Foundry Networks Q4 2005 Earnings Conference Call Transcript (FDRY)

Foundry Networks, Inc. (FDRY)
Q4 2005 Earnings Conference Call
January 26th 2006, 5:00 PM.

Executives:

Quinn Winn, Financial Dynamics
Bobby R. Johnson Jr., President and Chief Executive Officer
Timothy D. Heffner, Chief Financial Officer

Analysts:

Christin Armacost, SG Cowen
Stephen Kamman, CIBC World Markets
Wojtek Uzdelewicz, Bear Stearns.
William Becklean, Oppenheimer
Kenneth Muth, Robert W. Baird
Cobb Sadler, Deutsche Bank
John Mark Duncan, Pacific Growth Equities
Tal Liani, Merrill Lynch
Jiong Shao, Lehman Brothers
Andy Schopick, Nutmeg securities
Samuel Wilson, JMP Securities
Long Jiang, UBS
Gina Sockolow, Buckingham Research
Alex Henderson, Citigroup
Tim Long, Banc Of America Securities
Subrahmanyan, Natarajan, Sanders Morris
Mark Sue, RBC Capital Markets

Presentation

Operator

Welcome to the Foundry Networks Fourth Quarter 2005 Earnings Conference.
Operator Instruction I would now like to turn the program over to Quinn Winn of Financial Dynamics, go ahead please.

Quinn Winn, Financial Dynamics

Thank you operator and good afternoon everyone. Thank you for joining us for the Foundry Networks Fourth Quarter 2005 Earnings Conference Call. I am joined today by Bobby Johnson, President and Chief Executive Officer; and Timothy Heffner, Chief Financial Officer at Foundry Networks. Earlier this afternoon the company issued a release reporting its fourth quarter financial results. This release can be accessed from the Investor Relation section of Foundary’s website at www.foundrynetworks.com.

For reference we‘ve arranged for a taped replay of this call, which maybe accessed by phone. This replay will take effect approximately one half hour after the call concludes today and will available for seven days. The dialing access number for this replay is 402-220-2567. The call is also being webcast live with the web replay also available. These may both be accessed from the Investor Relations section at Foundry’s website.

Before we begin, I would like to make a brief statement regarding forward-looking remarks. The call today 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 filed 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 31st 2004 as well as the Safe Harbor statement and the press release 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 information contained in today’s call. Now I would like to turn the call over to Bobby Johnson, President and CEO of Foundry Networks.

Bobby R. Johnson Jr., President and Chief Executive Officer

Thank you Quinn. Good afternoon everyone. Turning first to the revenues for the fourth quarter of 2005 of $116.1 million, 9% sequential increase from $106.6 million in the September period and 11% increase over the last year’s $104.8 million fourth quarter results. We reported an operating profit of $26.7 million and a net income of $20.6 million. This represents a quarterly revenue record for Foundry Networks. Our book-to-bill ratio continues to be greater than the one during the quarter. There were so many successes that we experienced during the fourth quarter, I would like to review these beginning with our financial highlights.

First, our 9% sequential revenue growth reflects strength across almost all geographies in the European markets. The US enterprise and Asian markets delivered robust growth in the fourth quarter with Japan representing approximately 12% of revenue. The fourth quarter results reflect investments made over the last several quarters particularly in our sales footprint and product portfolios.

Second, revenue for the US Federal Government with strong even in the absence of US Federal budget. US federal represented 21% of total revenue in the fourth quarter.

Third, our gross margins did continue to be strong for the last 16 months.

Fourth, we generated approximately $47 million in cash for the quarter, leaving us with $746 million in cash; this represents over $1 million in cash per employee and leaves us with significant growth and investment options for the future.

Next, I would like to address five additional key product and operational highlights of the quarter. The first key product highlight in the quarter was strength and demand and shipment of our new flagship product line: The BIGIRON RX Series. The BIGIRON RX platform was announced in the second quarter of 2005 and began revenue shipments in the third quarter. Shipments in Q4 more than tripled over the third quarter. We have received great interest from such sectors like premier universities, key research labs, very large enterprises and many leading service providers.

The second part of highlight of the quarter, we will start with file testing of our new NetIron router family: the NETIRON XMR series. The XMR is a complete product family of small, medium and large chassis family members. It has up to twice the switching and routing capacity of any other single MPLS router in the market. It sets new levels of price performance and scalability for both service providers and even large enterprises looking to deploy MPLS backbones and are interested into cost savings associated with long haul Ethernet infrastructures versus SONET infrastructures. The XMR series did receive orders last quarter and we began revenue shipments of the XMR in the first quarter of 2006.

