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Foundry Networks Inc. Q1 2008 Earnings Call Transcript

posted on: April 24, 2008 | about stocks: FDRY

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Foundry Networks Inc. (FDRY)

Q1 2008 Earnings Call

April 24, 2008 5:00 pm ET

Executives

Mike Iburg - VP Treasurer

Bobby Johnson - President and CEO

Dan Fairfax - CFO

Analysts

Matt Robison - Ferris Baker Watts

Troy Jensen - Piper Jaffray

Bill Choi - Jefferies

Manny Recarey - Kaufman Brothers

Andy Schopick - Nutmeg Securities

Mark Sue-RBC Capital Market

Presentation

Operator

Welcome to today's teleconference. At this time all participants are in a listen-only mode. Later you'll have the opportunity to ask questions during our Q&A session. Please note this call maybe recorded. I will now turn the call over to Mr. Mike Iburg of Foundry Networks. Gentlemen please go ahead.

Mike Iburg

Thank you Jill. Thank you, good afternoon everyone. Thank you for joining us today for Foundry Network's first quarter 2008 financial results conference call. I am joined today by Bobby Johnson, President and Chief Executive Officer, and Dan Fairfax, Chief Financial Officer of Foundry Networks.

Earlier this afternoon, the company issued a release reporting its first quarter 2008 financial results. This release can be accessed from our Investor Relations section at Foundry's website at www.foundrynet.com. For reference, we have arranged for a taped replay of this call, which may be accessed by phone. This replay will take effect approximately one hour after the call's conclusion today and will be available for seven days. The dial-in access number for this replay is 402-220-2661. This call is also being webcast live with a 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. Today's call contains forward-looking information regarding future events and the future financial performance of the company. We wish to caution you that such statements are just predictions and actual results may differ materially as a result of risks and uncertainties that pertain to our business.

We refer you to the documents the company files periodically with the SEC. Specifically, the company's Annual Report on Form 10-K for the year ended December 31, 2007, as well as the Safe Harbor statements in the press releases that the company issued today. These documents contain important risk factors that could cause actual results to differ materially from those contained in the company's projections or forward-looking-statements. Foundry assumes no obligation to revise any forward-looking-statements contained in today's call.

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

Bobby Johnson

Thank you Mike and good afternoon everyone. I would first like to start by reviewing some key highlights for the quarter. First highlight is that our revenues were at the upper end of our preannouncement range. They were $150.1 million which was a [10.5%] increase over Q1 of last year. The second highlight is that our gross margins remained strong at 63.2% approximately the same level as in Q4 '07.

The third highlight is that in our service provider markets, our revenues increased to 29% of total revenues. Overall our service provider business was up 53% year-over-year and was essentially equivalent revenue wise to Q4 '07.

Fourth highlight is that we continue to execute on our previously announced stock repurchase program. We spent $60 million repurchasing approximately 4.4 million shares during the first quarter. This leaves us with $57 million remaining on our previously announced $200 million buyback plan. To date we've used $143 million in cash to repurchase 8.8 million shares over the last three quarters. The fifth highlight is that today we are announcing an additional $100 million repurchase plan giving us a total remaining for repurchase funds of $157 million total.

The sixth highlight is during the quarter we were pleased that the highly regarded market research firm Gartner positioned Foundry in the leaders’s quadrant in its 2008 Campus LAN Magic Quadrant report. And the seventh highlight is that recently both heavy reading and [surgery] research, which are networking, consulting and research organizations published results stating that we gained the market share during 2007 in the carrier Ethernet switching and routing markets.

Operationally, during the quarter we had great progress on mapping key hires in both our sales and engineering organizations allowing us strength for long-term revenue growth and increased product development capability. Looking forward our operating expenses are expected to increase at a more modest pace. We will continue to hire during this quarter, mainly in cellular R&D at a lowered rate compared to the last two quarters.

For the service provider market, we continue to have success in many differing applications in markets, including wired and wireless metro and regional backbones, internet exchanges, content delivering and data center applications. We now have four tier 1 service providers and overall approximately 550 customers deploying our Internet Metro Router platforms for these, plus other applications.

Now, for a detailed review our financials, I'll turn the call over to Dan Fairfax, our CFO.

Dan Fairfax

Thank you, Bobby and good afternoon everyone. I'll take the next few minutes to present a more detailed discussion of our financial results for the fiscal quarter ended March 31st, 2008. Foundry's revenue for the first quarter of 2008 was $150.1 million, compared to $135.8 million in the first quarter of 2007, an increase of 10.5% year-over-year and down 11% compared to $168.7 million in the fourth quarter of 2007.

