.

John Vincenzo

Thank you and thank you, everyone, for joining us today. 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 H3C integration activities; strategic initiatives, including our intent to separate the Tipping Point business from 3Com; future financial performance, financial condition 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 measure and the required reconciliation can be found in tables at the back of the press release announcing our results attached as an exhibit to our 8-K for this earnings release, 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.

With that, I will turn the call over to our President and CEO, Edgar Masri. Edgar.

Edgar Masri

Thank you, John and thank you, everyone, for joining us on the call as we review our results for the first quarter of our fiscal year 2008. I am here today with our new Chief Financial Officer, Jay Zager, and our Corporate Controller, Bob Aldridge. We will be walking you through the business highlights for the quarter, as well as specific details regarding our financial performance.

We recognize that historically, we’ve had a fairly complex financial model which oftentimes made it difficult for the financial community to clearly see the value in 3Com. The overall goal of today’s call and our financial calls moving forward is to provide you with more transparency into our business. We also intend to articulate our long-term business and financial objectives and make our results and our business easier for the investment community to follow. I hope you find that the information we provide moving forward meets this goal.

First, let me start by sharing our long-term business objectives. I am driving this business to become one integrated company that is a networking leader in both the enterprise and small and medium business markets. I define leadership as being among the top three in units, market share, and the major categories in which we compete.

According to some industry analyst reports, we are currently among the top three in several enterprise categories but we need to continue to grow our market share. We also need to gain market share in the small and medium business space.

From a financial perspective, we have identified three significant goals we hope to achieve by fiscal year 2011. First is to become a $2 billion company. This will require us to grow our business at an average annual rate of 12% over the next four years. We plan to achieve this through a combination of organic growth and strategic acquisitions; second is to achieve 10% operating margin on a non-GAAP basis, compared with about 2% margin last year; and third is to generate cash from operations during this period.

Certainly these are ambitious goals, given our history, but I believe we are well-positioned to begin the march towards achieving our long-term financial and business objectives.

Fiscal year ’07 was a transition year for 3Com. Most notably, we acquired 100% of H3C, giving us a strategic business and technology advantage and helping us attain overall profitability on a non-GAAP basis.

Additionally, in our traditional data and voice business unit, which we call DVBU, we worked through the restructuring and expense reductions we orchestrated at the end of fiscal year ’06, to help establish a leaner, more operationally efficient organization that puts us in a better position to grow moving forward.

Now, we are looking to capitalize on the momentum we achieved this past fiscal year to grow our business and improve our overall profitability and operating margin in fiscal year ’08. We have specific objectives for each of our key business units.

First, for DVBU; our objective for DVBU segment is to show steady year-over-year revenue growth this year and to achieve break-even no later than the fourth quarter;

Second, for H3C; at H3C, we expect strong top and bottom line performance;

And third, at Tipping Point, our goal is to see positive sequential revenue growth and that it will become profitable on a segment basis in the second half of the fiscal year and be profitable for the year in total.

In fiscal Q1, we took a positive first step in reaching both the fiscal ’08 and long-term financial objectives, achieving revenue of $319 million and non-GAAP operating profit of $10.1 million. This was our fourth consecutive quarter of non-GAAP profitability.

Now let’s look at our performance in each of our key businesses. First, DVBU; DVBU contributed revenue of approximately $140 million in the quarter, achieving year-over-year revenue growth for the first time in almost two years. Positive revenue growth in DVBU is one of our most important objectives in fiscal ’08.

A key component of this revenue growth is an increase in DVBU sales of H3C products. In Q1, sales of H3C products grew 53% year over year, particularly in the areas of our enterprise gigabit switching. Also within DVBU, sales of our voice product continued to grow while also pulling through sales of networking products.

I am particularly pleased with sales to customers, such as the French Home Office, which is leveraging our switch 5500 to build its network backbone. One of the things, by the way, that attracted this customer to 3Com, in addition to our price and performance advantages, was the ability to add open service network, or OSN modules, in the future.

Other examples of customers turning to 3Com are AutoScout in Germany and the Washington Board of Education in the U.S., both of which are leveraging our gigabit ethernet solution for their infrastructures.