The third product highlighted the quarter was in our Layer 4-7 Traffic Management portfolio. We had several successful bidder files of new Layer 4-7 as it’s our Traffic Management module. It is now shipping in this calendar Q1 of ‘06 quarter for revenue. The fourth set of product highlights for Q4 ‘05 included a record number of wireless units, a record number of 10 Gigabit Ethernet port shipments, a record number of PoE port shipments and a record number of Gigabit Ethernet over copper port shipments.

And the fifth operational highlights of the quarter was that we had 427 new customer wins during the quarter, which is our largest number of new customer wins in a single quarter. We now have a worldwide install base of nearly 9300 end-users.

We are carefully implementing key product transitions and solutions that refreshes, every year, we introduce more new products than the prior year. Our R&D in intelligent investments are continually increasing and we are experiencing excellent reception for our new products.

During the quarter, we generated approximately 80% of our revenues from the overall enterprise and cluster computing environments. We generated the remaining the 20% of our revenues for the worldwide service provider markets. I will now turn the call over to Timothy Heffner, our CFO.

Timothy D. Heffner, Chief Financial Officer

Thank you Bobby, and good afternoon everyone. I am pleased to present our financial results for the fourth quarter and the year-ended December 31st 2005. Foundry posted record quarterly revenue for the fourth quarter of 2005 of $116.1 million, that’s compared to $106.6 million in the third quarter of 2005, and $104.8 million in the fourth quarter of 2004. This was an increase of 9% and 11% respectively. We continue to generate a profit, posted an operating profit of $26.7 million, a net income of $20.6 million. Diluted earnings per share were $0.14 for the fourth quarter of 2005 compared to $0.11 per share in the third quarter and $0.12 per share in the fourth quarter of 2004. Our revenue for the year-ended December 31st 2005 was $403.9 million compared to $409.1 million for 2004. Net income for the full year of 2005 was $56 million or $0.39 per diluted share compared to $48 million or $0.34 per diluted share for 2004.

During the fourth quarter of 2005, our Federal business grew slightly in absolute dollars representing 21% of total revenue compared to 22% in the previous quarter. Our America’s enterprise business represented 49% of total revenue. Our overall domestic revenue was 70% of our total business and our international business represented 30% of the total. This compares to 72% for domestic and 28% for international sales in the third quarter. Sales in Japan this quarter increased significantly representing 12% of total revenue. Our enterprise business was again our primary source of revenue. Enterprise customers accounted for approximately 80% of our total revenue for the fourth quarter. The revenues from our chassis-based products decreased slightly compared to the third quarter representing 69% of revenue in the fourth quarter of 2005.

Our gross margins were 61.3% for the fourth quarter compared to 62% for the third quarter, a decline of 70 basis points. The product gross margins declined primarily due to product mix and an additional inventory reserve taken at year-end associated with product transition, which is running slightly ahead of plan.

The service gross margins were of 300 basis points sequentially due to a benefit of the year-end reserve adjustments. Looking at operating expenses like: Research and Development was $12.2 million, which was nearly unchanged from the third quarter; R&D expenses represented 11% of revenue in the fourth quarter compared to 12% in the third quarter; Sales and marketing expenses was $25.6 million, representing 22% of total revenue in the current quarter, down slightly from $25.8 million in the third quarter. The decline was related primarily to lower marketing cost offset by increased headcount in the sales organization.

In the fourth quarter of 2005 G&A spending was $7 million, down 26% from $9.6 million in the third quarter of 2005. The $2.5 million decrease was due to the one-time cross-license agreement with IBM, which impacted Q3. Foundry delivered $26.7 million or 23% operating margins and net income of $20.6 million in the fourth quarter of 2005. This compares to an operating margin of $18.3 million or 18% of revenue and net income of $16 million in the third quarter for 2005.

Earnings per diluted share were $0.14 for the fourth quarter of 2005 compared to $0.11 for the prior quarter. Our tax rate for the quarter was 37% as compared to 31% in the third quarter of 2005. The increase was primarily due to our year-end adjusted of deferred tax assets. Our cash and investments at the end of Q4 totaled $746.4 million, which is an increase of $47.4 million from the third quarter. Year-over-year our cash balance grew $128.9 million.

DSOs were 61 days down from 65 days in the third quarter. Our book-to-bill ratio was again greater than one. We ended the year with 737 employees, an increase of 27 people mostly in the sales organization and to a lesser degree Research and Development. With that I’ll now turn the call back to Bobby.

