3Com F3Q08 (Qtr End 2/29/08) Earnings Call Transcript

| About: 3Com Corporation (COMS)

3Com Corporation (COMS) F3Q08 Earnings Call March 24, 2008 5:00 PM ET


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


Manuel Recarey - Kaufman Brothers

Mark Sue - RBC Capital Markets

Analyst for Michael Leavitt - Chesapeake Partners

Jeff Evenson - Sanford C. Bernstein


Thanks so much for holding, everyone, and welcome to this 3Com Q3 earnings announcement conference call. Just a reminder, today’s conference is being recorded. Now at this time for opening remarks and introductions, I will turn things over to Mr. John Vincenzo, Head of Investor Relations. John, please go ahead.

John Vincenzo

Thank you and thank you, everyone, for joining us today to review our Q3 FY08 financial results. With me today are 3Com President and Chief Executive Officer, Edgar Masri, and Chief Financial Officer, Jay Zager.

Before I turn the call over to Edgar and Jay, I would like to inform you that 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 our proposed acquisition by affiliates of Bain Capital, integration activities; strategic initiatives; 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 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 third quarter of our fiscal year 2008. I am here today with our Chief Financial Officer, Jay Zager, and we will be walking you through the business highlights for the quarter with specific details regarding our financial performance and some thoughts on the future.

However, before I turn the call over to Jay, I want to spend a few minutes discussing three main topics. First, a brief report on where we are regarding our proposed merger agreement with Bain Capital; second, key highlights from a quarter that produced very encouraging overall results; and third, progress we are making on our restructuring efforts and the anticipated cost savings.

Let me start with a brief recap of where we are with the proposed acquisition by Bain Capital. As I am sure you are all aware, last week there were several announcements and news articles published related to the deal. First, Bain Capital issued a news release saying they are terminating the merger agreement to acquire 3Com. In response, we stated that we firmly believe the reasons Bain Capital cited in their press release are not grounds for terminating the agreement. Therefore, we believe both parties continue to have obligations under that agreement.

One of our own obligations under that agreement was to convene a shareholder meeting and take a vote on our existing merger agreement. This past Friday, we held the shareholder meeting to vote on the existing merger agreement and approximately 70% of our shareholders voted in favor.

The approval of the merger agreement by our shareholders is to preserve our rights under the existing merger agreement, including the right to pursue a break-up fee of $66 million under certain circumstances. We will continue to fulfill any remaining obligation in terms of the existing merger agreement.

Beyond these comments, we will not be saying anything more regarding the transaction.

Now let’s look at our performance in each of our key businesses. Overall, I am very pleased with our Q3 operational performance. We clearly showed our ability to execute and generate positive and in many cases record results. All of this was done despite a touch economic climate, particularly in North America, and where we believe the uncertainty around the transaction with Bain Capital and the dampened economic environment directly impacted our revenue numbers.

Total revenue in the third quarter was approximately $336 million, the highest it has been since we formed H3C in 2003, and our overall gross margins were a record 53%. We also achieved our sixth consecutive quarter of non-GAAP operating profit and we generated $44 million in cash from operations.

Also in the quarter, we reached several record and positive achievements. Our H3C segment had a record quarter in terms of revenue and gross margins, which were $213 million and 57% respectively.

Within our DVBU segment, two regions achieved 20% year-over-year growth and one saw 15% year-over-year improvement. Our non-GAAP operating profit is now approaching 10%. Jay will give you more clarity around these numbers during his comments but I believe that these strong results point to one thing -- improved execution.

As I stated during one of my first earnings calls as CEO, for 3Com to become a global networking leader we needed to achieve profitable revenue growth as well as market share leadership in each of our core product categories. I am proud to report that we are making significant progress on both goals.

According to various industry analysts, we now are either first or second in terms of market share for enterprise and small business switching, based on ports sold and enterprise routing based on units sold. For example, in China IDC reports that we are the number one vendor in enterprise stackable switching and are now the number one vendor in enterprise router units. They also report that we are the number two vendor in small business switching. Worldwide, we are the number two vendor in ethernet switching ports according to the [Delora] Group and number two in enterprise router units sold according to Infonetics.