Now, from a geographic standpoint, DVBU did exceptionally well in Europe, Middle East and Latin America, with both organizations exceeding their internal targets. Sales in North America were slightly behind internal projections, while sales in Asia-Pacific were mildly impacted by our continued integration efforts. By the way, I’ll speak about the integration later in my comments.

It is important to note that we essentially discontinued sales of our connectivity product which last year accounted for $6.3 million of revenue in the quarter.

Now, taking a look at H3C, revenue in the quarter was $187 million, which represented 6% sequential and 10% year-over-year growth. While this was slightly higher than our guidance, it was lower than our historic growth rates. We believe that the activities associated with the acquisition by 3Com and the integration efforts underway have had a temporary impact on our business.

However, we were pleased with the margins this revenue generated. H3C gross margins in the quarter were 50.7%, almost four points higher than the corresponding quarter last year. H3C has managed its expenses well and as a result, has significantly exceeded its profit plan for the quarter.

In Asia, we sold several network infrastructure solutions to companies such as Beijing Capital Airport, which is using H3C routers and switches; and Hong Kong University, which is enhancing its network with H3C switches.

We are also gaining traction with IP Storage in China, winning a deal with Sohu.com video blog project, among others.

Moving on, for Tipping Point, Tipping Point achieved more than $25 million in revenue for the first time in its history and recorded an operating loss of $600,000. The revenue growth represents a 36% year-over-year increase. In addition, the operating loss was substantially lower than the prior quarter, improving by 83%. During the quarter, the company signed a significant deal with a major U.S. telecommunications carrier.

Now I would like to focus on two major activities that impacted the quarter. First, H3C integration; with respect to integration, we continue to make progress in our efforts to combine our H3C and DVBU businesses. As we discussed previously, our initial focus has been in the sales and marketing area.

Last quarter, we completed the integration in the Latin America, North America and Asia-Pacific regions. We are currently addressing the integration in Europe.

We’ve also made significant progress in developing a corporate branding strategy. Our objective here is to take advantage of the strength of both of the 3Com and H3C brand, recognizing that they have different attributes in various parts of the world. This is a significant undertaking where we have made substantial progress and we are pushing to roll out the strategy in the coming months.

In fiscal Q1, we also extended our integration efforts in other functional areas, particularly research and development, supply chain, information technology and service and support.

Integration teams were created and the hard work has begun to rationalize the organizations. The goal is to establish one system that leverages the synergies of a larger organization and leverage the significant Asia-based research and development and supply chain talent we acquired from H3C.

I am personally driving this effort and I’ve put in place a structured review process to ensure key issues are raised and worked through in a timely basis.

As you can imagine, this is a significant undertaking and one that takes time to implement. However, it is a critical step in our achieving the cost savings from the integration.

I would also like to address the status of our Tipping Point IPO. During our last conference call, we announced our intent to file an IPO of Tipping Point. At that time, we stated that our plans were to file the offering by the end of the calendar year.

While our strategy to conduct an IPO remains unchanged, we have decided to delay the offering until some time in calendar 2008. The primary reason driving this decision is the recent volatility in the financial markets. We believe it would be in our best interest to allow the markets to settle down before we go forward. We will use this time to strengthen Tipping Point’s performance and focus on its profitability.

Finally, I would like to talk about our efforts to improve our customer service and satisfaction. During the past year, I’ve traveled around the world, meeting with our customers and partners and it became very clear to me that we could do a better a job in this area. To address this, several months ago I launched an initiative to significantly improve the delivery of service and support to our customers. The work done on this project is already yielding results and I anticipate customer satisfaction will improve along with it.

All in all, Q1 was a positive quarter for 3Com. We still have much more work to do but we are executing against our plan and I have every confidence that fiscal year 2008 will be a key first step in reaching our long-term business and financial goals.

With that, let me turn the call over to Jay. Thank you.

Jay Zager

Thank you, Edgar and good afternoon, everyone. Before I begin to provide some comments on our financial results, I would like to say that I am delighted to have joined 3Com and I look forward to working with Edgar and the management team.

With the inception of our new fiscal year, we are also making some changes in the way we report our financial results, as follows: first, we have simplified our press release to include only the key financial schedules. Financial information that was previously included in the press release will be covered in my remarks today and is available for review on our webpage in the investor relations section.