Bobby R. Johnson Jr., President and Chief Executive Officer

Thank you Tom. On balance, we are pleased to be making progress as Foundry continues in its quest to be a total solutions provider for IP-centric enterprise and service provider environments. For the enterprise markets we offer wireless access routing LAN switching securities and Layer 4-7 traffic management solutions. With campus backbones workgroup, data center mobility and online applications.

For the service provider markets we offer Metro, data center, core routing, access routing and web hosting solutions for emerging as well as existing infrastructures and providers. During the first quarter 2006 we’ve already begun shipping integrated SSL security features in our Layer 4-7 products and also we’ve begun revenue shipments of our first dedicated security products to enable new levels of innovative security and access protection for our customers.

We have an installed base of approximately 9300 Gigabit and 10 Gigabit Ethernet customers around the world and it is estimated that we lead the 10 Gigabit Ethernet for Layer 3 market. Additionally, the largest consumers of Layer 4-7 switches are standardized on Foundry and we have among the largest installed base in Layer 4-7 switches.

We’ve now concluded seven consecutive years of net profits and we are continuing to invest in Foundry. We’ve added a significant amount of headcount in the last 12 months and of course see 2006 as a continued investment year for Foundry. I would now like to turn the call over to the operator for questions and answers.

Questions & Answers

Operator

Operator Instructions We will take our first question from the side of Mark Sue with RBC Capital Markets. Go ahead please.

Q - Mark Sue

Thank you. Just on your guidance for the March quarter directionally how we should model the revenues, if you could just help us there first of all, Bobby?

A - Bobby Johnson

On this call, we are not giving guidance for Q1. Traditionally we have strengths in certain geographic areas and we have weaknesses in certain geographic areas. Additionally Q1 is going to be a little bit of an additive but also a transitional period for us since we ramp up the new XMR series. And we are looking at where all of the Federal budget dollars go. So we are not providing specific forward guidance for Q1 on this call.

Q - Mark Sue

Maybe then if you can help us understand the level of topline growth that you might be planning for the full year of 2006 or maybe your estimates for the market growth for Layer 3 switching? And if you could just give some thoughts on industry comments?

A - Bobby Johnson

Well I think overall in the first quarter, you mean the first half of 2005, the LAN switching market basically took a breather. All LAN switching companies had some trouble a year ago, to this date I can’t put a very specific rocket or you know a rocket shot explanation of what exactly happened. So we are being a little bit cautious on that but overall in the second half of the year we saw Ethernet switching markets return for us, not only Q3 but obviously Q4 was very good. And we think that overall the economies are improving and in particular for our market sectors, and I think we have high hopes for the long term, for the SP market to return on this arena, specifically with the XMR series.

Q - Mark Sue

Got it. And lastly Japan was leading by others but you had a good quarter there in Japan, maybe just some quick thoughts on Japan?

A - Bobby Johnson

We had a good quarter in Japan. There was a little bit of calling as looking into Q1, Q1 is traditionally a good quarter for us because it is their end of year quarter, their budgeting end of year quarter. But with some events in their NIKKEI, it provides a little bit of problem as for us of what happened over the last 1-2 weeks in Japanese economy. But overall I would say worldwide, we were feeling much better with this quarter than we felt a year ago.

Operator

Thank you. We will take our next question comes from the side of Subrahmanyan Natarajan for Sanders Morris, go ahead please.

Q - Natarajan Subrahmanyan

Hi thanks. First, could you give us the split between LAN and Layer 4-7 and the split that you usually give us?

A - Quinn Winn

So Subu, you want the split between LAN and Layer 4 -7 switches?

Q - Subrahmanyan Natarajan

Yes, it's switch LAN and Layer 4 -7 switches.

A - Bobby Johnson

Layer 4 -7 was somewhere between 10% and 15% of revenues last quarter.

Q - Subrahmanyan Natarajan

Okay, and then just moving to gross margins, as some of the service provider products ramp and some of your new products ramp, can you just can talk about what you expect for gross margin in the March quarter, and just kind of the progress into 2006?

A - Timothy Heffner

Subu, this is Tim. Although our gross margin flipped slightly, we continue to believe that we can maintain our margins in the 60% to 65% range. We have the basic philosophy that we either are first to market or early to market, the new products which typically carry higher gross margins and as older products mature, we tend to see erosion on gross margins but the blended average should allow us to maintain our overall gross margin between 60 and 65.

Q - Subrahmanyan Natarajan

And final quick question on OpEx, as you see revenues, continued revenue growth opportunities in ’06, I think you made a comment talking about ’06 being a continued investment period. Should we see a similar kind of OpEx edition in ’06, as we saw in ’05 versus 2004?

