Network Equipment Technologies F3Q08 (Qtr End 12/31/07) Earnings Call Transcript

Network Equipment Technologies (NWK)

F3Q08 Earnings Call

January 31, 2008 5:30 pm ET

Executives

Leigh Salvo – Investor Relations

John F. McGrath, Jr. - Vice President and Chief Financial Officer

C. Nicholas Keating - President and Chief Executive Officer

Analysts

Eric Buck - Brean Murray, Carret & Co.

Greg Mesniaeff - Needham & Company

Nick Farwell - Arbor Group

[Joel McCullen] – [West Coast] Associates

Bob Stafford - Stafford Capital

Michael Prouting - 10K Capital

Operator

Good day ladies and gentlemen, and welcome to the Q3 2008 Network Equipment Technologies earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call Leigh Salvo of Investor Relations.

Leigh Salvo

Thank you and welcome everyone to our call this afternoon, during which we’ll discuss results for Network Equipment Technologies third fiscal quarter of 2008. With me today are Nick Keating, President and CEO, and John McGrath, CFO.

In keeping with the Safe Harbor Provisions of the Private Securities Litigation Reform Act, I want to remind everyone that we will be making some forward-looking statements and projections today, including those relating to future revenue, operating results and financial conditions.

Investors are cautioned that these statements are based on current estimates and assumptions that involve risks and uncertainties that might cause actual results to differ materially from those expressed or implied in the forward-looking statements.

These risks and uncertainties include market acceptance for our new products, timely completion of product development initiatives, new competition and technological changes, the successful integration of Quintum’s operation, success in building new sales channels, circumstances regarding specific sales that can affect the recognition of revenue, effective completion of the transition of contract manufacture and other risks, including those identified in the company’s filings with the SEC including Forms 10-K and 10-Q and in other press releases and communications.

The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Additionally, though an audio archive of this call will be available on the company’s website for at least 12 months, the statements made on this conference call are only made as of January 31st, 2008 and we disclaim any duty or intention to update forward-looking statements.

In addition to financial measures presented in accordance with GAAP, we will also be discussing certain non-GAAP financial measures that are adjusted from results based on GAAP to exclude certain expenses, gains and losses. These non-GAAP measures should not be considered a substitute for or superior to GAAP results. Please refer to the press release issued today for further detail regarding the non-GAAP measures. Reconciliations to GAAP can be found in the press release, which is posted on our website.

Our agenda today begins with NET CFO, John McGrath, who will provide a detailed review of our financial results. Nick Keating, CEO will then comment on the quarter’s financial and operational highlights. John will then offer financial guidance for the remainder of this fiscal year and we’ll open the call for your questions.

At this time, I would like to turn the call over to John McGrath.

John F. McGrath, Jr.

Thank you, Leigh. In the press release issued today and available on our website, we reported that total revenue for the third quarter of fiscal ‘08 was $29 million, up 6% from the prior quarter and up 32% from the third quarter of fiscal ‘07.Revenue for the third quarter of fiscal ‘08 included $1.1 million, recognized by Quintum following the completion of the acquisition on December 4, 2007.

Product revenue was $25.5 million, a 6% increase from the prior quarter and a 31% increase from the same period last year. Government product revenues were $21.2 million in the third quarter, representing a decrease of 7% sequentially and an increase of 17% from Q3 last year. However, the sequential decrease was more than offset by the increase in international and enterprise sales.

Promina revenue, as a percent of total product revenue was 54% in both Q3 and in the prior quarter and 69% in Q3 fiscal ‘07. Service and other revenue of $3.6 million was 12% of total revenue.

Service and other revenue was relatively flat compared to Q2, but up 35% compared to the third quarter last year. The increase resulted primarily from revisions made to our relationship with CACI in the fourth quarter of fiscal ‘07. Under the new arrangement, both companies self services for any two products. Each company is responsible for various aspects of service delivery and revenue from service is shared between both parties.

Gross margins as a percentage of revenue declined to 49.3% in Q3, compared to 53% in Q2 and 54.7% in Q3 last year. As a result of decreases in our product margins arising from transition cost related to the move to Plexus, our new contract manufacturer and non-cash charges from our acquisition of Quintum Technologies.

Product margins as a percentage of revenue were 54.2% in Q3, compared to 58.7% in Q2 and 61.1% in Q3 of the prior year. Product margins in the most recent quarter were impacted by $1 million of cost and charges related to moving to our new contract manufacturer, including transition costs of nearly $500,000 of cash charges and non-cash charges of an additional $0.5 million for inventory sold at less than our carrying values. In Q2 ‘08 and Q3 ‘07, the total of these costs were approximately $600,000 and 0 respectively.