Second, in an effort to provide greater clarity, we will be discussing our net income and earnings per share on both a GAAP and a non-GAAP basis, and have included in our press release a reconciliation between the two sets of numbers to help our shareholders, analysts and other interested parties understand the differences.

Third, we have changed our segment reporting to be in line with the way we are now internally managing our business. This change will break out the SEN segment into the DVBU, Tipping Point, and corporate expenses. We do not use any allocation methods to distribute these corporate expenses to our operating business units.

And finally, starting with this conference call, we will provide more projected financial information.

With that as background, I would like to review our first quarter results. Sales for the first quarter were $319.4 million, an increase of 6.4% from a year ago. We reported a net loss in the quarter of $18.7 million, or $0.05 per diluted share.

On a non-GAAP basis, net income for the quarter was $12.2 million, or $0.03 per diluted share. Our non-GAAP portrayal is defined as excluding restructuring, amortization, in-process research and development, stock-based compensation expenses, and other unusual non-recurring items.

A full reconciliation between GAAP and non-GAAP results is included in the press release in Table C. Reconciliations for additional non-GAAP disclosures, which I will reference in my commentary, are available on our webpage in the investor relations section.

Let’s look at the revenue levels. Revenue for the data and voice business unit, the DVBU, was $139.6 million, an increase of 1.8% from a year ago. H3C revenue was $186.9 million, 10% above the prior year quarter, and Tipping Point revenue was $25.5 million, almost 36% above last year’s levels. Inter-company eliminations were $32.5 million.

From a geographic perspective, China revenues were $146.8 million, or 45.9% of our total. EMEA was $69.7 million, or 21.8% of the total. North America revenue was $60 million, or 18.8% of the total. Asia-Pacific excluding China was $23.3 million, or 7.3% of the total, and Latin America revenues were $19.6 million, or 6.1% of our total revenue.

Sales from networking products were $262 million, 7.4% higher than a year ago. Sales from security products were $31.5 million, about 24% above Q1 fiscal year 2007. Sales from voice products were $16.3 million, slightly more than 2% above last year’s levels. Sales from services were $9 million, an increase of 8% from a year ago, and sales from our connectivity products declined from $6.3 million in Q1 fiscal year ’07 to $600,000 last quarter, as we have essentially exited from that business.

Let’s spend some time on each of the business segments. We were particularly pleased with the overall performance of our traditional business, the DVBU, which had $139.6 million in revenue, reflecting positive year-over-year growth for the first time in almost two years. This growth was driven by increases in both our EMEA region and our in our Latin American business.

As you may recall, we undertook a significant restructuring of our sales operations and we are now seeing the benefits of that restructuring. Since the end of fiscal year 2006, we have reduced DVBU sales and marketing headcount from 522 people to 425 people. So during this period, we’ve improved sales efficiency by about 17%.

The DVBU gross margins were 31.2%, compared with 32.5% a year ago. The net year-over-year reduction in gross margins was due to product mix and pricing, partially offset by cost improvements. The DVBU reported a loss in the quarter of $4.7 million, which was an improvement of 56% when compared with the $11.1 million loss in the first quarter of fiscal year 2007.

H3C revenue of $186.9 million was slightly higher than our guidance and 10% above the prior year quarter. This growth was driven primarily by a significant increase in sales to the DVBU and by continued strong sales to Huawei.

H3C segment gross margin in Q1 was 50.7%, the highest level in its history. This is 3.6 points higher than a year ago and 2.3 points higher than Q4. These improvements resulted primarily from favorable pricing, including inter-company pricing, as well as cost reductions. And driven primarily by the increase in gross margins, segment operating profits at H3C were $27.0 million, a 33% year-over-year increase.

As the size of the H3C business grows, quarterly revenue growth rates have slowed down but increases in the gross margin and careful management of operating expenses have resulted in continued strong growth in segment operating profitability.

We expect these trends to continue for the balance of the fiscal year at H3C. Slower revenue growth than we have traditionally experienced, continued strong gross margins, and careful expense management, resulting in solid operating profit performance.