During Q1, we had expected typical seasonal softness in the first quarter, in the North American commercial and federal markets. However, as the quarter progressed, we saw pronounced weakness which we had not anticipated in Europe, Japan and Asia. Now, in order to make the following discussion of our business operations clearer, when we use the term enterprise market, we mean it to be inclusive of both our commercial and government customers, including the US Federal government. When we use the term commercial market, we are describing enterprise and service provider customers, and exclude just the US Federal government business.

During the first quarter of fiscal 2008, we experienced a modest decline in our North American revenue and saw a more pronounced decline in other geographies. As customers both delayed purchases, and/or broke up large projects into smaller orders to be deployed over several quarters, our North American commercial and US Federal sales represented 53.4% and 19.4% of Q1 2008 revenue respectively.

Sales to Europe, the Middle East and Africa represented 15.7% of total revenue. Business from Japan decreased to 3.9% of total revenue, while sales from the rest of Asia represented 7.6% of total revenue. The decline in Asia was primarily due to a slowdown in some large deployments in the region.

Although down modestly quarter-over-quarter on a dollar basis, router growth increased slightly on a percentage basis to 20.8% of total revenue up from 20.3% in the fourth quarter and grew 45.5% year-over-year. Service provider revenue was flat in the quarter in absolute dollars, but grew to 29% of total revenue up from 26% in the prior quarter. Our visibility into the service provider pipeline remains good.

GAAP net income was $13.9 million or $0.09 per diluted share compared to net income of $9.1 million or $0.06 per diluted share in the first quarter of 2007, and net income of $28.9 million or $0.18 per diluted share in the fourth quarter of 2007. Included in Foundry's results for the first quarter of 2008 were $14 million of non-cash stock based compensation expenses. Excluding these expenses and the related tax effect, non-GAAP net income in the first quarter of 2008 was $23 million, and a non-GAAP net income per diluted share was $0.15.

Contained in our earnings press release is a reconciliation of GAAP to non-GAAP for further reference. The following is a further breakdown of our revenue. Our overall domestic revenue was 72.8% of our total business, and international sales represented 27.2% of total revenue. That was compared with 67.1% for domestic and 32.9% for international sales in the fourth quarter.

During the first quarter, enterprise customers accounted for approximately 71% of our total revenue, while service providers grew to 29% of the total revenue compared to 26% in the fourth quarter. The service provider business has grown 52.6% year-over-year. Revenue from our chassis based products represented 75% of revenue in the first quarter of 2008, up from 72% in the prior quarter.

Before I begin my discussion of our gross margins and operating expenses, I would like to point out that the figures I discuss next are all non-GAAP numbers. We have excluded charges for stock based compensation to make our results more comparable to prior periods and to those reported by other peer companies.

Gross margins remained strong in the first quarter at 63.2% due principally to favorable product to service mix and product cost reductions. The key driver to the favorable mix shift in the quarter was our stable service revenue, while product revenue declined sequentially. Our higher margin service revenue was essentially flat. That’s creating a favorable shift in gross margin. Product gross margins were 61.9% for the quarter, representing a 110 basis point increase from the fourth quarter level of 60.8%.

Service gross margins were 70.2% for the first quarter, representing a 690 basis point decrease from the fourth quarter level of 77.1%. The shift downward in service gross margin is directly related to a change we made in our allocation and support costs in the quarter. These costs are principally incurred by our sales and marketing organizations, and charged to service costs to sales on an activity basis.

The change we made in our support allocation has no operating margin impact since the increased allocation to costs of sales is offset by a reduction in sales and marketing expense. We expect the new rate of allocation to continue in the future.

Details of our operating expenses are as follows. Foundry’s research and development costs increased to $16.8 million or 11.2% of revenue in the first quarter compared to $14.7 million or 8.7% of revenue in the fourth quarter of 2007. To end the quarter we added 22 people in engineering.

Sales and marketing expenses increased to $41.7 million or 27.8% of revenue in the first quarter, compared to $38 million or 22.5% of revenue in the fourth quarter. We expanded our sales foot print by 25 sales people in the quarter, and completed a compensation review for our sales force, which included both merit and market based adjustments.

General administrative expenses were $9.6 million or 6.4% of revenue for the first quarter compared to $9.8 million or 5.8% of revenue in the fourth quarter of 2007. Operating margins decreased to 17.8%, which fell below our long-term target range of 20% to 25%.