A - Timothy Heffner

Well, I think, we do, we’ve not had a history of growing the infrastructure too far ahead of the topline. We will make the necessary investments to continue to grow the topline. But as we previously stated we believe we can maintain our operating margins between 20% and 25% though. You got to get a feel for where the operating expenses will fall.

Operator

Thank you. We will now take our next question from the side of Tim Long with Banc Of America Securities, go ahead please.

Q – Jeff Flubber

Good afternoon. This is Jeff Flubber calling in for Tim. Just to dig into Japan a little bit more, how much of the success that you saw in Japan this quarter was from new products and have you seen any change in spending behavior by the carriers?

A - Bobby Johnson

Okay, so...

Q – Jeff Fuller

Are you winning deals that maybe went to router vendors previously?

A - Bobby Johnson

Well certainly we feel though we are having success in the service provider router market. We have a series of products that can be sold into the router and into the SP world. They are primarily the MGXs to 40Gs, the RXs, the IMRs and XMRs. If you take a look at all of that combined, we sold more routers into the service provider market last quarter than we’ve ever sold in a single quarter in our history. So, and Japan is one of our stronger SP market. So if you ask we think we are having a good success in the Japanese service provider market but I believe, I want to focus people there on the long-term, there will be some investments that we are making in the router market for the long-term to gain even greater foothold than we have previously.

Q – Jeff Fuller

And then how much revenue did you recognize this quarter that came from deals originally scheduled to close last quarter, can you quantify that somehow?

A - Bobby Johnson

I am not quite sure...

Q – Jeff Fuller

There was some deals that were pushed out last quarter due to high priority federal orders?

A - Bobby Johnson

Well, couple of different things. I can’t answer exactly what you ask but I don’t event know if I have got all that data, so…

Q – Jeff Fuller

Okay.

A - Bobby Johnson

…let me kind of give you the flavor. Two things, one is our book-to-bill continue to be greater than one it has for maybe infinity. So book-to-bill is greater than one and our federal business remained strong in Q4, not just in Q3. So and because of where we sell in Federal still a significant percentage of our orders come in March priority. There is different priority ratings but in general the federal team gets on average more priority on the manufacturing floor than many of our other sectors. So in other words coming out of Q4 is not a whole lot different than that coming out of Q3.

Operator

Thank you. We will take our next question from the side of Alex Henderson with Citigroup, go ahead please.

Q - Alex Henderson

Thanks. First just a tone of management thinking comment. The stock was indicating up quite a bit on the earnings release this afternoon and you just said you weren’t offering guidance that promptly sold-off. So I just want to get some clarity, first of all that you haven’t been offering guidance, so this is no new news and second the lack of guidance is not an indication of concern about the outlook for 1Q or beyond?

A - Timothy Heffner

I think, it’s always our objective to grow the topline quarter-over-quarter. We are affected by seasonality, federal budget, all kinds of things but we certainly have objective to continue and grow the business.

Q - Alex Henderson

But certainly the lack of offering guidance is not an indication of any concern about the outlook?

A - Timothy Heffner

That’s for right.

A - Bobby Johnson

If we look over last year, we haven’t provided guidance and have added $32 million a quarter in the last third quarters to the topline.

Q - Alex Henderson

And I just wanted to make sure that they have understood, that’s the stamp there. And second on, a more important question, can you go through where you are on your sales hiring, what you did in terms of hiring new staff in the fourth quarter for sales? How that staff – what the increase in the staff was is a percentage of staffing year-over-year for the full year and what’s your expectations are for additional sales hires as we go into ’06?

A - Bobby Johnson

Well, our objective is to continue to add sales because we are a direct sales moderator, a great touch model I would like to refer to ourselves. We don’t use distributors, so if our guys making to call or working with our partners, resellers of ours and so forth, making joint calls to make the end sale. So the way we look at it, the more feat of the street, the more we could affect the topline. The challenge is always finding qualified people, they are highly technical sales, just can’t take any salesperson, that person need to have an engineering background. And so we will continue to increase the heads as we go, year-over-year our total company is going from, its gone from 658 to 737 and….

Q - Alex Henderson

You are not total staffing, right?

A - Timothy Heffner

Absolute staffing and as we say, the majority of those people end up in sales and in R&D.

Q - Alex Henderson

Can you tell us what the least, just what the percentage change in the sales staffing was during last year or during the fourth quarter, quarter-to-quarter?

A - Timothy Heffner

Wait I will pull up my calculator.

A - Bobby Johnson

Okay, I will give you a round number. I think the headcount increase in terms of quarter sales people it’s between 35% and 40% and it is our goal to at least do that this year.

Operator

Thank you. We’ll take our next question from the side of Gina Sockolow with Buckingham Research, go ahead please.