Now let me touch on a few key highlights within each operating segment, H3C, DVBU, and Tipping Point. I’ll start with H3C.

H3C revenue in its fourth quarter, which as a reminder is October through December 2007, was a record $213 million, 9% year-over-year growth and 16% sequential growth. For its fiscal year 2007, H3C revenue was $758 million compared to $711 million a year ago. In addition to the revenue growth, gross margins continued to climb, reaching a record 57% and operating profits were almost 85% higher than they were a year ago, coming in at $47 million.

This strong performance in the quarter was really driven by two factors. First, direct sales in China were up significantly. You may recall that over the past few quarters, this was an area we believe was impacted by the uncertainties surrounding our ultimate acquisition of the remaining 49% of H3C from Huawei and our subsequent integration efforts once we owned 100% of H3C.

We now believe that we have stabilized the situation and will continue to see strong performance by our direct sales team in China.

Another factor that contributes to H3C's strong performance is the continued growth in sales of H3C product by our DVBU segment outside of China. The other significant positive performance driver in the quarter was progress the H3C team is making in selling its high-end routers as well as its new product and services, such as IP storage and IP video surveillance. These products and services not only have higher margin; they also pull through our switching and routing products, enabling us to provide customers with end-to-end solutions rather than point product like many of our competitors.

Clearly the team in China did an excellent job this quarter.

Moving on, the DVBU segment contributed revenue of approximately $135 million in the quarter, achieving slight year-over-year revenue growth. On a regional basis, our Europe, Middle East, and Africa, or EMEA region, continues to improve on both a sequential and year-over-year basis. The team delivered more than 20% growth year over year.

I attribute much of this success to strong management and increased focus on selling H3C sourced enterprise product which represented approximately 45% of the region’s revenue in the quarter.

In Latin America and Asia-Pacific outside China, the teams are also taking a similar, more focused go-to-market approach and they too are seeing strong results. Latin America were up 20% year over year and Asia-Pacific was up 15%.

Which brings me to North America, a region that to be honest, struggled this quarter with a significant year-over-year revenue decline. I believe that many of the issues in the region can be attributed to the poor economic climate, as well as the added impact of the uncertainty around the Bain Capital transaction.

We believe that several customers delayed purchasing decisions due to a lack of clarity around the acquisition, or the difficult market environment. That being said, we also saw an execution issue, causing us to make some changes in the sales leadership in North America. We believe these changes will help get the team back on the right track. While we search for a new head of sales for North America, our Senior Vice President of worldwide sales will directly oversee management of the team as they work hard to improve their performance in the coming quarters.

Now the final operating segment to review is Tipping Point. From a revenue perspective, Tipping Point revenue declined slightly due to a one-time adjustment, which Jay will address later. Gross margins in the quarter were also very strong at 70%, largely driven by sales of the higher end, higher margin products.

What I see as impressive is that Tipping Point produced these results in spite of a difficult selling environment and softening general economic conditions. The majority of Tipping Point's sales are in North America. Given the noise in the market associated with the Bain Capital transaction, the team found it harder to sell to certain customers, particularly the Federal Government. But despite these challenges, the team was able to perform well. They were also helped by the continued recognition of revenue from one of our largest customers.

Looking ahead, Tipping Point has planned to deliver several new products and product enhancements over the next which we believe will set them apart from the competition and help drive continued growth and profitability. In fact, the team delivered the first major product on that map at the end of the quarter. The new Tipping Point core controller is the industry’s first scalable true 10-gigabit IPS solution and enables Tipping Point to capitalized on the growing demand for 10-gigabit network links.

Core controller provides flexible deployment options and enables customers to add capacity to their existing Tipping Point IPS solution as their bandwidth and security requirements increase.

Now let me talk about our restructuring efforts. Prior to our announcement of the Bain Capital acquisition in September, we outlined our plan to achieve cost savings from restructuring or through our integration efforts with H3C. Our focus was in three key areas -- research and development, supply chain, and general and administrative.

Our timetable for implementing several of these initiatives was impacted by the Bain Capital transaction but several steps have been taken recently in which we’ll have -- which will have a positive impact on expense reduction efforts. For example, as part of the integration efforts, we recently made the decision to restructure our engineering function to more effectively capitalize on the high quality, low cost engineering capability we have in China and in India.