Other sources of increased operating expenses in Q1 were higher payroll taxes which Foundry reset principally at the beginning each calendar year, and the reset of certain employee benefits such as our 401(k) match, which many employees are in the first calendar quarter. Our pro forma effective tax rate for the quarter was 36%, which increased in Q1 due to the drop off of the non-recurring Q4 tax return to provision adjustment. Our full year 2008 tax rate is said to be approximately 38%.

Looking forward operating expenses are expected to increase at a much more modest pace, and we expect operating margins to improve in the second half from top line growth, and we scale back our hiring plans. We do sales and marketing expenditures related to our industry trade shows.

Following up on a comment Bobby made earlier, in light of the uncertain macro-economic environment, while we intend to slow our overall rate of hiring, we do expect to continue to make targeted investments in our sales and engineering headcount, although at a much slower pace than we did in the previous two quarters.

Interest and other income decreased by $1.9 million to $9.3 million in the first quarter as the impact of the lower interest rate environment has begun to effect our portfolio. As interest rates decline, we expect our interest income to decline at a rate approximately $600,000 for every 25 basis point reduction in rates

Our portfolio's rate of return during the first quarter was approximately 75 basis points above prevailing rates for the types of securities we hold due to the latter nature of the portfolio. We would expect our interest income to further decline in the second quarter as our portfolio turns over and our interest earned drops down to prevailing rates.

Now let me turn to the balance sheet for a few comments. I would like to first discuss the share repurchase program our Board of Directors initiated last July. We conduct our share repurchase program in accordance with the rules set forth by the Securities and Exchange Commission.

During the quarter we returned $60 million to shareholders by repurchasing 4.4 million shares of Foundry common stock at an average price of $13.56. To-date, the company has spent $143 million to repurchase 8.8 million shares of Foundry common stock at an average price of $16.23.

Earlier today, we announced the expansion of our share repurchase program by increasing the total dollar amount authorized for repurchases from $200 million to $300 million. The time frame of the share repurchase plan remains unchanged and runs through December 31st, 2008.

Of the $300 million authorized, $157 million is currently available for repurchases. Management and the Board of Directors actively assess the company's ongoing requirements for operating liquidity, including sales expansion, new product development, and funds available for potential acquisitions. Consistent with our past share repurchases, we plan to be in the market from time-to-time, Foundry's trading window, market conditions, SEC regulations and other factors permitting.

The company's cash and marketable securities decreased by $18.7 million in the first quarter of 2008. The reduction was primarily due to the $50 million share repurchase offset by cash flow from operations of approximately $35 million. The total value of cash and marketable securities now stands at $946.9 million.

With respect to our securities portfolio, we continue to manage our investments closely to avoid undue risk in an already conservative portfolio. During Q1, we have shortened the average term of our investments and further reduced a little of risk by reallocating $250 million to US treasuries. The net effect of our recent changes in asset allocation has reduced the interest income.

We have taken these actions in response the unprecedented credit market events that occurred during the first quarter of 2008. We evaluate our portfolio on a continual basis, and as credit markets stabilize, we would expect to latter out of the concentration in US treasuries and back into more traditional investments.

As disclosed in our recent Form 10-K, the company has $83 million invested in student loan based Municipal Securities with an auction reset feature, commonly referred to as auction-rate securities. The auctions for the securities we hold began to fail in mid February, and despite the fact that all of them hold investment grade ratings they are currently [liquid].

The net effect in our financial statements is that we have recorded a temporary impairment of $4 million to the value of these investments, which we have recorded as a reduction to both marketable securities and a charge directly to stockholders equity. This will reflect the loss of liquidity and we've also reclassified these investments. They are those investments that have failed auctions to long-term investment. We will continue to evaluate these securities on an on-going basis to determine if the impairment is other than temporary. Also, one of auction rate securities are student loan instruments, and in most cases over 90% of the collateral is backed by the Department of Education.

Now moving on down to balance sheet, day sales outstanding and accounts receivable were 64 days in Q1 down from 65 days in the fourth quarter. Our net inventories increased by approximately $7 million to $49.4 million in Q1. And we were turning our inventory at the annualized rate of five times in the first quarter.

As a result of the softness we experienced in our Q1 bookings, our book-to-bill in Q1 fell to less than one. We ended the quarter with a total headcount of 1,041 employees compared to 981 in the fourth quarter of 2007. The increased personnel in Q1 were primarily in sales and engineering departments. Our sales headcount at March 31, 2008 was 465.