Q - Gina Sockolow

Thank you. Could you explain, just going back to the third quarter why there was a half a million-dollar reduction in the revenue numbers. Than what was reported in the SEC filings is different from (multiple speakers) quarters?

A - Timothy Heffner

Last quarter?

Q - Gina Sockolow

Yes.

A – Mike Hybrid

Hi Gina, this is Mike Hybrid. So that was just a timing issue between September and October. So as we run into a project discount which we went back and allocated a portion of it to our partial shipment in September. So it's not a big deal its own course of business.

Q - Gina Sockolow

Did any other shipments fall into this quarter from prior quarters?

A – Mike Hybrid

No, it wasn’t a factor of falling into the quarter was a project that we shipped half of that in September, and other half in October but we normally take a project discount at the end. We went back and allocated half of that to the first half of the shipment.

Q - Gina Sockolow

Great, thank you

A – Mike Hybrid

Sure.

Operator

Thank you. We will take our next question from the side of Long Jiang with UBS, go ahead please

Q - Long Jiang

Yes hi, one question for Bobby and one question for Tim. First of all, can you comment about your trial activities with IMR and XMR and I think a quarter ago you mentioned you expect XMR to achieve volume shipment in 2Q or 3Q and given your experience so far do you think is that tracking according to plan? And the second question is regarding to your, if you have any guidance for option expense that you are starting fiscal ‘06 now so any comments will be helpful? Thanks.

A - Bobby Johnson

Okay, so I will take the first part. On IMR and XMR, both prospective customers, they are being bogged, and I would say worldwide the service providers: Backbone carriers, Metro carriers and even big enterprises and big government sectors. So right now interest in the XMR, which really is going to replace the IMR is at or near the top of our expectations, we went through nearly ten trials with the XMRs with lots of purchases, we still have trials, we have a lot of new trials starting and we did not ship the XMR in calendar Q4 of ’05 for revenue. But we have already begun revenue shipments of the XMR in January of ‘06. So we are in hard-collecting revenue on XMRs but like the carrier market of the past we expect it to be a little bit up lumpy, so we will expect build-out some trials and some trails will basically bring the result quickly and some will go on for extended periods of time. But right now, I am very pleased with the XMR progress and overall, I would want to caution people that I believe the XMR is really a long-term 18 to 24-month ramp but I am happy with where we are already.

A – Timothy Heffner

Okay, now this is Tim. On the option expensing, you know I am sure the companies are – they are experiencing just warming up to it now because its gets starting January 1, but the early estimates we didn’t come with it. We believe it will be somewhere between $5 and $6 million charge per quarter for the options that are out there. Now we’ll know more later this quarter as we refine those numbers but that’s my best guess at the moment.

Q - Long Jiang

$5 to $6 million before or after-tax?

A – Timothy Heffner

After-tax.

Q - Long Jiang

Great thanks gentlemen.

Operator

Thank you, we’ll take our next question from side of Samuel Wilson with JMP Securities, go ahead please.

Q – Samuel Wilson

Thank you. My question was answered, it was on stock options.

Operator

Thank you, we’ll take our next question from the side of Andy Schopick with Nutmeg Securities. Go ahead please.

Q – Andy Schopick

Thank you. Two quick questions for you Tim, and then I want to go back to Bobby. First of all you made reference to an inventory reserve that was taken as one of the reasons for the decline in product gross margins. Can you specify what that was, if I look at the cash flow statement I just see a change of just over $3 million from the third quarter to the fourth quarter, is it all, is that what it is?

A – Timothy Heffner

We did $3 million provision for the quarter and we did $1.5 million write-off, so the net increase in the reserves was $1.5 million.

Q – Andy Schopick

Did that increase was 1.5?

A – Timothy Heffner

Yes.

Q – Andy Schopick

Okay and also on the international. For the year what was the percentage in 2005 versus 2004 do you have that number?

A – Timothy Heffner

I don’t, you know but it has to be somewhere around the 30% range.

Q – Andy Schopick

Okay and Bobby if I can come back to you. I just like to ask you if you could comment at all or give us your views on what the current dynamics are in the service provider market that might help to improve the overall growth outlook or opportunities whether you see anything in particular that you would care to highlight on the service provider front?