Tipping Point’s Q1 revenue was $25.5 million, a year-over-year improvement of more than 35% and the highest quarter in its history. Within this total, product revenue was $17.8 million and maintenance revenue was $7.7 million. This separation is significant because the maintenance revenue represents a recurring, growing revenue base for Tipping Point.

Tipping Point’s gross margin in Q1 was 65.3%. While this gross margin was slightly higher than a year ago, it was negatively impacted by a higher-than-normal E&O reserve provision of about $600,000. This provision resulted in a two point degradation to Tipping Point’s gross margin in the current period. As a result of the provision, Tipping Point reported a loss of about $600,000 in the quarter. That was an 83% improvement over the $3.4 million loss reported in Q1 fiscal year ’07.

And corporate expenses were $11.6 million, essentially unchanged sequentially and from the prior year.

From a consolidated viewpoint, our gross profit was $148.9 million in Q1, or 46.6% of sales. Adjusting for the amortization of the purchase accounting inventory mark-up and stock-based compensation charges, our non-GAAP basis gross margin was 48.5%. This is a 2.9 point increase over the prior year period and a 3.6 point sequential improvement. These improvements are primarily driven by increases in our H3C segment gross margin, as previously discussed.

R&D expenditures in the quarter were $52.3 million, or 16.4% of revenue, including $700,000 of stock-based compensation charges.

Sales and marketing expenditures were $74.4 million, or 23.3% of revenue, including $1 million of stock-based compensation charges. Sales and marketing expenditures have decreased by about 3.5% since the first quarter of fiscal year ’07, reflecting the significant reorganization and headcount reductions in the DVBU sales organization.

General and administrative expenses were $21.5 million, or 6.7% of revenue, including $1.8 million of stock-based compensation expense. While this spending level was relatively flat with Q1 of fiscal year ’07, we believe there is some additional opportunities to reduce overall G&A expenses.

And headcount at the end of the quarter was 6,174 people, down about 100 people from the year-end levels. H3C headcount was 4,696 people.

As a result of these factors, our operating profit on a non-GAAP basis was $10.1 million, or 3.2% of revenue, compared with a non-GAAP operating loss of $5.5 million a year ago. We have made significant progress in turning our business around and the financial results reflect this progress.

Net interest expense in the quarter was $3.6 million, compared with net interest income of $7.6 million in the prior quarter and net interest income of $10.1 million in Q1 fiscal year ’07. This expense is primarily due to the costs associated with the $430 million loan which was undertaken to acquire H3C.

Other income, primarily composed of the VAT software subsidy at H3C and unusual items, was $12.1 million, compared with $11.8 million in Q4 and $4.7 million a year ago. The current quarter included a gain on a patent sale of $5 million, and the Q4 numbers included a $4 million insurance settlement gain.

As a result of these factors, our pretax losses were $16.9 million. We had a $1.8 million tax provision in the quarter, resulting in a net loss of $18.7 million, or $0.05 per diluted share. On a non-GAAP basis, our net income was $12.2 million, or $0.03 per diluted share.

Let me now turn to our balance sheet. At the end of the quarter, our cash balance was $501 million, compared with $559.2 million at the end of the fiscal year. During the quarter, we used $59 million of cash at our operations. Included in this usage was a $93 million payment to H3C employees for the change in control portion of the equity appreciation rights plan known as the EARP, which was triggered by the acquisition of H3C.

Accounts receivable was $128.7 million, an increase of $25.7 million since the end of the year. As a result of this, our DSO at the end of the quarter was 36 days, six days higher than at the end of the year.

Notes receivable was $64.9 million, a decline of $12.5 million since year-end.

Our inventory was $104.7 million, which was $3.3 million less than our year-end levels. This reduction occurred at H3C and was due to the amortization of the inventory write-up related to the purchase accounting treatment of the H3C acquisition.

Inventory turns for the quarter were 5.7, an increase of 1.5 turns over the fourth quarter of fiscal year 2007.

Capital spending in the quarter was $6 million, compared with $4 million in the prior quarter. This increase was due primarily to acquisitions in preparation for changing our customer support delivery model, which Edgar had mentioned in his comments.