Consistent with our practice, we will not be providing quantified revenue or EPS guidance. We would however like to provide a qualitative view of the current quarter. We believe our business is being impacted by the macro economic slowdown. As we sit here today, we are unable to predict the direction of the global economy of what further impact can they have on us.

The first quarter has made us cautious and in particular we are concerned about the pace of deal closure rates and the general availability of IT funding. That said, our pipeline of sales opportunities remains strong. Assuming no further deterioration to the macro economic environment, we currently believe overall revenue should grow modestly in the second quarter when compared to the first quarter of 2008.

In our Federal government business, we expect to see a typical seasonal drop before rebounding in the seasonally strong third quarter. We still anticipate achieving a higher level of Federal revenue in the first half of 2008 then in the first half of 2007, and expect to see a robust second half of 2008. Our Federal revenue in the first quarter of 2008 for reference was 16.5% above the same quarter last year.

In the service provider business we continue to believe our revenues will grow faster than our overall enterprise business. Our router business is expanding, and large accounts are beginning meaningful deployments. We continue to demonstrate our ability to bring value to tier 1 service provider customers, as well as our traditional tier-2 and tier-3 service provider customers. Particularly, as they build out their networks with cost effective high performance solutions to meet the ever increasing needs for additional service offerings and network capacity.

Regarding operating expenses, we anticipate operating expenses to grow modestly for the balance of 2008. The current June quarter is our trade show quarter when our largest trade shows occur, and it’s correspondingly our marketing expense. Lastly while our target operating margin range remains 20% to 25%. we expect we will not fall in the range for the full year 2008. However we do expect to operate in the range by the end of the fiscal year.

With those comments I’d now turn the call back over to Bobby.

Bobby Johnson

Thank you Dan. The second quarter is our biggest trade show quarter of the year. As you may have noticed yesterday, we had major new enterprise announcements. In advance in the next week's NetWorld+Interop trade show. We will continue to have new data center and service provider announcements next week at the show.

Additionally today, we announced that our BigIron RX has been selected as a finalist for next weeks Best of Show award. The BigIron RX is a LAN backbone and data center focused platform and next week we are announcing new data center capabilities for this platform. These new announcements drive the 10 Gigabyte Ethernet density to 512 ports per BigIron RX 32. This keeps us at the top of the industry for 10 Gigabyte Ethernet density, pricing, performance and routing and switching leadership. For the enterprise, we have announced new intelligent edge solutions for high speed 802.11n wireless infrastructure, IPv6 routing, new price and feature leading stockable switches and advanced first-to-market enhanced power output for our power over Ethernet connectivity products. This last capability nearly doubles the power output of our power over Ethernet capable switching platforms allowing us to power new generations of devices such as surveillance cameras, point of sale terminals, video phones and high speed 802.11n access points. Overall, these new announcements will allow us to deliver new applications and lower our customer's total cost of ownership.

Given the Foundry's last two year's of growth in revenue install based headcount, product and cash, we believe Foundry is well positioned for the future. As such we continue to focus on our leadership in the high performance IP switching, routing and application delivering networks. We continue to focus on market share gains in building a balanced enterprise and service provider solutions company. Our strategy of diversifying within our Federal business to branch out into new agencies is continuing to be successful and continues to give us optimism for the long term.

Additionally we continue to focus new efforts on expanding our service provider business and we believe we will continue to gain traction in key strategic accounts. The recent positive comments and statistics by Gartner heavy weighting and synergy research substantiate our progress and positioning to date.

In spite of the volatility in the financial markets we believe we are well positioned to continue to gain in both the enterprise and service provider. We believe that the investments we've made and continue to make in the business will indeed drive improved performance and establish a stronger foundation for the longer term. I would like to thank all of our employees, partners, customers and shareholders for their commitment to Foundry.

I would now like to turn the call over to the operator Jill for a question and answer period.

Question-and-Answer session

Operator

(Operator Instructions). We'll take our first question from Matt Robison from Ferris, Baker Watts. Go ahead.

Matt Robison - Ferris Baker Watts

Hey good afternoon. I was wondering first of all if you could provide us maybe a little more detail on the weakness you saw in terms of if there any particular sectors and what time in the quarter you started to see it go and if there has been continued downward trend this quarter to date. The other question I had is on sales and marketing if that increase was just purely headcount related or if there was something else going on there to drive it in the quarter?