Product margins were also affected by costs of approximately $150,000 for approximately one month’s amortization of intangible assets acquired and new stock options issues to employees in connection with our acquisition of Quintum during the quarter. The year-over-year decline in product gross margins was also affected by product mix as Promina is now a lower proportion of total revenue, even though total Promina revenue was flat year-over-year.

Service and other margins in Q3 increased to 14.2%. This is up from 11.9% in the prior quarter and up from 8.2% in the second quarter of the prior year. Service margins in fiscal ‘08 have been aided by our new revenue sharing arrangement with CACI.

Third quarter operating expense was $13.7 million and consisted of $695,000 for Quintum, representing three and half weeks of expenses, and $13 million for NET. The Quintum-related expenses included stock compensation charges of $41,000 and amortization of intangible assets of about $50,000.

NET-related operating expense of $13 million is down from $13.5 million in the prior quarter. The decrease in non-Quintum related expense was in large part due to lower fringe costs, which are traditionally less in calendar Q4 as employer FICA limits and employer benefit matches reach maximums, as well as decreased incentive compensation costs.

Operating expenses excluding Quintum decreased from $13.2 million in Q3 of the prior year as a result of a decrease in rent and facilities charges of approximately $850,000 a quarter, related to the write-off of an under-utilized facility in Q4 ‘07, offset by increases in stock compensation charges and investments in sales and engineering.

Sales and marketing expense was $5.1 million and consisted of $260,000 for Quintum and $4.8 million for NET, up slightly from $4.7 million in the prior quarter and flat as compared to Q3 of the prior year.

R&D expense was $5.8 million and consisted of $238,000 for Quintum and $5.6 million for NET, down from $5.9 million in the prior quarter and up from $5 million in Q3 last year. The sequential decrease was due to less engineering-related expenses, which typically fluctuates based upon the timing of new products, as well as decreases in fringe benefit costs and variable compensation. The increase from the prior year is primarily due to expanded investment in our VoIP product line.

General and administrative expense was $2.8 million and consisted of $197,000 for Quintum and $2.6 million for NET, down from $2.8 million in Q2 and $3.3 million in Q3 of the prior year. It should be noted that Q2 ‘08 has a one-time charge of $160,000 for the acceleration of stock option vested, related to a retiring board member. The decrease from the prior year is primarily due to the elimination of expenses related to under-utilized facilities, offset by increases in compensation expenses related to additional head count.

Total head count at the end of Q3 was 310 employees, including 73 new employees who joined NET as part of the Quintum acquisition. Excluding these new employees, we saw a decrease of 6 head count from the end of the prior quarter. Total charges for stock compensation resulting from FAS 123R were $769,000 in Q3.

Amortization of intangible assets related to Quintum in Q3 was approximately $200,000. Other income in the third quarter was $254,000 compared to other income of $14,000 for Q2 and expense of $16,000 in Q3 of the prior year. The income in the most recent quarter was from the realized gains on investments liquidated for the purchase of Quintum.

Net interest income for Q3 was $676,000, compared to $675,000 in the prior quarter and $511,000 in Q3 of the prior year. The improvement over the prior year was primarily the result of increased deals in our investments and higher cash balances.

The third quarter had tax expense of $47,000, as compared to $101,000 in the second quarter of this fiscal year and a $1,000 benefit in the third quarter a year ago. Although we have significant tax loss carry forwards, we still incur tax expense as a result of international taxes in U.S. Federal alternative minimum tax.

Turning to net income, the company reported non-GAAP earnings in Q3 of $2.6 million or $0.09 per share, compared to $2.5 million or $0.09 per share in Q2 and a net loss of $292,000 or $0.01 per share in Q3 a year ago. GAAP net income in Q3 was $1.5 million or $0.05 per share, compared to GAAP net income of $1.6 million or $0.06 per share in Q2 and a net loss of $599,000 or $0.02 per share in the third quarter of fiscal ‘07.

Cash balances at the end of Q3 were $161.2 million, up from $97 million at the end of Q2. In Q3 fiscal ‘08, we received net proceeds of $82.2 million from our $85 million convertible senior debt offering and we used approximately $24 million of cash for the acquisition of Quintum.