A – Bobby Johnson

Okay I think there are several different aspects of the service provider market and believe me optimistic long-term. One is obviously the XMRs received good acceptance already. Overall, there is many service providers whether they will be traditional which we call carriers or which we call ISPs or metro providers that are very open to long haul Gigabit and 10 Gigabit Ethernet replacing on it because of really cost, price to them so the account for equipment purchases are substantially less. Also the rollout of worldwide Metro deployments, which has been going on for years but it seems to be gaining steam and there is the whole triple play aspect that is voice, video and data, emerging service providers in that arena. So you’ve got new emerging service providers, you have a little bit of a rebirth in some of the hosting and data center concepts, you’ve got traditional carriers, SAN this Ethernet stuff it was actually okay after all, the SONET stuff maybe seen this day. And for those people some convergence but all of that is good for Foundry because we saw more performance, more scalability and up to 1/10th the price, a big in SONET-oriented routers. And we’re out proving that in many of the world’s toughest environments as we speak.

Operator

Thank you. We’ll take our next question from the side of Jiong Shao with Lehman Brothers, go ahead please.

Q – Jiong Shao

Thanks a few quick questions I hope that’s okay. Tim, first what’s the tax rate we should see going forward?

A – Timothy Heffner

Well that’s option expensing, its going to jump around, so you know if you exclude the option expensing we should be in the 35% to 37% range.

Q – Jiong Shao

Okay great. Bobby, could you also talk about your outlook for the government of vertical I know in the past you have talked about its lumpy but over the last couple of quarters seems to be pretty stable or could you give us an update on that?

A- Bobby Johnson

After really, you know Q1 of last year, we are seeing federal returns of 15% to 22% or so of our revenues. The last two quarters I believe its covered 20% to 22% of revenues. So overall Foundry’s goal is to keep federal strong, grow federal but also to currently grow the diversity of our prospects in install base beyond federal. So we would like to get more vertical and geographic market diversity but not at the expense of not going federal. So we are going to try to grow across the board.

Q – Jiong Shao

Okay. Great and back to Japan, sort of my rough math indicated that sales in Japan in absolute dollars increase over the $5 million, is that in a right ballpark? And I was also wondering do you feel that the very strong performance in Japan maybe sustainable and perhaps should accelerate this quarter because of seasonality?

A- Bobby Johnson

Well, one were to hope for all that but right now we have some shakiness last week or two in the Nikkei and we will be a little bit precautious but yes we are experiencing good demand in the Japanese market. And I don’t know if we will accelerate because we did have particularly good growth similarly to what you pointed out between Q3 and Q4. We are still expecting Japan to be probably our premier international site and certainly our premier Asian circle.

Operator

Thank you. We’ll take our next question from the Tal Liani with Merrill Lynch, proceed please.

Q – Tal Liani

Good after this is Vancouver calling in for Tal. I just wonder if you can discuss the trends in the European business, you mentioned that Asia was strong, Japan recovered well and I was just wondering if you could talk about Europe and also if you can help us understand the seasonality in the US business on the enterprise side, if we exempt the Federal business, what has it typically declined or has it always grown in the March quarter, if you can help us there? And give us perhaps the impact of stock options if they were expensed this quarter? Thank you.

A- Bobby Johnson

Europe grew for us throughout the year. So we are adding as I said we are trying to get more diversity in not just vertical but geographic coverage so from Q1 to Q4 Europe was up 20% or so. But obviously we would like to continue to grow out and have plans to do that. The US economy minus Federal always seems to be unpredictable in Q1. We always come off with a very big Q4 and we run into Q1 and that depends. So I would say right now our note of caution a little bit will be on US enterprise.

A – Timothy Heffner

Okay and then on the stock option expense, we’re still going through analysis than what the appropriate measurement is like Shoulders, one of the Matrix model and so forth but our early estimates as I said earlier will be between $5 and $6 millions per quarter?

Q - Carl

Thanks, if I can just have a quick follow-up on the end, just putting the math on the business in Asia Pacific, and just wondering if you can give us some color on maybe the percent change in revenue during the quarter? And you didn’t mention Europe as a percentage of revenue, did it dip below 10% or you just didn’t mention it because it didn’t perform as well as you hoped in December? Thanks.

A – Timothy Heffner

We’ve not historically given out that level of detail for Europe. We gave out Japan because if you ship to any one specific customer or country that’s greater than 10% of your total revenues you need to call it out. And since Europe and a number of countries we don’t call it out, directionally it’s up quarter-over-quarter.

Q - Carl

Great, thank you.

Operator

Thank you, we’ll take our next question from side of John Mark Duncan with Pacific Growth Equities, go ahead please.

Q - John Duncan

Good afternoon. Bobby, I believe you said that you exited the forth quarter in similar fashion to the third quarter meaning possibly that you exited with some pretty sizable backlog. You talked a little bit in terms of the linearity, which you saw throughout the December quarter and then particularly or specifically I guess Extreme noted that, December had decelerated, can you talk about what your December looked like?