Bobby Johnson

Okay. This is Bobby and I'll take first part of the question and ask Dan or Mike to fill in. So if you can look at our service provider results, they were reasonably strong given the overall economy. So the majority of the downturn so to speak was attributable to mostly the seasonality in both Federal and I would say worldwide enterprise customers. Certainly North America was influenced but also some of Europe.

So it was mostly enterprise and mostly Federal and we kind of cautioned about seasonality on our last call, in particular Federal where we tend to go gangbusters in the second half of every year. In the first half, we tend to go a little bit down compared to the prior first half. So overall Federal was not surprising to us and overall enterprise was a little bit surprising to us. So Dan and Mike if…

Mike Iburg

Yeah. So Matt let me, talk about the expense build for the sales and marketing teams. So we added, as I mentioned the 25 sales resources in the quarter. We also had a heavy hiring in the fourth quarter. Some of those employees reported late in the quarter, so that explains a piece of it. And we also as you would guess from actively recurring like that we've been in the market and we were understanding there had been a shift in compensation for a high quality sales resources and we did go through our entire sales and marketing and staffs and do a merit and market adjustments for the compensation. So those two elements increased the expense base. Then on top of that we still have predominance of our sales and marketing candidates in the US, we had to reset for the tax as the payroll taxes in the first quarter and those employees also participated in the 401(k) match which adds expenses. That was principally the big change in expense quarter-over-quarter.

Matt Robison - Ferris Baker Watts

It's helpful. Further more help on the geographic perspective, now one thing started to decline more precipitously and how things look quarter-to-date if that has continued to decline as severely?

Mike Iburg

Well, so this is Mike. I don't think from our perspective things accelerated in the back half of the quarter, but didn't accelerate to the amount necessary to make the quarter at least to land where we would have hoped to have landed. The, it wasn't necessarily the case it was any particularly week or couple of weeks. When we look back in hindsight it's a little bit more clear that the acceleration that we saw, sort of in the back half of February and continuing through the month of March was not the level of acceleration that would've been that's necessary to hit the numbers. But we are probably half way through that time frame before we could see enough of that to understand kind of what the issues where.

And as Bobby said it was more of a broad based issue. As Dan highlighted in the script, a lot of it was international in many cases it was either projects that were either postponed or larger projects that were broken up into smaller pieces. Some of that, I think there is a little bit of the sliver lining there, because for those orders that were broken up into smaller pieces. We believe that now that the customer has made the decision to go with Foundry that we'll get those subsequent pieces further downstream. Does that help?

Matt Robison - Ferris, Baker Watts

Yeah and I imagine some of the other callers will hit you with the topic, so I'll just yield the floor and listen to the rest of the call. Thanks.

Mike Iburg

Thanks, Matt, next question.

Operator

We will take our next question from Troy Jensen from Piper Jaffray. Go ahead.

Troy Jensen - Piper Jaffray

Hey guys. I'll follow-up on that. (inaudible) up there on the international weakness. Just seems a little cornering to it is right, since North America was the weak economy and you guys had marginally stronger economies in Europe and Asia plus a currency effect to boost it there. So was it completely just project related kind of delays or do you think there is increased competition or poor execution?

Mike Iburg

I will jump in and say one thing real quick, which is if you dial back to the call we had in January we told you folks that we had a bunch of North American backlog into January out of Q4, just because of the linearity and how the international quarters came in the fourth quarter.

Troy Jensen - Piper Jaffray

Okay.

Mike Iburg

So and what we said on the call back in January was that although we expected to see a seasonally soft North American enterprise market, we thought we can offset a portion of that because of the backlog that we have. So what you are seeing in the North American numbers is that we reported today is the backlog help in the North American fees. We didn’t have that backlog benefit in the international markets and that's why the international markets which come out of Q4 we actually thought Europe would carry forward with a fair bit of momentum which didn’t materialize.

Bobby Johnson

Also one other disappointing area was Japan for us. Japan has usually been pretty good to Foundry, but we have not been immune over the last two years to the general capital equipment spending recession in Japan and like most of their equipment manufacturers, I think we are all little disappointed in our Japanese results.

Troy Jensen - Piper Jaffray

That's fair. And Mike, so you brought up all the backlog stuff?

Mike Iburg

Yeah.

Troy Jensen - Piper Jaffray

Could you guys give us any color around -- how far away from one was it?

Bobby Johnson

Well I don't think we're to give color as to how far away was from one, but I think if you go back to Dan's outlook section. He did say in his outlook that we believe that we can be up modestly in the June quarter, which tells you know that between pipeline and what we have in backlog, we think we got a good shot of being up.