Now I would like to provide some insights on the current quarter. On a consolidated basis, we are forecasting Q2 revenues to be slightly higher than Q1. Within this total, we expect that H3C revenues will be in the range of $185 million to $190 million, essentially unchanged from the current quarter and slightly below Q2 fiscal year ’07.

The worldwide integration has been a greater distraction on the H3C organization than we had previously expected, and while we are pleased with the progress that the integration teams have made, we have seen and expect to continue to see some impact on the H3C revenue.

While the H3C revenues will be essentially unchanged from Q1, we do expect that the gross margin will improve over the record Q1 level. At this time, we expect that the Q2 H3C gross margin will be in the 52% to 53% range.

Also in the second quarter, in our DVBU segments, we expect to incur a $4 million to $6 million charge associated with the change in our customer support delivery model. This change will negatively impact the DVBU gross margin in Q2, which we expect will be in the 28% to 30% range.

As a result of these factors, we are projecting that Q2 operating profits on a non-GAAP basis should be in the $8 million to $12 million range, and non-GAAP EPS is forecast to be in the $0.01 to $0.03 range.

Now I would like to open the meeting to questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Manny Recarey with Kaufman.

Manuel Recarey - Kaufman Bros.

Hello. Good afternoon. Two questions; first, you said in your comments earlier about the SMB space, you want to improve your market share there. Could you give a little bit more description on how you plan to do that?

And then a question, Jay, for you; if you could just help me understand how you get to the $10 million pro forma operating income, I would appreciate that. I’m having a little trouble in figuring that out.

Edgar Masri

Thank you for your question. Let me take the first one, regarding the small and medium business. As a segment, if you look at it as sort of the web-managed, switches, et cetera, we, according to analysts, have about 12% market share which puts us in the top three. What we have done since I joined last year was one, to assign a vice president leader to the SMB space, and the other activity that we are undertaking is to take advantage and leverage over 120 engineers in H3C who are also working on that segment and bring and combine the forces together, so as an entity we have a stronger push in that market segment.

I am going to turn now -- your second question was directed to Jay about the $10 million, right?

Jay Zager

Right. If you take a look at our schedules in our webpage, I think Table B provides some clarity but I think the easiest way to look at this is basically we are adjusting our GAAP results for some purchase accounting adjustments, the re-class of the FAS-123 expense, and some restructuring charges.

I think if you take a look at schedule B, I believe it is, it should be fairly transparent. If you have anymore specific questions, I would be happy to walk you through it on a line-by-line basis.

Edgar Masri

Does that help, Manny?

Manuel Recarey - Kaufman Bros.

Yes, I’ll take that offline then, thanks.

Edgar Masri

Sure. Just on the SMB also, I mean, I mentioned to you what we are doing internally. From a product point of view, we’ve refreshed a lot of our office connect and baseline over the past couple of months. It helped tremendously and we are planning to make a major push in voiceover IP specifically targeting the small businesses and you will hear a lot more about it in the coming weeks.

Manuel Recarey - Kaufman Bros.

Okay, thanks.

Edgar Masri

Thank you, Manny.

Jay Zager

And Manny, just to try to help a little bit on a simple basis, we are reporting on a GAAP basis an operating loss of $25.7 million. Again, what schedule B refers to is there’s a $26 million adjustment for the amortization of intangible assets. There’s about $5.5 million adjusted for the purchase accounting changes. There’s about $3.9 million of stock-based compensation, and then about $400,000 of some amortization of intangible assets. So basically, those adjustments bring you from a loss of $25 million to the gain of $10.1 million.

I believe also if you take a look on the webpage, you’ll see that $10.1 million broken out by business units.

Manuel Recarey - Kaufman Bros.

Okay, and the gain on sale on the assets is not -- you are not including that under operating profit at all?

Jay Zager

That’s right. That we characterized, the patent gain, was a one-time gain and we didn’t think it was appropriate to give ourselves credit for it.

Manuel Recarey - Kaufman Bros.

Okay, thanks.

Operator

We’ll take our next question from Long Jiang with UBS.

Long Jiang - UBS

Good afternoon. You mentioned for next quarter, for the $6 million charge for DVBU, for customer support, so that will impact your gross margin. Is this charge included in your EPS guidance of $0.01 to $0.03?

Jay Zager

Yes.