Additionally, the company increased cash in investments by more than $6 million from operations. Accounts receivable were $20.4 million, including $1.3 million of accounts receivable acquired from Quintum. Compared to the prior quarter, this represents an increase of $4.4 million and an increase of $7.6 million from the third quarter of the prior year. The increases are primarily due to higher revenues and receivables acquired from Quintum.

DSOs at 59 days increased from 53 days in both the preceding quarter and the third quarter a year ago. The increase from the prior period is due mostly to the timing of shipments in the quarter. Our target DSO remains between 60 and 70 days.

Net inventory was $12.9 million in the third quarter, including $2 million of inventory acquired from Quintum. Compared to the prior quarter, this represents a decrease of $1.4 million or excluding the additional Quintum inventory, a decrease of $3.4 million, which resulted primarily from sales of inventory to our new contract manufacturer. Inventory increased $4.1 million, compared to the third quarter of the prior year, as a result of the build up of inventory preceding our move to a new contract manufacturer and the inventory acquired from Quintum.

In summary, this was a challenging but exciting quarter for NET. We began the quarter with a launch of a new ERP system, which we expect will provide an IT platform for growth at a lower cost than our previous Oracle system.

Throughout the quarter, we made progress in transitioning to our new contract manufacturer. Although these costs remain high in the short-term and the transition has used a significant amount of our internal resources, this change is core to our strategy to reduce costs and improve efficiencies.

We believe that Plexus will ultimately provide us with a full outsourced model, with a scale to grow our business and manage our manufacturing cost and product risk margins going forward. Additionally, Plexus’s financial strength offers us a greater piece of mind that our sole-source manufacturing supplier will not be severely affected by changes in the economy.

Early in December we completed the Quintum acquisition. We continue to work on the integration to insure that it goes smoothly and that we maximize the strategic benefits of this business combination.

Finally, the $85 million convertible senior debt offering augments our solid balance sheet and will enable us to take advantage of strategic opportunities as they arise despite the recent downturn in the stock market. Our successful execution on each of these challenging initiatives in a single quarter bears pointing out. To that end, Nick and I would like to acknowledge the efforts of all of our colleagues here at NET.

Now I would like to turn the discussion over Nick Keating, our CEO.

C. Nicholas Keating

Thank you, John. During the third quarter of this fiscal year as John just highlighted, we completed some major projects in pursuit of our strategic objectives, while effectively executing on our business plan. We moved forward on our plans to grow the company through not only internal product development but also through acquisition and partnerships. We also took steps to position the company for future growth by strengthening our cash position, expanding our international footprint and progressing on important third-party product certifications.

Financial results for the third quarter demonstrated continued improvement in NET’s performance, marking our 7th consecutive quarter of revenue growth. Sales of our new products including our VX Series and the NX5010 continue to gain traction.

Recent business highlights include completion of the acquisition of Quintum Technologies, strong order flow for VX and NX products in the government market, progress on key third-party product certifications and general availability of our VX1800 Voice Exchange products and our NVX, PBSE Secure Voice Card, extension of our existing general services administration or GSA schedule contract through January 2010, and finally completion of the convertible debt offering, which added $82 million to the company’s cash position.

Before I go into more detail on recent activity, I would like to briefly review NET’s current business and market positioning. NET develops solutions that enable seamless integration and migration of existing networks to secure Internet Protocol based voice and data communications. NET’s products focus on government applications for high performance switching, multi-service platforms and secure voice.

For the enterprise, our products address the growing desire to integrate unified communications and unified messaging into existing voice networks and business applications. In addition, our products target the growing demand within enterprise environments for fixed mobile convergents, which is the integration of wireline and wireless technologies to create a single telecommunications network foundation.

NET’s strategy for internal development partnership and acquisition has focused on these opportunities. Turning back to the quarter’s highlights, I would now like to provide some additional detail.

Last quarter, we announced the acquisition of Quintum Technologies and the integration is progressing well. The combination of Quintum and NET provides a number of strategic benefits. Specifically, it enables us to offer the broadest product line to our customers from the large enterprises environment to remote office locations. Our technologies, product strategy and sales focus are highly complementary and we share a common vision for the converged unified messaging and unified communications markets.

The acquisition of Quintum has also significantly expanded our national and global presence, adding international offices in Shanghai, Hong Kong, and Taipei as well as domestic locations in Schaumburg, Illinois and Eatontown, New Jersey. Today, nearly half of our personnel are located outside of the San Francisco Bay area, with key development centers located on both East and West Coast of United States.

NET’s products are used by a variety of federal government agencies, particularly within the Department of Defense. A substantial portion of NET’s revenue from these government customers has been based on this GSA contract. During the third fiscal quarter as a result of our long-term successful association with GSA, we were awarded an option to extend the contract held by NET subsidiary, NET Federal, Inc. to January 13, 2010.