Troy Jensen - Piper Jaffray

Okay. That's fair and last one I'll get out of the line here. Any sense of what percentage of your routing sales came from these four Tier 1 customers?

Bobby Johnson

Can I give you an exact percentage, but I would say that from the four Tier 1s it's still modest percentage because we're in early stage deployments there. Overall the service provider contribution was pretty broad based. We added north of, worldwide north of 80 new high end and or SP customers during the quarter. So we still have plenty of opportunity depending upon how the initial deployments go in those four Tier 1s.

Troy Jensen - Piper Jaffray

Right, understood, good luck guys.

Mike Iburg

Thanks. Troy.

Operator

And we'll take our next question from Bill Choi from Jefferies. Go ahead.

Bill Choi - Jefferies

Okay, thanks. Couple of clarifications first. On the tax rate you said effective rate was 36% in the quarter and 38% for the full year, so does that mean we're going to have for the next three quarters something higher than 38%, just to make up for that?

Mike Iburg

Yeah I think just modestly higher to make up for that. That's right.

Bill Choi - Jefferies

Okay and that's the rate and 38% is obviously the number to use for 2009?

Mike Iburg

At this point…

Bobby Johnson

At this point we don’t have anything better?

Mike Iburg

Yeah. That’s right.

Bill Choi - Jefferies

Okay. And then the other clarification just on the inventory increase, are you anticipating that because there has been some build-up of inventory that you have some absorption counting issues impacting gross margins on the products in Q2? And is that part of the issues impacting over operating margins?

Mike Iburg

I'm sorry, say it again. What kind of problems?

Bill Choi - Jefferies

Just, not yes, not a problem which is higher inventory and just inventory absorption into…

Dan Fairfax

Yeah. We wouldn't anticipate that. Then clearly the build was our expectation that the order rate will be strong and we would have materials available shipped to those customers but there is nothing in that build that would lead to an excess or obsoletes in reserve.

Bill Choi - Jefferies

Okay. The other one is that, could we attribute all of the decrease in gross profit from the service side to this new way of allocating expenses i.e. $2.2 million coming out of sales and marketing and into cost of goods sold?

Bobby Johnson

Yeah. The entire change was related to them to the change in allocation. If you look at the difference quarter-over-quarter, it was from the allocation of these other sales and marketing expenses.

Bill Choi - Jefferies

And my math is about right that 2.2 or so million?

Bobby Johnson

I don't have it in my finger tips. $1.5 million would be closer.

Mike Iburg

Right, and I would just like to reiterate our overall gross margin remained strong even on a down quarter and even with the change in accounting?

Bill Choi - Jefferies

Okay. And then just…

Mike Iburg

I think we got to move on. Let somebody else have a chance.

Bill Choi - Jefferies

Got it. Thanks.

Mike Iburg

Thanks Bill. Next question.

Operator

We will take our question from Manny Recarey from Kaufman Brothers. Go ahead.

Manny Recarey - Kaufman Brothers

Thanks. I am trying to understand the revenue guidance a little bit here. If you look at the last two years, you had a pretty significant decline from the first and second quarter in the US Federal. So I understand that and I think that’s kind of what you were talking about in. That Dan spoke about. So we have to see a pretty big sequential increase in either the US enterprise or in international. Is that what you are expecting?

Mike Iburg

Yeah, I mean this is Mike and I'll just jump in and begin by saying that I think part of it is a fact that we don’t expect have the same sort of federal trough this year at least to the magnitude that we saw last year. If you recall last year federal went from roughly $25 million in the first quarter of ’07 to $16 million in the second quarter of ’07. We are not at this point anticipating that level of decline. So although we think federal may lighten up a bit more here in the June quarter, we don’t expect it to be of the magnitude that we saw last year. So that helps sort of provide a foundation upon which then, whatever benefit we can get out of North American enterprise, European and Asian enterprise plus the continuation of the service provider demand. As far as we can sell from what we said, so it adds up to indicate that we will be roughly where the unguided or provided given out the outlook to.

Manny Recarey - Kaufman Brothers

Okay, and then one more question is. Have you seen any impact from Cisco's new products and also Juniper starting to talk about introducing their new products. Have you seen any if that's contributed to any slowdown in the market at all?

Bobby Johnson

Let’s break the two down from Juniper announcement we have seen virtually no impact, their market presence in Ethernet switching is basically non-existent at this moment. And they have ways to go with their product line. Overall, Juniper is a good company, but we surely haven’t seen very much from their product lines.