Long Jiang - UBS

Okay, but that’s a one-time charge?

Jay Zager

Yes, but it is an operational charge. It’s a cost of doing business. It’s not something outside of the normal business operations.

Long Jiang - UBS

Okay, understood, so that’s basically just a temporarily higher expenses.

Jay Zager

That’s correct.

Edgar Masri

Because we are holding two systems. We are having the current system that we are ramping down while ramping up, and so in Q2, we are facing and incurring the expenses of two systems and beyond that, there will be only the emerging one.

Long Jiang - UBS

Okay, now, related to H3C guidance on revenue, it appears to be weaker than expected. Can you talk about what product category or what customer category are impacting the revenues primarily?

Jay Zager

I don’t think it’s unique to a particular product or customer. I think it is across the board. As we indicated in our remarks, the China marketplace remains very strong. The H3C product array remains very strong. The feedback we’re getting from customers remains very strong.

I believe that as we spend quite a bit of time focusing on the integration, it’s just distracting our sales teams and our management teams and we are paying a short-term penalty for that.

Long Jiang - UBS

Okay, so you have a total year target for H3C?

Jay Zager

We do but we are not at this point going to be disclosing any kind of projections beyond Q2.

Long Jiang - UBS

Okay. Thank you.

Operator

We’ll take our next question from Jeff Evenson with Sanford Bernstein.

Jeff Evenson - Bernstein

Two questions; one, I was wondering if you could tell us about the currency impact on the DVBU, and also talk a little bit about how you set the transfer prices between H3C and the legacy business, and what that contributed to the gross margin increase.

Jay Zager

Okay, the first question with respect to the currency, the impact is generally very small because most of the sales that the DVBU has are in U.S. dollars, so when we look at the impact of currency in our business in total, we don’t believe it’s a significant factor that we need to identify it.

With respect to the transfer pricing, I’ll make two points. First of all, our transfer pricing between the H3C and the DVBU is basically no different than our pricing between H3C and other OEMs, so we don’t treat the DVBU differently from any of H3C’s key partners.

At the end of the day, from a consolidated standpoint, obviously our profits are not impacted by the transfer price because whatever that price is, we eliminate the markup, so that the transfer pricing really only affects the way we report the segment profits. It doesn’t reflect the way we report our total company’s profits with respect to the H3C DVBU transaction.

Jeff Evenson - Bernstein

And what OEMs, other that Huawei, are you selling to?

Jay Zager

There are several. I think there is quite a few that H3C deals with.

Edgar Masri

Yes, let me mention, Siemens is one. We’ve worked with NEC, is a very good one in Japan. We’ve worked with Marconi, but it’s not as large as the other two I mentioned.

Jeff Evenson - Bernstein

Thank you.

Operator

We’ll take our next question from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets

Yes, hi, this is Jennifer dialing in for Mark. Just a couple of questions; number one, are you possibly thinking about maybe doing a reverse stock split anytime soon? And the second question is on Tipping Point. If you could just talk about the growth rate there, and also any idea of what you think it might be worth once that goes IPO?

Jay Zager

We are not contemplating any kind of reverse stock split at this time.

Edgar Masri

Regarding Tipping Point, what you notice as we start sharing more of the information is that this business continues to be healthy and growing strongly -- 36% is a very, very exciting growth rate for us. Keep in mind though that this business is for very large enterprises and therefore includes very many large deals that sometimes hit one quarter before or one quarter after we were expecting them.

So I like people to look at the Tipping Point growth rate and performance on a yearly basis, and from that point of view, I am very pleased with what we are seeing. Right now, a lot of our focus is on profitability, to get it, and we came very, very close this quarter and the team has done a commendable job and I expect them to continue on that route.

Mark Sue - RBC Capital Markets

Okay, and any idea what it might be worth when you IPO? Any comment there that you can --

Edgar Masri

There is no way I could even say anything on that front, as you could totally understand, I hope.

Mark Sue - RBC Capital Markets

Just thought I’d try. And just one last question on H3C, you commented on the fact that the growth rate is slowing. How should we think about that going forward? I mean, that’s kind of been your star performer in terms of growth. Now it seems to be slowing.