With H3C R&D now fully engaged in the development and testing of the majority of our enterprise networking products, we are integrating the majority of our product level testing. We are also moving much of our voice software engineering function to our India development center.

We will continue to maintain an engineering presence in North America and Europe to support our open services networking development. However, by integrating our R&D functions, we are reducing our annualized R&D costs. One this integration is fully implemented, we anticipate annual savings of approximately $15 million. We expect to complete this transition by September 2008 and these savings are not included in today’s results.

We are also in the process of identifying and implementing changes that ultimately could result in total annual savings of approximately $50 million or more, although more work needs to be done to finalize these items and we will get back to you with more details at a later time.

Finally, I would like to wrap up my comments with a few key points about the business.

Going forward, we are focused on four key objectives that are directly tied to our company strategy. Company strategy is first leveraging our presence in Asia to deliver low cost, high quality products that are based on open standards. Second, it’s about delivering on the promise of convergence through our open services networking strategy. And third element of our strategy is enhancing our go-to-market efforts.

What are these four objectives? First, we want to maintain the profitable growth and revenue growth we have seen in our international market and drive better performance in North America. We need to continue pushing and increasing the sale of product sourced by H3C.

Second objective -- to continue to show year-over-year growth for H3C.

Third objective -- continue driving down our cost structure through restructuring initiatives just as the one I just outlined.

And then fourth objective -- to support the development of new industry leading product, including new solutions that leverage our open services networking.

If we can deliver on these objectives, I am confident that we will be able to capitalize on the momentum and success we have seen to date.

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

Jay Zager

Thank you, Edgar and good afternoon, everyone. Today I’d like to provide some insights on the Q3 financial results we just released and provide some guidance for our fourth quarter.

Sales for the third quarter were $336.4 million, an increase of 4.0% from a year ago. We reported a net loss in the quarter of $7.8 million, or $0.02 per share. On a non-GAAP basis, net income for the quarter was $34.2 million, or $0.08 per diluted share, compared to $11 million or $0.03 per diluted share in the corresponding period last fiscal year.

This non-GAAP portrayal excludes restructuring, amortization, in-process research and development, stock-based compensation expenses, and certain unusual non-recurring items. A full reconciliation between GAAP and non-GAAP results is included in the press release in Table C, as well as on our webpage.

Let’s look behind these revenue levels. Our H3C segment revenues were $212.6 million, up more than 16% on a sequential basis and 9% higher than a year ago. Revenue for the data and voice business unit, the DVBU, was $134.6 million, down 3.8% sequentially and up about 1% from a year ago. Tipping Point revenues were $23.6 million, which includes a $3.2 million one-time, non-cash revenue adjustment primarily associated with the deferral of certain sales, mostly with the Federal Government.

Inter-company eliminations were $34.4 million. These eliminations take into account inter-company sales between our business segments.

From a geographic perspective, China revenues were $169.9 million, or 51% of our total revenue, with a 10% increase on a year-over-year basis. Europe, Middle East, and Africa revenues were $75.4 million, or 22% of the total revenue, with a 15% year-over-year increase. North America revenues were $42.9 million, or 13% of our total revenue and had a 27% decrease year over year. Asia-Pacific rim excluding China revenues were $27.0 million, or 8% of our total and essentially flat year over year and Latin America revenues were $21.2 million, or 6% of our total, with an increase of 18% year over year.

From a product perspective, sales from networking products were $279.8 million, 8% higher than a year ago. Sales from security products were $30.5 million, including the Tipping Point $3.2 million revenue adjustment, essentially unchanged from a year ago. Sales from voice products were $15.1 million, down almost 20% from last year and sales of our service offerings were $10.3 million, up 5% from a year ago.

Now let’s take a look at each of our business segments.

H3C revenues of $212.6 million reflect 16% sequential growth and 9% growth over the corresponding period last year. Within this data, direct sales in China grew by 19% sequentially and 24% on a year-over-year basis. This reverses a trend from earlier in the year where we had begun to see a slowdown in the growth of direct China sales, which we had attributed to fallout from the then recently completed acquisition of the remaining 49% interest in H3C.