From, Cisco's announcement, once again not very much have we seen that, obviously they have made some major new statements. Cisco is a great company, we do compete with them in virtually every deal, many of our customers are aware of their products or opportunities. There may be a few opportunities that I would like to see their product. But they really haven’t shown up as much as the announcements would tend to indicate. And they are having their challenges, positioning the Nexus 7000 against their existing 6500 et cetera. Not to say that those aren’t good products, but then again Foundry has been the market leader and with our announcements this week and next, I think we continue there.

So I think for Foundry we are more of a status quo for the last 11 years of product shipment. We compete against Cisco and we see them in every deal and that's what we do. We get up everyday and that's what we go at. There is nothing in those announcements that drastically changes the roadmap at all for what we have been doing.

Mike Iburg

Next question please.

Operator

We will take our next question from Paul Manskey from Citi. Go ahead.

Unidentified Analyst

Hi. It's actually John calling in for Paul. Couple of questions. First I would like to get a little more clarity if you could on the OpEx particularly in the sales and marketing, up quite a bit sequentially. What percent of that increase is due to this new comp plan you are talking about and then what percent is from a onetime event with the other stuff that you are talking about. What can we think of going forward a little bit is ongoing there?

Dan Fairfax

So I guess the way to look at is, you take the headcount that I gave you. The folks that have been hired much recently were being hired at the markets, so we hired 25 in Q1, 20

Mike Iburg

40 somewhat in Q4.

Dan Fairfax

Q4 and then Q3 we didn't add much to the sales force. So if you back those out of our total headcount of say 465, the sales force itself had not had an adjustment to its compensation for the last couple of years and the market certainly has become much more aggressive in terms of recruiting experienced sales people. Our belief is that we wanted to give you the rational.

We want to preserve and protect our performing employees because we know that the competition is out trying to build enterprise sales forces and our folks are a good place to go, they are looking. So we did boost the pay for a significant portion of our employee base. So I think you can probably back into it, if you think about what merit increases or base adjustments might be for that group of employees.

So that's a big chunk of the change and then in the current quarter, I'll say roughly 7.5% of compensation is the payroll taxes and most of our employees are highly compensated. So if you look at Q4 there is little of that 7.5% expense in the fourth quarter but that shows up in the first quarter. So hopefully those numbers will help you build a way to get to your model.

Unidentified Analyst

Okay. It should help a little bit. And then kind of going back to the international weakness, was it just a few deals or can you maybe give us a little clarity on maybe a few verticals that it was worse in overall, anything along those lines?

Bobby Johnson

Well, as we said the biggest disappointment overall was Japan and that was both service provider and enterprise in Japan. In Europe, mostly enterprise from a vertical, so…

Paul Mansky from Citi

Right, and Asia Pac did you see a slowdown of the…

Bobby Johnson

I think there were some slowdown by too, but overall okay. I mean, they would have a lot of to digest from us from last year.

Unidentified Analyst

Thank you.

Bobby Johnson

Yeah. I would just add that I think just because of our presence in Asia, it was probably more concentrated in Asia and a handful of accounts because we don’t exist everywhere in Asia and then when you get into Europe, it was much more broad-based.

Unidentified Analyst

Okay, great. Then I'll proceed forth.

Bobby Johnson

Thank you. Next question, please?

Operator

Next question from Mark Sue from RBC Capital Markets. Go ahead.

Mike Iburg

Mark?

Operator

We will take our next question from Tim Long from Banc of America. Go ahead.

Unidentified Analyst

Hi. Good afternoon. This is Jeff dialing in for Tim. Couple of quick questions. On the operating margins you indicated that you expected improvement during the second half, but you talked about a lot of trade shows coming up in the June quarter. Should we expect the operating margins to be down during the June quarter and then trend up from there?

Bobby Johnson

I think that as we look at the model that we have the company is taking a number of steps to try to moderate the increase in operating expenses that only in the current June quarter but for the rest of the year as well. And although we are going to continue to hire at a slower pace and it's down at a much slower pace. We still were making strategic hires as necessary, but I think we can at least the models that we've been working on, pretty much back at the operating income or operating margins close to where they were in the first quarter and then more of noticeable improvement in the back half.

Unidentified Analyst

And then product gross margins have now increased for, I think four consecutive quarters. Can you give a sense of where they can go and should we expect that to kind of trend up as we go through the year?