Edgar Masri

Obviously Jay and I highlighted that integration has been taking a lot of the management bandwidth. These integration efforts will continue over the next six to nine months but they are tailing off in terms of taking time from Dr. Zhang and his team and you could quickly imagine how they are going to be very much refocused on sales and outside performance.

Jay Zager

If I could just add to that; looking at it going forward, I think there are two or three key points. One is the China market is growing and is projected to continue to grow. You can guess as to what the growth rates are but I think a consensus would be somewhere in the 12%, 15% range.

And secondly, in the case of H3C, we are expecting that there will be a substantial increase in sales of H3C products through the DVBU, and that obviously won’t have a complete flow-through impact on our bottom line revenue, it bodes very well for our H3C projections.

Mark Sue - RBC Capital Markets

Okay, great. Thank you very much.

Operator

We’ll take our next question from Scott McCabe with Lehman Brothers.

Scott McCabe - Lehman Brothers

Hey, guys. Can you give more details as to -- around the integration issues that are causing the H3C revenue to decelerate? And then, what is being done to reverse this trend? When do you expect it to reverse?

Edgar Masri

These integration activities are necessary and we’ve been planning for them all along, but you could imagine that it takes time for management to sit down in various meetings we have. We have 11 sub-groups covering various areas from supply chain all the way to service and support, and some of them have made great progress and they are behind us on the branding, so I expect a lot of the marketing activities that were inwardly focused on measuring what the branding activities should be like now to be more outwardly focused.

It is still going to be six to nine months, don’t get me wrong, but we are not factoring it more accurately and I expect the impact to be more towards some of the infrastructure activities and less on the sales and marketing side.

Scott McCabe - Lehman Brothers

Okay, and how many employees did you lose from H3C this quarter?

Jay Zager

We don’t track it at that level. One of the things that happened, as an example, is we transferred a bunch of H3C employees over to our traditional DVBU business as we move through the integration. So as we integrate and as we make adjustments, it becomes very hard on a consistent basis to look at the H3C population on a stagnant basis. We don’t go back and restate for prior periods.

Edgar Masri

And one very important point is the whole management team at H3C is still intact. I think from that point of view, it beats any acquisition that has taken place anywhere in the world and we have people who know the business, who are very committed and working very, very hard. That is a pleasure to know and to be able to count on.

Scott McCabe - Lehman Brothers

Okay, and then going to the overall market, do you think that the -- you know, the results would suggest that the market is slowing down or you lost share. Which one would that be?

Edgar Masri

Typically we find out our market share data about a quarter in arrear, just because the data for Q2, for Q3 will be coming out in a couple of months. My sense is perhaps the market has slowed down for a short period of time in China, I don’t know. But if it hasn’t, we may have lost a bit of share. I don’t think it is major and I think if it is, if it indeed happened, it is temporary. But we won’t know for sure for another quarter.

Scott McCabe - Lehman Brothers

Okay. What verticals were strong and what were weak? And then, within EMEA, what countries were strong?

Edgar Masri

So you are talking about the --

Scott McCabe - Lehman Brothers

Overall, what verticals were strong, which were weak?

Edgar Masri

Overall, think about it; Q1 is typically an education quarter. We are very strong in education, so we benefited from that across the board, across all geographies. We had maybe at the tail end also some deals around government, specifically in Latin America. There was a very, very large deal that was a combination of Tipping Point, voice, and gigabit switching.

In terms of your other question was what countries in Europe, it’s primarily Western Europe, sort of England, France and Germany. But we were very pleased with the performance of Europe across the board. And as important as the top line is the contribution margin of Europe continues steadily to improve.

Scott McCabe - Lehman Brothers

Great. Thanks a lot.

Operator

That does conclude our question-and-answer session. At this time, I would like to turn the call back over to, Mr. Masri, for any additional or closing remarks.

Edgar Masri

Thank you, Operator. Appreciate it. Thank you, everybody, for being on the call. We are very excited again about sharing those results with you and we are forging ahead towards a great Q2 performance. Thank you.

Operator

That does conclude today’s conference. Thank you for your participation. You may disconnect at this time.

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Source: 3Com F1Q08 (Qtr End 8/31/07) Earnings Call Transcript
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