In addition as part of the extension, the GSA agreed to add product maintenance and support services onto the contract, which expands our revenue opportunity and simplifies the sales process by offering our government customers a complete solution.

Turning to our government business, sales to the federal and international agencies remain the majority of our current business. We continue to see more opportunities for our NX5010 product.

The NX5010 is being used by government customers for high-speed encryption and data transfer applications, transporting data over InfiniBand, 10-gigabit Ethernet and SONET networks. We are also focusing on expanding the NX5010 into the commercial market, in areas such as disaster recovery and grid computing applications.

During the third quarter, we shipped additional NX5010 platforms for use in a large DoD visualization program. In addition, the NX5010 is currently in a trial at Oak Ridge National Laboratory, a Department of Energy research lab, for use in large data transfer applications within remotely distributed datacenters.

During the third quarter, we received the first major order for our NX1000 tactical platform for use in the Warfighter program within the Department of Defense. Warfighter is a term used by the United States Department of Defense to refer to any member of the U.S. armed forces or a member of any armed forces operating under the U.S. flag. The NX1000, which was purpose built for tactical deployment scenarios, was selected for the Warfighter program for its reduced footprint, higher bandwidth and IP capabilities.

Turning to the VX, last quarter we completed the first of two phases of testing required to place the VX platform on the DISA, that’s the Defense Information Systems Agency, approved product list. This phase of testing was the DoD information assurance certification, which was performed at the Joint Interoperability Testing Center or JITC at Fort Huachuca, Arizona.

Similar Phase I testing was also completed on the Promina product. We shipped the first major order of our VX9000T, the tactical deployment version of our VX VoIP switch, to a joint service command within the DoD that allows secure voice communications from any location in the world.

For NATO, we shipped VX and Promina Systems for use by the Coalition Forces in Afghanistan and for expansion of their core network. For the Navy, orders were received including additional Promina Systems for expansion of the Navy CB Voice and data tactical deployment systems and VX orders for the second phase of a multi-year program for the Navy ship-to-shore network.

We also received additional orders and shipped Promina platforms to expand the defense satellite communications control center teleport GENIE program, which allows the Warfighter to quadruple the bandwidth available per mission from the satellite gateway facilities.

Other notable orders during the quarter included delivery of a large number of tactical deployment systems to ITT, and I might mention that ITT acquired EDO so we now refer that to ITT as our customer, in support of the U.S. Marine Corps Transition Switch Module or TSM Systems.

In line with our strategy to build our enterprise business, we progressed on key third-party certifications. This quarter, NET has successfully completed the Microsoft Unified Communications open interoperability programs testing and qualification process. This establishes NET’s VX voice exchange as a qualified gateway solution for the Microsoft Unified Communications platform.

In January, NET was also awarded Microsoft Gold Certified partner status in the information worker solutions competency with a specialization in unified communications. Achieving gateway qualification and Gold Certified partner status are of strategic importance, and will greatly enhance the company’s ability to work with Microsoft and its partners.

We also became a member of the Hewlett-Packard or HP Developer and Solution Partner Program. As a member of this program, NET is committed to working closely with HP, to build and deploy secure, scalable, high-performance, unified communication solutions for the global enterprise IT market.

Finally, this quarter, we continued the upgrade to the Routers network, with expansion to central Europe and to certain Mediterranean locations.

Turning to product development, today we announced general availability of our VX1800 Voice Exchange Switch. The VX1800 is a high capacity intelligent media gateway that is purpose-built for enterprise VoIP and unified communications.

With advanced interoperability features, the VX1800 provides capabilities that go beyond the limitations of existing VoIP media gateways. Ideally suited for the large enterprise, the VX1800 can support up to 5,000 users in a single box solution that features redundant AC power and expanded software modules.

Quintum recently announced general availability of its Tenor Hybrid 60 Gateway. The integration of a gateway with Windows Server delivers two key elements of a Microsoft OCS 2007 deployment in one easily-managed device. The Tenor 60 complements our existing portfolio products, enabling integration and migration to secure IP voice and data communications.

Turning to operations, Plexus, our new contract manufacturer, made significant progress coming up to speed on our most complex products, and I am impressed with the degree of knowledge transfer that was completed in a short time. We expect to largely complete this learning curve by the end of the current quarter.