A - Bobby Johnson

Yes so first of all there, the original part of the conversation was about Federal and priority yield each other. So if we look at the percentage of revenue, the Federal quarter-to-quarter was very similar. Secondly, more specifically to your question, overall we were pleased with not just Q4 but every month within the quarter. And we always did a little bit of recalibration in January because we take a week and held a worldwide sales meeting, and so we are recalibrating as we’ve just finished that.

A – Timothy Heffner

If I could add just a slight bit more color on the quarter, this quarter we saw more linearity from month to month than we have in recent quarters and that makes it easier to run the business?

Q - John Duncan

Okay, thank you.

Operator

Thank you. We’ll take our next question from the side of Cobb Sadler with Deutsche Bank, go ahead please.

Q - Cobb Sadler

Thanks a lot. Question, you said that the RX tripled quarter-over-quarter, can you tell us how many months you shipped last quarter and what the growth rate would have been had you shipped for the full quarter last quarter?

A – Timothy Heffner

The RX began shipping in July in Q3, it shipped all three months in calendar Q3 and shipped for all three months in calendar Q4.

Q - Cobb Sadler

Okay great and what percent of revenue is the product can you tell us that?

A – Timothy Heffner

I don’t think we’ll break that out.

Q - Cobb Sadler

Okay. And then on Japan the strength there is a carrier or enterprise and you think if you have taken share in the carrier space in Japan?

A – Timothy Heffner

I think we have pretty good strength in all sectors in Japan. On your second point I think we did well in service providers in Japan, we historically have done well. There is no single quarter can make a trend in that because we have customers that do very large build ups so we have these bubbles when they are purchasing for very large Backbone or Metro build out, they can bubble up. And so what they’ll have to do is take a look at say the next quarter eight quarters to really say we are taking share.

Q- Cobb Sadler

Okay and the trend in the Federal business, the positive trend, do you think that last quarter was more backend loaded and so you saw a better quarter this quarter or do you think it’s really organic streamed products that you are associated with that are helping you grow faster than you have on the last several quarters?

A – Timothy Heffner

I’m not quite sure I understood all aspects of it but I would say that overall we’re getting good repeat business, we’re are getting new wins, we’re getting diversity, you know within federal, and so that helped us in Q4 as I said even in the lack of a Federal budget. So we were pleased with what happened with Federal in Q4.

Operator

Thank you, we’ll take our next question from the side of Kenneth Muth with Robert W. Baird, go ahead please.

Q – Kenneth Muth

On the expense side you guys have done a very good job kind of maintaining your expenses here, you have revenues go up obviously in the quarter sequentially and yet your expenses is, kind of total OpEx came down, is that a trend that can continue or at some point you will have to reinvest more dollars?

A – Timothy Heffner

Well we will always be reinvesting dollars its just a matter of the magnitude of certain bigger events that we do throughout the year. Also, so we do have swings in discretionary budget such as advertising from time to time when we have very big pressures concentrated in the particular quarter over rollout that’s under. So I think you will see still some swings quarter to quarter but we should be increasing our overall investment throughout the year.

Q – Kenneth Muth

Okay now a follow-up, Tim, you alluded to little bit earlier on the gross margin, again you had record revenues in gross margins tick down a little bit, could you just give the more clarity on that?

A – Timothy Heffner

Sure we took a little additional charge for the older product line because the newer products are ramping up a little bit slightly faster than we originally anticipated so we just want to make sure that we don’t get caught with old inventory but there was little bit of product mix in terms of cyclic versus chassis, and a little bit of additions to the reserve. I wanted to also clarify that on the quarter-over-quarter expenses and actually if we exclude the one-time charge for cross-license agreement we did with IBM in Q3, the quarter to quarter they are almost exactly the same, we didn’t – R&D stayed the same, sales and marketing remained the same, and G&A would remain the same excluding that cross-license.

Operator

Thank you, we’ll now take our next question from the side of Matthew Robinson with Ferries Baker and Watts, go ahead please

Q – Mark Donahue

Actually this Mark Donahue for Math, with the XMR release, just one question is there any strategic customers driving the efforts in that products?

A – Timothy Heffner

Well, there is certainly everyone strategic at this stage early in the product cycle. There is nothing that I can publicly disclose at the moment.

Q – Mark Donahue

Okay my other questions were answered. Thank you.

Operator

Thank you, we will take our next question from the side of William Becklean with Oppenheimer, go ahead please.

Q - William Becklean

Thanks this is actually Priya Parasuraman for Bill, just one quick question as you look at your investments for ’06, how do you anticipate that would breakout between hiring new sales people and investing in R&D?