Sales to Huawei also increased sequentially by 19% but were down on a year-over-year basis by about 9%. Huawei remains H3C's largest customer and purchases have remained strong throughout this fiscal year.

Inter-company sales from H3C to the DVBU also grew, up about 13% sequentially and up about 17% on a year-over-year basis. Continued increases in sales of H3C products through the DVBU sales channel is a key goal for our company moving forward.

On a full year basis for its 2007 calendar year, H3C's revenue was $758 million, a 7% increase over the prior year. This growth was driven primarily by increased sales in direct China and sales to the DVBU.

H3C's gross margin in Q3 was 56.6%, the highest level in its history and more than 10 points higher than a year ago. This improvement is due to a shift in sales to more profitable high-end products and to a lesser extent, improved efficiencies in the supply chain process. For H3C's full year 2007, the gross margin improved 5.6 points.

H3C's segment operating income was $46.8 million, almost 85% higher than a year ago. Full year operating income was $131.5 million, a 25% increase over calendar year 2006. We expect that Q4 will be another strong quarter for H3C. While we expect to see continued year-over-year revenue growth, there will be a seasonal decline from the reported Q3 numbers. We anticipate that gross margins should continue to improve and segment profits will also be strong.

DVBU segment revenues of $134.6 million were only slightly above last year’s levels. The majority of our consolidated revenue in the non-China regions is from the DVBU segments. DVBU’s EMEA and Latin American regions had outstanding quarters, showing significant year-over-year revenue growth in excess of 20%. EMEA in particular is the region that underwent significant restructuring last year and we remain very pleased with the new EMEA management team.

Sales in the Asia-Pacific region excluding China also grew year over year, up just over 15%. As we have discussed, we integrated the H3C Asia-Pacific sales force into the DVBU earlier this fiscal year and we are now seeing the positive results of that action.

In contrast, we did see a significant decline in our North American sales. This decline was due to a combination of factors, both internal and external. Clearly this region was most affected by the uncertainty surrounding our proposed merger and by aggressively deal posturing by several of our key competitors.

Having said that, we also did not execute well in North America. As a result, we have made significant changes to the North American management team and plan to further strengthen our management team in the near future in an effort to turn around our performance in this area.

We continue to deliver on our objective of increasing sales of H3C products through the DVBU. In Q3, DVBU sold over $60 million of H3C sourced products, an increase of 15% sequentially and 22% over the prior year period. In our third quarter, sales of H3C sourced products by the DVBU represented 45% of total DVBU sales, up from 37% in the prior year period.

DVBU gross margins were 32.2% in the quarter, a sequential improvement of 3.5 points. We have successfully completed the transition to a new customer support delivery model and we are now seeing the results of that effort.

DVBU reported a segment loss of $6.1 million in the quarter compared with a loss of $9.5 million in the second quarter. This loss was primarily attributable to the weakness in the North American performance. We expect to see an improvement in DVBU segment profitability in our fourth quarter.

Tipping Point Q3 revenues were $23.7 million, after recording the $3.2 million one-time adjustment I mentioned earlier. Within these totals, product revenues were $14.9 million and maintenance revenues were $8.8 million. We had previously announced a major order by a key U.S. telecommunications provider and we continued to record strong revenue from that order in the quarter.

Tipping Point's gross margin in Q3 was 70.1%, a sequential improvement of two points. This improvement was due primarily to a strong product mix and to decreased logistics costs.

While Tipping Point reported a segment loss of $800,000 in the quarter, that loss included a non-recurring net income effect of approximately $2.5 million relating to the revenue adjustments we previously cited.

We expect that Tipping Point will continue to show positive sequential revenue growth and improved profitability in the fourth quarter.

From a consolidated viewpoint, our gross profit in the quarter was $179.7 million, or 53.4% of sales. This represents a 5.5 point improvement over the prior quarter and a 6 point improvement over last year’s corresponding period. And as we have discussed, all of our business units contributed to these improvements.