In order to strengthen the company’s financial position, we completed a convertible senior debt offering in mid-December, with an aggregate principle amount of $85 million. The notes will be convertible at a conversion rate of approximately $13.63 per share. The net proceeds from the offering were approximately $82 million after deducting discounts, commission and offering expenses.

We intend to use the proceeds for working capital and general corporate purposes, which may include capital expenditures and potential acquisitions. It has been an extremely busy and productive period for NET with numerous actions relating the execution of our strategy.

Our enterprise market opportunity is expanding; we are growing business globally. Our Federal International Government business is embracing our new products and we are securing the third-party certifications necessary to address new market opportunities.

At this time, I will turn the call back to John McGrath for some comments on guidance and closing remarks. John?

John F. McGrath, Jr.

Thanks Nick. As we entered the fourth quarter, our backlog was solid. Although the economy in general seems more cautious than it was just a quarter ago. We expect our fiscal year 2008 revenue including quantum to be in the $116-118 million range. We have started our fiscal 2009 planning and will discuss our view of next fiscal year on our fourth quarter conference call.

Included in our Q4 forecast, our Promina and VX equipment has been chosen for a significant military upgrade program. The equipment has been solicited for procurement and the program is currently expected to be awarded in early February for delivery this quarter. However, any delays in this program would affect our revenue in net income in Q4.

In the fourth quarter, we expect operating expenses to be in the area of $16 million to $16.5 million as a result of having a full quarter of Quintum cost and increased benefit expenses. As I mentioned earlier, each calendar Q1, we incur higher employer FICA and employer matching of the 401(k) both of which are generally maxed out in the December quarter.

Further as we finalize the move of our contract manufacturing to Plexus, we will continue to see cost related to transition and charges for inventory transfers, but we anticipate that margins will remain around 50%. We expect that these transition costs will began to decrease significantly over the first half of next fiscal year. Summing this up and subject to the risks related to an expected order, we anticipate that our annual fiscal 2008 non-GAAP earnings per share will be in the $0.31 to $0.34 per share range.

Further, we expect the annual GAAP net income will result in the largest profits since fiscal 1998. We expect any cash for the quarter to be in the $160-165 million range. As we continue to transition our manufacturing to our new contract manufacturer, we expect inventory levels to continue to drop.

Operator, this concludes our prepared remarks. We would like to open the call now for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Eric Buck - Brean Murray, Carret & Co.

Eric Buck - Brean Murray, Carret & Co.

First of all on the Microsoft Certification congratulations on that. I was just curious as exactly what products are covered by that certification, is that across the board or is it on specific gateways?

C. Nicholas Keating

It relates to the operating software, and a particular software release was approved and it’s approved with the use of our Sticks card so it would apply to the VX1200 and VX1800. And as long as other members of the VX Series are on the same release then it could be extended to those also.

Some of our products in the VX Series are really focused on the federal government. The VX900 and the 900T and the 400 are really government products but to the extent that they would use the Sticks card and have the same operating system, and then they would qualify under the certification.

The other thing I want to point out is that the Quintum product line is also Microsoft certified. It has been in the past. The Gold Partner status that we achieved also was a result of bundling the core competencies of both Quintum and NET and it’s a certain point scale you have and the combination of that point scale enabled us to achieve the Gold Certification status.

Eric Buck - Brean Murray, Carret & Co.

Can you remind us the difference of the 1800 versus the 1200?

John F. McGrath, Jr.

It’s really a matter of size. The 1200 has two of our telephony cards, which we call the Sticks card and supports about 1500 to 2000 users. The 1800, which we said in the script supports at least 5000 and in certain circumstances could support up to 10,000 users. VoIP companies use different standards. In some cases they assume 10% utilization; by the employee base others assume 20% utilization. We factored in 20%, which set 5000 users. If you had 10% utilization, we would actually be supporting 10,000 users.

Eric Buck - Brean Murray, Carret & Co.

And on the migrating into Plexus, given the strength in the Promina line, this quarter I assumed there wasn’t any revenue impact from the migration?

C. Nicholas Keating

Well this quarter like other quarters, a number of our orders are FOB destination and this was also the case in Q2. In some cases the products that we build arrived at destination later. I, quite frankly think that that’s going to be an ongoing; some of our destination locations are around the world.

In this third quarter, we had a shipment to Afghanistan, a shipment to the Ministry of Defense of the U.K., which arrived after being shipped out of Plexus. We build that into our forecast when we do that. One of the things we are seeing and this program that we are working on right now that we hope to book in the near future has a fair component of large Promina 800s in it as well as VXs. So one of the things we have been pleased about in this last quarter was the strength of the Promina because its gross margins are strong.