Bobby Johnson

Yes, there is a couple of different forces that impact progress margins. So one and probably the most, the one that has the most dynamic range to it is what's happening in the pricing environment and we've had I think going back to may be and we said in the third quarter last year we had. We've been and what we described as a beneficial pricing environment to this point. When I think that may be echoed by some of our peers in their commentary. If that were to change that could have a dramatic effect on gross margins and at this point we just can't predict seeing the direction that might go.

The other factors that positively influence our gross margin is the efficiency of our factory. These products are now becoming more matured from a production stand point, we're able to continue to ring cost out of them, so that's favorable. And then within our chassis space line, the chassis have been out in the market long enough. Now the customers come back and add extension those networks by bringing blades into the systems and blade the chassis mix can also be positive on the gross margin side.

Unidentified Analyst

So can you get to the mid 60% range on the products?

Bobby Johnson

We are fundamentally a hardware company and we always get a little nervous thinking that the numbers in that area are in that range. I think that we are pleased with what we have been able to deliver. The dynamics that Dan outlined obviously are the ones that play into the improvement. Another one which I've just mentioned, may not have been picked by others is that. As Dan said we had 75% of the revenue came from chassis products that's was up from like 71% or 72% last quarter.

That in itself was a pretty good shift towards chassis and the margins are better there. As you have heard from the product rollout or rollup, a lot of weakness was on the enterprise side, which meant a lot of the weakness was on the Layer 2, Layer 3 LAN switches, the routers actually did pretty well, in terms that they didn’t experience as much of a decline and the routers at this point because of the continued cost reduction. The routers are at a beneficial gross margin of the corporate average.

So all these little things add up, and unfortunately there are lot of dynamics that can put pressure on the product margins. So we're never inclined to start bragging about how far we think they can go, we are just pleased to where they have been.

Dan Fairfax

From a historical perspective, yes, we have climbed into higher gross margins and fast. However a lot depends upon product mix and vertical market mix and geographic mix. If you were to see the US market and service providers climb dramatically, and that could lead to an improved gross margin for us, but we don’t want to signal any improvement at this time, want to keep with sort of the historical average over the last year or so, not some of our averages some several years ago.

Unidentified Analyst

Lastly, with was supplemental getting pushed out again, what gives you confidence that we're not going to see a similar sequential decline in Federal as to what we saw in 2007 and 2006?

Bobby Johnson

It depends upon the agencies that we are selling in. It depends upon new wins versus continuing O&A spend. Right now we are optimistic. Obviously there are a lot of things that could be beyond our control. But that's a part of what we are trying to do is go into diversification to avoid some of these swings. Now at the moment what we are seeing is that we do have more diversification than in the past.

Dan Fairfax

I think also the thing that we take a little comfort in is the fact that more of the pipeline or more of the business expected in the June quarter is coming program spending as opposed to operational and maintenance spending. And typically a program has dollars appropriated to the program and those dollars can't be used for anything else. So that's a different position that we've bid. We worked in this position last year or in 2006. So with having the higher portion of the pipeline or of the forward-looking business coming from program spending as opposed more sort of operational maintenance spending that give us little bit more comfort.

Mike Iburg

Next question.

Operator

(Operator Instructions). We will take our next question from Andy Schopick from Nutmeg Securities. Go ahead.

Andy Schopick - Nutmeg Securities

Thank you. I just want to follow up Federal kind of from another angle. I am not sure what experience the company has had with election cycles per se. Is there any concern coming out of presidential election or coming in to a presidential election. There could be either a freeze or some hesitation either in the December quarter or even prior to that?

Bobby Johnson

Andy this is Bobby. There is always that chance that’s beyond our current…

Andy Schopick - Nutmeg Securities

Expectation?

Bobby Johnson

It is beyond our current expectation and although we have fairly good visibility in Federal. The reality is we don't have nine to twelve month visibility. We are pretty dialed in and we think it is a 90 to 180 day period and there is always some fluctuations even in that. I think a lot depends upon other macro economic conditions that could influence the US government.

Andy Schopick - Nutmeg Securities

Okay.

Bobby Johnson

But I will also just add that historically there has been movement by the sitting administration in an election year to actually get the budget in place prior to the election, because they don't want to go in to the election under the backdrop that Republicans or the Democrats can't even put a budget in place. So another time period, it is not in all of them, but in other election years we have seen that the budget actually gets put in place earlier rather than later.

Andy Schopick - Nutmeg Securities

Okay.

Bobby Johnson

This is an observation.

Andy Schopick - Nutmeg Securities

Thanks.

Mike Iburg

Next question

Operator

We will take our next question from Mark Sue from RBC Capital markets, go ahead.