R&D expenses were $50.5 million on a GAAP basis and $49.4 million, or 14.7% of revenue, on a non-GAAP basis. Sales and marketing expenses were $82.4 million on a GAAP basis and $80.7 million, or 24% of revenue on a non-GAAP basis. And general and administrative expenses were $26.3 million on a GAAP basis and $21.1 million, or 6.3% of revenue, on a non-GAAP basis.

And headcount at the end of the quarter was 6,149 people, a reduction of about 160 people since year-end. And as we look forward, we believe that there are still significant opportunities to further reduce costs in R&D, supply chain, and G&A. Programs are underway in all three areas to identify and capture these potential savings.

On a GAAP basis, we had an operating loss of $6.1 million. Our operating profit on a non-GAAP basis was $29.0 million, or 8.6% of revenue, compared with a non-GAAP operating profit of $7.3 million in Q2 and $10.1 million a year ago.

Third quarter non-GAAP operating profits were more than 65% higher than the first six months of the fiscal year combined. We continue to make significant progress in turning our business around and these financial results reflect this progress.

Net interest expense in the quarter was $2.9 million, a reduction of $1.1 million from the prior quarter. Because our H3C cash flow from operations has exceeded our plan for calendar year 2007, we have elected to make a $35 million prepayment on our debt later this month.

Other income of $10.6 million primarily reflects the recording of the VAT software subsidy in H3C. As a result of these factors, we had pretax operating income of $1.7 million. Our provision for income taxes in the quarter was $9.5 million. Included in this provision was a non-cash tax expense of $6.1 million related to the revaluation of the deferred tax balances in our H3C subsidiary. We expect to reverse this provision in the coming quarters, assuming that we get government approval on our application to continue to be a high-tech enterprise. Accordingly, we expect that our going forward tax rate in China will continue to remain at 15%.

We recorded a net loss for the quarter of $7.8 million, or $0.02 per share, and on a non-GAAP basis, our net income was $34.2 million, or $0.08 per diluted share.

Let me now turn to our balance sheet. At the end of the quarter, our cash balance was $466.0 million, compared with $419.1 million at the end of Q2 and $559 million at the end of the fiscal year. During the quarter, we generated $44.1 million of cash from operations.

Notes receivable were $106.6 million, an increase of about $35.6 million from the prior quarter. Accounts receivable were $142.3 million, an increase of about $14.7 million from the prior quarter. This increase was due to the higher sales volumes at H3C. As a result, our DSO increased from 36 days at the end of Q2 to 38 days at the end of Q3.

Our inventory was $93.7 million, essentially unchanged from the prior quarter and about $14 million lower than our year-end levels. And capital spending in the quarter was $3.5 million, compared with $4.1 million in Q2.

Now I’d like to provide some insights into our fourth quarter. We are currently forecasting Q4 revenues to be in the $310 million to $315 million range. Within this total, we expect that H3C revenues will be in the $180 million to $185 million range. Direct sales in China should be particularly strong, with year-over-year growth in excess of 20%, and sales to Huawei should be about 25% lower than a year ago.

DVBU revenue should show modest sequential growth. We expect a continuation of the trends we experienced in Q3 with strong international sales tempered by continued weakness in our North American business.

And Tipping Point sales should also reflect double-digit year-over-year growth.

We expect H3C will continue to see sequential improvement in its gross margin while operating expenses should remain essentially flat on a sequential basis. As a result of these factors, and driven by the modest sequential reduction in revenue, we currently anticipate our Q4 operating profits on a non-GAAP basis to be in the $18 million to $25 million range. Non-GAAP earnings per share should be between $0.04 and $0.07, and we will continue to generate cash from operations.

In closing, I would like to add that we expect to be more proactive with respect to the investment community in the coming months. We will be meeting with investors and shareholders on a more regular basis and I look forward to meeting with many of you soon.

And now, before I open the meeting to questions, I would like to reiterate that we will be only addressing questions related to our business performance. Operator.

Question-and-Answer Session


(Operator Instructions) We’ll take our first question this afternoon from Mr. Manuel Recarey with Kaufman Brothers.

Manuel Recarey - Kaufman Brothers

You put -- H3C was certainly -- posted a good quarter and I understand sequentially the seasonality in the first quarter. Can you talk a little bit about your outlook for the relationship with Huawei with what you can? And when does the non-compete expire?