But the other thing I’d like to highlight, Eric, is this win on the NX1000, because this Warfighter program could be very large and could extend to all the armed services. We are working with General Dynamics of Lockheed Martin on that right now. But in theory, the Army, Navy, the Marine Core, the Air Force, the National Guard could all participate in this Warfighter program and this could have many multi-year positive implications. It’s too early to tell, but this was a very significant win for us.

Eric Buck - Brean Murray, Carret & Co.

And then, if I heard right, Promina was 54% of revenues which when I also account for the $1.1 million in Quintum that it was added in the quarter, looks like otherwise VX and NX combined were down sequentially?

John F. McGrath, Jr.

Yes. It was down slightly sequentially. As Nick had mentioned, we have received recently, actually a couple of significant orders for our Promina and then it has been on the larger end so it’s certainly has helped our core margins.

Operator

Your next question comes from the line Greg Mesniaeff - Needham & Company.

Greg Mesniaeff - Needham & Company

I just have a question on the government product revenues which you’ve said early in the call, were down 7% sequentially or up year-over-year. I am wondering whether the Quintum acquisition or the new products coming on line from that acquisition had an impact on that.

C. Nicholas Keating

It did not. The Quintum closed into the second week of the quarter so there was about three weeks of revenue in there. It would not have had an impact on the rest of our operations. The Quintum product, by the way, is assembled in Hong Kong and in Eatontown, New Jersey, so it is not being manufactured by the Plexus facility.

Greg Mesniaeff - Needham & Company

So is it fair to say that it was really more a function of the enterprise opportunity getting more significant?

C. Nicholas Keating

Well. I think in any given quarter now that the Enterprise has started to grow and also we had an extremely strong quarter in our European business, both in European Government as well as some significant European Enterprise business. And these mixes change; one of the things that John pointed out was that we have come into this quarter with a pretty reasonable backlog, so we try to balance all these out.

I think we had the Plexus plant probably maxed out because of the number of large P800s that went through in the third month of the quarter, but we look at all these factors in putting our manufacturing and revenue plan in place.

Greg Mesniaeff - Needham & Company

As the federal sectors transition from TDM to IP continues, do you see the Promina revenue stream kind of trailing off gradually or is it going to be kind of flattish and then all of a sudden a down draft, a significant drop off?

C. Nicholas Keating

Well. I mean, in the large run that is hard to predict. In the shorter term, we have been adding a lot of capabilities to the Promina to extend its life. So, as an example we have an IP trump card in the product. We are developing this NVX card that will support both Legacy Voice as well as voice over IP. That goes inside the Promina as well as it will go into the card slot on the NX1000, so that basically IP-enables a Promina and allows you to do that transition from TDM to IP inside the Promina itself.

Another development that we have underway here, which we refer to as our IEM or Integrated Encryption Module, is that we are adding some encryption capability into another card that will go into the Promina. It will also be compatible with the NX1000 and we are looking at other features of an IP nature to extend the life of the Promina.

A number of these projects right now are new customers and new expansions. So we’ve got customers that are putting in new networks with Prominas. And they are using it predominantly as an access and aggregation device, feeding into an IP backbone and that’s why having some of these IP interfaces in the Promina is so important, so that it extends the life and it is an efficient way of aggregating excess data in to IP backbones.

Greg Mesniaeff - Needham & Company

With the financing now behind you of last quarter, I was wondering if you had some commentary you could give us regarding the potential use of those proceeds, whether it’s strictly for acquisitions or for perhaps some kind of repurchase of shares program or something like that?

C. Nicholas Keating

Let’s look at how we have been using cash in the past. The financial arrangements we have with Bay Microsystems are a good example. We are doing co-development work with Bay, including licensing and getting development rights to certain of their technology.

We made a $3 million contractual investment to acquire certain technologies for the 5010, and then in September, we made a commitment of $5 million more. So we have committed ourselves to $8 million, of which $5 million have already been spent, we have $2.5 million more to spend.

And so I am very interested in finding other Bay-like partners, where we could do some forms of joint development and where we would use our cash to invest in those type of partnerships and to fund some of the NRE.

Obviously, we used a fair amount of cash in the Quintum acquisition. What I have been telling investors is that we have three focus areas. And our focus areas are government systems, voice and mobility, and broadband.

And whether these would be development partnerships or acquisitions, if we use our cash, it’s most likely to be used in one of those three focus groups, either one of them or more than one of those three focus groups and could be either co-development NRE funding or acquisition or some hybrid version of it.