A – Timothy Heffner

We’ll continue to invest in both but obviously when you do have products and you are trying to ramp revenue and market share the larger percentage of investment will go to sales and marketing activity.

Q - Priya Parasuraman

Okay and are majority of the sales people have been hired at international occasions or supposed to the United States?

A – Timothy Heffner

They are going to be hired everywhere.

Q - Priya Parasuraman

Okay thank you.

Operator

Thank you, we will take our next question from the side of Wojtek Uzdelewicz with Bear Stearns. Go ahead please.

Q - Wojtek Uzdelewicz

Hi, this is actually Matt Schimmel for Wojtek. Just couple of quick questions, first of all you are looking at your sales and marketing expenses as of the course of the year, it actually looks pretty much flattish except for the June quarter which is your big tradeshow quarter, can you explain how did that while adding a lot of people?

A – Timothy Heffner

Continual trade-offs, so we do continued trade-offs of advertising, seminars, trenches versus new headcount.

Q - Wojtek Uzdelewicz

Okay. Should I assume that in the December quarter you did payout on your accelerators so that expensing comes on a little bit for the March quarter?

A – Timothy Heffner

Certainly we tend to indeed pay our accelerators at the end of the year especially when you have a record revenue quarter there were indeed accelerators. I don’t have all the calculations in front of me but there are new sales people that have started post December that will be in the expense line for sales and marketing in Q1 and their contribution in Q1 will be marginal as you are getting ramped.

Q - Wojtek Uzdelewicz

So how do you think about your investment in sales and marking then? Are you trying to manage the dollar amount or a percentage of sales or.

A – Timothy Heffner

I am trying to make sure that we build federal re-brand, we treat our existing customers well and we gained new prospects, and getting new prospects is a combination of both hiring and promotional activities, and we do a continual month by month look and planning associated with the trade-offs between the two. So it wasn’t planned to be spend as a percentage of revenue, if it turned out that way that’s okay but it was really looked at on a virtually month-by-month basis what were the best activities we are pursuing at that moment for what we could see for the next 30 to 90 days. I don’t know if you are always paying attention to the percentage of revenue at sales and marketing. We’re just trying to do the right thing at the right time.

Quinn Winn, Financial Dynamics

Thanks Matt.

Operator

Thank you, we’ll now take our next question from the side of Stephen Kamman with CIBC World Markets, go ahead please.

Quinn Winn, Financial Dynamics

Alright, is there anyone else on the line operator?

Operator

Yes, we’ll take our next question from the side of Christin Armacost with SG Cowen, go ahead please.

Q – Lucas Bianchi

Hi this is Lucas Bianchi for Christin. I was wondering if you could somehow quantify whether most of the recent increases in revenue have come from new sales people or new products and maybe one way to get there is if you can kind of describe to us what has occurred with sales people that has been there over a year in terms of absolute sales level?

A – Timothy Heffner

Oh I think the answer is yes. Part of any investment strategy is to get return on that, we certainly wouldn’t have the sales headcount today, I must have filled the – the sufficient number of them were indeed adding to topline, and secondly part of the reason is having for everybody is the new product cycles.

Q – Lucas Bianchi

So in terms of sales people who have been there over a year, could you quantify what kind of increased sales per salesperson that would be or that have been?

A – Timothy Heffner

I am not tracking it with that level or that specific view because when you take a salesperson’s territory, sometimes you are splitting their territory. So sometimes a person can deliver a last year-over-year but you still feel good about them because you took so much accounts wherein you give to some new guy. So I’m looking at it a little bit more strategically than that focus.

Operator

Thank you, we are out of time for questions. I will now turn the call back to Ms. Winn for any closing remarks.

Quinn Winn, Financial Dynamics

Actually our CEO, Bobby Johnson is going to make the closing remarks.

Bobby R. Johnson

Well I want to thank everybody for joining. I want to remind everybody that indeed I think our new products are gaining traction. We are gaining traction in our traditional markets and I think we are gaining traction in new revitalized adjacent markets. I’m happy with the progress of our new sales hires. I am happy with the progress of hiring on the sales front. And obviously in this year I believe ‘06 will be an investment year very similar to ‘05. Right now Federal appears to be doing much better compared to Q1 of last year and Federal basically did fairly well as 27% in Q3 and Q4. And I would say right now our level of dual activity and level of interest at Foundry remains solid. Once again I would like thank everybody for joining us this afternoon. Thank you.

Quinn Winn, Financial Dynamics

Thanks everyone.

Operator

This concludes today’s conference, thank you for your participation, you may disconnect at anytime.

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