Edgar Masri

So your question, Manny, is about our relationship with Huawei and the non-compete. Huawei is and has continued to be a strong partner of 3Com, specifically H3C, and we are looking to maintain this relationship. The non-compete expires in September ’08, which is about six or so months from now, to answer your question.

Manuel Recarey - Kaufman Brothers

Okay, so you are still discussing and still talking with them and is kind of the status quo for now.

Edgar Masri

Right. Just as a reference, there are certain products that were not part of the original joint venture where we today compete in the marketplace with Huawei and we feel that we’ve been doing well and will continue to do well.

We are keen on maintaining our relationship, specifically on the switching and mid-range routing products, which are covered by the non-compete.

Manuel Recarey - Kaufman Brothers

Okay. Can you give any outlook for what your plans are for Tipping Point? This summer you had spoken about spinning that off and then -- and with the whole Bain acquisition, that’s -- you know, was put into question so just kind of curious what update you have with that.

Edgar Masri

On Tipping Point, if you’ll recall about nine months or so ago, we announced our desire to spin off Tipping Point and when we went into the merger agreement discussion with Bain, we decided to put this on hold until after we closed the merger.

We continue to operate Tipping Point as an autonomous entity and track them as a segment, as you see. And we are keeping our options open about how to maximize this business value as part of 3Com.

Manuel Recarey - Kaufman Brothers

Okay, and then one last question -- can you talk about the channel’s reaction to the acquisition? Obviously the economic environment is much more challenging than it was when the acquisition was first announced and so over these past several months, how has the channel reacted to this? Is there anything that you have to do to try to reinvigorate it?

Edgar Masri

Yes, well, we mentioned that the -- I mentioned in my comments and so did Jay. In North America, we were the most affected by the merger announcement because there was a lot of uncertainty about the implication of various discussions we were having to sort of mitigate the deal from a government point of view, et cetera.

In Tipping Point specifically, the federal sales were affected but since then, we have been back to many of our customers and even during the negotiations and while the merger agreement was being worked on, we reached out to customers and explained to them our commitment to various product lines and our commitment to our business overall and we expect that now that there’s more clarity, we should be able to win back those channels that were hesitant about making purchases.

Manuel Recarey - Kaufman Brothers

Okay, and one quick clarification for Jay -- the Tipping Point, the sequential increase, is that off of the reported number or adjusted for the one-time charge?

Jay Zager

That’s off of the adjusted number.

Manuel Recarey - Kaufman Brothers

Okay. Thank you very much.


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

Mark Sue - RBC Capital Markets

Thank you. Recognizing you had some execution challenges in North America and some disruptions due to Bain, what about the environment overall? Do you feel it’s getting any better? Are you seeing some signs of stabilization? And perhaps you could also comment on some of the U.S. verticals.

Edgar Masri

Yes, so the question is about North American market, whether we’re seeing any stabilization. It is early in our Q4 quarter to tell you but we are starting on an encouraging note. But what we see is still continued softness at the macro level. We hope that the various actions that the fed has taken and the stimulus package that has been approved by Congress will help but we are taking a cautious approach to North America and we are focusing on our execution to deliver to our plan.

Mark Sue - RBC Capital Markets

And within North America, are you seeing --

Edgar Masri

Yeah, within the verticals -- so you know, as you all know Q3, which is the quarter we just announced, is typically our seasonally softest one because we tend to be the strongest in education and government. We are hopeful that the education market is not affected by the softness and we should see that translated into sales actually starting in the April/May timeframe. Very often it tends to be in Q4 and in Q1 where we see an up-tick in sales thanks to the education/government, where we are very strong, followed in early Q2 by the government.

We do hope, but it is a little bit early. We need another month to be able to comment better but we do hope that the education market is not impacted by the overall softness in the economy.

Mark Sue - RBC Capital Markets

And on the federal side, if that’s not back within a quarter or so now that the deal is off with Bain, or how should we see that ramp considering the disruption you had in the recent quarter?