Operator

Your next question comes from the line of Nick Farwell - Arbor Group.

Nick Farwell - Arbor Group

I just had a couple of add-on questions, if I may. And the first one is I wanted to make sure I understood the revenue recognition that John commented on and using the Afghanistan order perhaps as an example. Once a chip from the factory, presumably you invoice customer, but I am assuming you don’t recognize the revenue until it’s signed off by we will say NATO in Afghanistan.

C. Nicholas Keating

There are two ways that we recognize revenue. One is if the purchase order calls for a title to transfer FOB shipping dock. And generally speaking, if we are selling to one of our systems integrators like that General Dynamics or ITT and we ship to them, the terms of the order are usually and I preface by saying usually FOB NET shipping dock or in this case, Plexus’s shipping dock.

When we ship directly to a government end user, the terms are typically FOB destination and require a signature by an authorized authority. That was the case in Afghanistan and the UK terms are the same way. So when we sell to the Ministry of Defense in the UK it actually has to be delivered to the dock and an authorized party has to sign off of it. That happens all the time so one of the things I don’t want to give you the impression and this was an extraordinary case.

We will get orders quite often in the third month of the quarter where we are able to ship it and where it just is not possible to get that into the loading dock and signed off by an official. The previous quarter, Q2 we had the same thing.

There was a military base in Pennsylvania and then it turned out, they tried to deliver on Friday evening and they had gone home. In the case of Afghanistan, it was a Muslim holiday that day and the case of the UK they were on Christmas break. So we tend to see these things and we try to over build in order to compensate for that.

Nick Farwell - Arbor Group

In this particular instance, though, my observation in the past has been especially in say foreign procurements or in the DoD department, when you get this statement of authorized signature of the party, sometimes there can be rather significant delays until such time as it is perhaps implemented or there are other issues. They can use it as an excuse for you finally getting receipt of delivery and being able to book that order. Is that fair with the…?

C. Nicholas Keating

I don’t think we have ever seen, at least since I have been here the last two and half years, anyone intentionally using that. Quite often, it’s your shipper. In the case of Afghanistan, we actually shipped pretty early, and it sat on a DHL warehouse for a couple of weeks.

As we understand, since DHL is the principle carrier in shipping into Afghanistan on behalf of the Department of Defense, they were just absolutely jammed up and didn’t have enough cargo capacity to get product in the country. So I don’t think any of these are deliberate.

Nick Farwell - Arbor Group

I did a very quick cash flow, John and I couldn’t make it balance out when I take the $97 and the $161 million.

John F. McGrath, Jr.

Yes, so you start off with the $97, you add the $82 to and subtract out the $24. There were $6 million from operations and then we will have what I call the casting the dogs. We will have a CapEx and that would fall into operating cash, but we will be putting out our 10-Q in the next a couple of days. So, we will have all…

Nick Farwell - Arbor Group

There was nothing unusual on that, either a big option, either some significant?

John F. McGrath, Jr.

As a matter of fact, our options weren’t as high as we’ve see in the prior quarters, because we’ve had a lot of exercises from prior executives that [inaudible] and so they pretty much worked their way out of their system in the summer. And so as a matter of fact that was quite a bit lower than we have seen in the prior quarters.

C. Nicholas Keating

And given the current stock price, I don’t expect to see a lot of options exercise right now anyway until hopefully that gets back up there.

Nick Farwell - Arbor Group

Well in that case so, I think it entered the quarter to relatively high still at a high price, Nick, till the deal was done.

C. Nicholas Keating

Yes, keep in mind that we have some pretty tight blackout policy here, no trading policy for our employees. So they are actually closed out for most of the quarter. The window is a relatively small window.

Operator

And your next question comes from the line of [Joel McCullen] - [West Coast] Associates.

[Joel McCullen] - [West Coast] Associates

Is there any consideration being given to a buyback?

C. Nicholas Keating

We are having discussions with our Board. I don’t think there have been any conclusions, but we are looking at all the options available to us in order to see we can do to get a more reasonable valuation in the marketplace right now.

[Joel McCullen] - [West Coast] Associates

And one follow-up here to a secondary question; is there a market for the convertible? I have yet to be able to find one.

C. Nicholas Keating

I would encourage you to talk to the Bear Stearns representatives that you work with if you do. Bear did the convert and they are making a market in that. I would have to defer to them.

Operator

Your next question comes from the line of Bob Stafford - Stafford Capital.