Edgar Masri

Tipping Point continues to have to explain its business and its status to various federal government situations. We have to take it one by one unfortunately because our story is still complex with all that has happened. I do believe though that with the new products that are setting Tipping Point ahead of the competition, the customers and the prospects will buy on the basis of the strength of -- the financial strength of 3Com as well as Tipping Point and their competitive offering.

Mark Sue - RBC Capital Markets

Okay, that’s helpful. And then on the consumer side, any thoughts on the SMB segment in North America?

Edgar Masri

The SMB segment very much suffered the decline that we saw in the enterprise. I still have to be honest and say that a good part of it is probably due to execution but when we look at the SMB in Latin America and APR, we have had very strong if not one of our strongest quarters. So it is a regional weakness that we saw in North America and our overall small business is actually doing quite well, both at the top line and at the bottom line.

Mark Sue - RBC Capital Markets

Okay, that’s helpful. Thank you, gentlemen.


We’ll go next now to Michael Leavitt with Chesapeake Partners.

Analyst for Michael Leavitt - Chesapeake Partners

This is actually [Ashra]. Guys, first of all, good quarter, so congratulations on that. Our presumption is that the board’s rejected the alternatives because you believe it’s the right thing to do for shareholders. That’s what you’ve told us.

My question is how is the management team going to drive the results that are going to allow us to see value that’s more than what was in those alternative transactions? And what’s the risk in executing on that plan?

Edgar Masri

Right. I’ll have Jay comment on some of the points regarding reaching out to the community and investors at large, but as I mentioned in my script and I’ll repeat them, we’ve been growing. We would like to accelerate this growth. It has taken place in certain geographies, not across the board. We want to make it happen across the board. I am confident that the changes that our worldwide sales executive has made will ensure that we are operating on all cylinders and second is to continue showing year-over-year growth for H3C and that means in China and outside China.

If we do those, if we meet those two objectives, I am confident that the value will be reflected in the stock price.

Analyst for Michael Leavitt - Chesapeake Partners

And how do you balance sort of I guess the risk of that? I mean, you must be pretty confident that you can execute on that and create value that’s more than the alternate proposals, right?

Edgar Masri

Yes, and let me tell you a few things -- I mean, the restructuring. I gave an example of $15 million of savings. We started on those $15 million and we actually even notified the people, so we are very confident that we can extract these $15 million of savings.

We are [applying] a good percentage of this amount into hiring sales, service, and support people throughout the various geographies. Our sales people and our sales execs are translating this into higher, more aggressive targets. And this combination is in line with the objectives I just highlighted to drive profitable revenue growth.

I think part of your question too is how we get the stock price to recognize the real value of the company. Jay started touching on that and I’m going to turn to him to expand more.

Jay Zager

The answer’s very simple -- we execute. You know, we -- before the Bain transaction was announced, we went forward and listed what I would characterize as three very challenging objectives for our company to grow to become a $2 billion company by 2011, to improve our operating profit margins to double-digits, and to continue to generate cash from operations.

We believe that as we continue to execute and achieve those objectives, the stock price will take care of itself. So we focus on execution, we focus on improvement, and we think that’s the right strategy for us.

Analyst for Michael Leavitt - Chesapeake Partners

Okay. Thank you.


We’ll go next now to Jeff Evenson with Sanford Bernstein.

Jeff Evenson - Sanford C. Bernstein

Edgar, you mentioned that you currently compete against Huawei in some product lines. Do you compete against Huawei in China at all?

Edgar Masri

Yes, on the high-end routers, Huawei has its own product -- still has its own product. Our H3C group introduced our own high-end router and we compete with Huawei. And as you can see and as we highlighted in our comments, both Jay and I, part of having the gross margin improvements is due to the fact that we’ve been meeting success with the high-end routers and high-end switches.

Jeff Evenson - Sanford C. Bernstein

And when you talk about direct sales increasing in China, are you referring only to these products that are not included, that were never included as part of the JV? Or will you actually go to the same customer and compete against Huawei selling H3C products?

Edgar Masri

What we were referring to was the direct sales of our own sales people in China directly to the enterprise or resellers, separate from the OEM Huawei segment. We do not have the same granularity around what Huawei resells between what they sell into China versus outside China. The growth we saw and we’re very proud of is direct sales of our product, from the high-end router all the way to the low-end switches, into the China market to direct -- directly to customers or to resellers.

Jeff Evenson - Sanford C. Bernstein

Are there any restrictions currently on what products you can sell directly in China versus those you can’t?

Edgar Masri

No, we can sell any of our products we develop in China and outside China. There has been no restriction.

Jeff Evenson - Sanford C. Bernstein

Can you remind me of how you -- what currency you denominate sales to Huawei in and how you deal with any currency fluctuations?

Edgar Masri

Jay, do you want to answer that?

Jay Zager

Could you just ask the question one more time, Jeff?

Jeff Evenson - Sanford C. Bernstein

I was asking what currency you use to denominate product sales to Huawei and how you deal with any currency fluctuations?

Jay Zager

The currency fluctuations are not a factor for us. The RMB has I think appreciated consistently over the last couple of years, so if anything it’s probably helped our business. But luckily we have a situation where the currency in China is relatively stable, particularly compared to the dollar, so it’s not been a factor for us.

Jeff Evenson - Sanford C. Bernstein

But I’m wondering if weakening of the dollar versus global currencies, to what extent does that contribute to the revenue growth numbers that you cited today?

Jay Zager

That helps us a little bit, although as I said, it’s not a significant factor. But there is some modest appreciation due to the weakening of the dollar.

Jeff Evenson - Sanford C. Bernstein

Your options are currently priced at a strike price significantly below where you are trading. How are you retaining and incenting employees?

Edgar Masri

Good question. We are spending a lot of time, as you can imagine, putting in place a retention -- set of retention programs specifically for employees outside China. In China, because stock options are not easily distributed or distributable or available to the population at large, we had put in place a very generous, long-term incentive plan that is cash-based and that gets distributed over three years. And so based on this program, we are confident that the incentives for the China team are in place and what we need to focus on are the incentives for employees outside China, where it is stock-based and where the current value of the stock requires us to take some action.

Jeff Evenson - Sanford C. Bernstein

Okay, last question from me is in the proxy statement that you filed in association with the merger agreement, you gave a projection for fiscal year 2008 revenue of $1.407 million. If you add it up, you’re off by a little -- by more than a little over $100 million. How should we think about those projections in the proxy statement and what are the sources of the deviation?

Jay Zager

I think basically those projections were done last summer as part of the [input] for this transaction. I think you should rely on the guidance that we give at these conference calls as really the current and management’s view of our performance and our future performance.

Jeff Evenson - Sanford C. Bernstein

Since at that time you also gave the $2 billion revenue projection for 2011, why should we put more stock in that than this one?

Jay Zager

I’m not sure I understand your question.

Jeff Evenson - Sanford C. Bernstein

At a similar time, you put out your challenging goal of reaching $2 billion revenue in 2011. Since those projections were created at a similar time, I’m wondering why we should continue to believe that one but not the one in your SEC filing.

Jay Zager

Well again, the goal that we established was merely a goal. It’s not a detailed three-year projection by any means. It’s really management’s view of how we want to drive and run the business. Obviously you now have a fairly good handle on where we see calendar -- fiscal year 2008. At our next conference call, our intention would be to give you a better handle on 2009 and I can tell you that we are moving rapidly toward those objectives.

Now, some of those objectives may be easier to achieve than others, so obviously compared to where we were last summer, our revenue projections for 2008 are somewhat dampened as you correctly indicated. On the other hand, our profit margins this quarter I think were 8.6%, which probably has us on a faster ramp than we might have anticipated. So I would use those three broad objectives that I mentioned before as long-term goals for the company and not specific financial projections.

Jeff Evenson - Sanford C. Bernstein

Thank you very much.


Gentlemen, it appears we have no further questions this afternoon. Mr. Masri, I’ll turn things back to you for any closing or additional remarks, sir.

Edgar Masri

Okay. I just want to thank everybody on this call. We had very encouraging results to share. We have a lot of work still to do and I appreciate you’re following up the stock on the company and thank you and good night.


Again, that does conclude today’s 3Com Q3 earnings conference call. I’d like to thank you all for joining us and wish you all again a great evening.

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