Bob Stafford - Stafford Capital

I was wondering if you could comment on the outlook for the relationship with Hewlett-Packard and its significance.

C. Nicholas Keating

We have had significant discussions with HP now over a number of months and one of the gaining factors that we had to overcome was getting to the Microsoft Certification. Microsoft and HP obviously work very closely together. And I am not sure my data is correct, but I remember hearing that HP was supporting more Microsoft exchange servers than any other integrator in the United States. So that says they have a huge installed base of Microsoft users.

We think HP is probably going to be one of the significant systems integrators that will be promoting Microsoft’s unified communications strategy. And so we want to align ourselves as closely as we can with them, with the hope that when they go in to upgrade a customer from exchange over to unified communications that they will consider using our gateway as part of the solution to be able to perform that upgrade.

One of the things that we bring is we bring a lot of telephony expertise. We know how to integrate with most of the major PBXs and IPBXs and soft switches there. One of the things we also bring to an HP is the ability to deal directly with one vendor, where they can order directly from us and then take advantage of our field service organization, our TAC, our professional services group.

And we think some of these large enterprise projects are going to be pretty complex. And so we want to be able to back stop systems integration partners with the level of expertise that NET has.

I think the thing you should assume over the next few quarters now that we have completed the Microsoft Certification is that on a global basis we will be working with selected systems integrators, because we think that they will be the delivery vehicle for upgrading large enterprise users from exchange and all the office products going over to OCS.

Bob Stafford - Stafford Capital

And could you tell us a little bit more about the Warfighter program?

C. Nicholas Keating

This is a tactical switch. These will be switches that will be deployed in the field. And will presumably be used by all the armed services as part of DoD standardization program to make sure that each of the services has platforms that communicate, interoperate and to the extent that they use any kind of proprietary protocols of those proprietary protocols are available to all of the services.

And as the definition, that’s one of the reasons I want to give you the definition, it basically applies to our mobile Warfighter of the future, wherever they’re deployed, wherever in the world, whether they have wireless satellite fixed wire or other forms of communications connectivity. And so this has been a program that has been worked on I think for probably 4 to 5 years, and we actually designed the NX1000 to try to meet the specifications of the Warfighter program.

Operator

And your final question comes from the line of Michael Prouting - 10K Capital.

Michael Prouting - 10K Capital

I was curious given that the VX and NX revenues were roughly flat in the quarter; I am wondering if that just reflects the strength that you had in the September quarter and what your outlook might be for VX and NX going forward?

C. Nicholas Keating

Well, I would say in the case of the NX first, we are in some large DoD programs that are rolling out. Some of them are projected to have 30 nodes in the network and quite often what happens is we’ll ship 10 nodes and it will take them a while to get installed, to be able to get them up and running, to optimize the network. And one of the things that we are seeing is that once we install into a particular network and there are follow-on orders.

The ideal scenario for us is to get new networks, where we are seating them and maybe that’s only a three or five node network, in other cases it could be a 10-node network. And then as they expand, then we’ll see upgrades. And I think that in this product line, you’ll probably see up and downs in any given quarter.

The key for us is continuing to get in to new networks successfully get them up and running and then work with the customers to continue to expand them. These are all multi site type networks.

In the VX, the VX has really been successful in penetrating most of the DoD agencies, and so we have it on aircraft, we have it on ships; we have it on programs such as the Marine Course Tactical program, which was EDO. And EDO of course was acquired by ITT. We have got it in the Army through General Dynamics, mobile or tactical communications networks.

What you will see in those networks is that they’ll buy a number of them, they will get integrated in, they will get deployed, and then there is a certain cycle tool. The Navy is an example. For their ship-to-ship program, we got the order a year ago. We shipped a number of units. The navy ships coming to be upgraded, outfitted in dry dock. They get installed and then the Navy then orders another group of them for the next 12 months. And so in the Navy’s case, we are seeing kind of 12-month increments.

Having said that, there are some navel base opportunities that we are looking at, so that they are not just on ships, but could be on naval bases. The Air Force is the same way. We are trying to get them on as much Air Force passenger aircraft, but what you are going to see overtime that then they have to also be put in ground station locations for air-to-ground communications.

And you may see a surge in one quarter and a leveling off in the next quarter. I think the way that you slue that out on a longer term is just with more and more penetration in greater user groups.

Operator

There are no further questions at this time. I would now turn the call over to Leigh Salvo for closing remarks.

Leigh Salvo

I would like to thank you all for joining us for our fiscal third quarter 2008 conference call. This concludes our call. Thank you.

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