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Meru Networks, Inc. (NASDAQ:MERU)

Q2 2012 Earnings Call

July 26, 2012 05:00 pm ET

Executives

Dr. Bami Bastani – President & Chief Executive Officer

Brett White – Chief Financial Officer

Sarosh Vesuna – General Manager, Education

Steve Pasko – Market Street Partners

Analysts

Jayson Noland – Robert W Baird

[Jason Willie – Talon and Company]

Blaine Carroll – Avian Securities

Rajesh Ghai – ThinkEquity

Erik Suppiger – JMP Securities

Name - Company

Operator

Good day, ladies and gentlemen, and welcome to Meru Networks’ 2012 Earnings Call. (Operator instructions.) As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s conference, Mr. Steve Pasko from Market Street Partners. Sir, you may begin.

Steve Pasko

Thank you. Thanks for standing by and welcome to the Meru Networks Q2 2012 conference call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation the conference will be open for questions. On the call today are Dr. Bami Bastani, President and CEO; Brett White, CFO; and Sarosh Vesuna, General Manager of Education.

During the course of this call Meru Networks’ management will make forward-looking statements regarding future events and the future financial performance of the company. Generally these statements are identified by the use of words such as “expect,” “believe,” “anticipate,” “intend” and other words that denote future events. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements.

We caution you to consider the important risk factors that could cause actual results to differ materially from those in the forward-looking statements in the press release and this conference call. These risk factors are described in our press release and are more fully detailed under the caption “Risk Factors” in Meru’s most recent quarterly report on Form 10(q) as filed with the SEC on May 4, 2012, and the company’s other filings with the SEC.

During this call we will present both GAAP and non-GAAP financial measures. Non-GAAP measures exclude amortization of acquisition-related intangibles and stock-based compensation expenses. These non-GAAP measures are not intended to be considered in isolation from, a substitute for or superior to our GAAP results and we encourage you to consider all measures when analyzing Meru’s performance. For additional information regarding our non-GAAP financial information and the most directly comparable GAAP measures please refer to today’s press release regarding our preliminary Q2 2012 results.

The press release has been furnished to the SEC as part of a Form 8(k). In addition, please note that any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events. Now I will turn the call over to Dr. Bami Bastani, President and CEO of Meru Networks.

Dr. Bami Bastani

Thank you, Steve, and welcome everyone and thank you for joining Meru’s Q2 2012 earnings call. Today in addition to discussing our 2012 Q2 results I will give you an update on my first 100 days here at Meru and our progress towards the Q2 priorities I set on our last earnings call.

As a reminder, these priorities included one, holding OPEX at or below Q1 levels with heightened focus on efficiencies and performance management including sales and marketing where we have increased investment by roughly 60% over the prior twelve months; two, redirecting marketing from brand and broad media to targeted demand generation; and three, improving our product development engine to better manage product transitions and put in place processes consistent with our best-of-breed strategy. I believe these areas of focus all serve as key catalysts for Meru to get back on a profitable growth path.

Now on to our Q2 results: I’m pleased to announce that the company had record revenue in Q2. I would like to thank our customers, our partners and our employees who made this possible. The company’s Q2 total revenue was $24.5 million US representing a quarterly sequential growth of 26% and exceeding our guided range of $20 million to $22 million. Our non-GAAP gross margins were at 65.1%, above our guided range of 63% to 64% and a 60-basis point improvement from Q2 2011.

Q2 2012 was a strong quarter for us across the board including our reduction in OPEX and cash use. As we stated on our April call, we set a goal of holding OPEX at or below Q1’s level of $24.1 million. I’m happy to report that in Q2 we achieved $20.1 million in OPEX representing a reduction of 6% from Q1. We continue to remain extremely focused in executing in our key markets and improving the efficiency of our markets as we optimize our cost structure and drive towards our goals of growth and profitability over the next several quarters and expect that the cash burn in the second half will be significantly reduced from the first half of the year. Brett will discuss the numbers in greater detail after my comments.

On our last call we had talked about key transitions that impacted our Q1 2012 results. These transitions included the company bringing onboard the new CEO, the rapid expansion of the sales force and the introduction of major new products and software releases. I’m happy to report that the CEO transition is complete. These included considerable travel and numerous deep dive meetings with our customers and employees. I believe my meetings helped give me a balanced view of Meru and our opportunities as well as our challenges. In Q2 we made significant operational changes and implemented new processes specifically designed to address the needs of our customer base.

As we pointed out in April the company has historically invested significantly in sales and marketing. In the last four months my goal has been to concentrate on accelerating productivity by rightsizing the spending with the goal of bringing our expenses as a percent of revenue to a number that is more in line with industry norms over the next several quarters. In this regard we have been closely monitoring planned and actual productivity rates as we align resources with our most promising opportunities. This is a big part of our management approach to profitability.

As further evidence of our narrowed focus we have moved from a horizontal go to market approach to a well-defined vertical marketing strategy with education, hospitality and entertainment, and healthcare as prime focus areas. As you may have seen in the press we recently named a GM of Education and a GM of Hospitality and Entertainment. This vertical emphasis is designed to maximize our available resources against opportunities and give more direct support to this field, sales organization in form of targeted sales tools, and lead generation.

We will continue to sell into other segments such as business enterprise but will do so with our broader horizontal solutions. We believe our enhanced vertical focus will produce efficiencies in product development, marketing, service and support as well as improved customer satisfaction. These moves combined with our robust new product pipeline are designed to not only result in reduced costs but to accelerate our growth going forward.

Now I want to highlight our progress in new products. Innovation is key to our differentiation and success and this is evidenced in our robust new product pipeline. In Q2 we instituted a rigorous engineering process designed to provide the foundation for next generation product releases built on our mutual sale and single-channel innovations to address market needs. Simply stated, we believe we have the best, most tailored and price flexible offering in the pipeline to meet our customers’ needs all on a single converged platform. Meru’s Wireless managed solutions can be managed by customers centrally with physical controllers and management applications, virtually, or in a private cloud in multiple locations. The customer can even deploy and manage Meru’s solutions in a combination of all three environments.

Looking ahead, as 802.11ac compliant devices become available in PCs, tablets, phones, we’ll be unveiling our 802.11ac solutions to support this new standard. We are very excited about the 802.11ac standard because we believe our single-channel architecture is best suited to deliver on its promise of greater coverage and bandwidth. By definition, the 802.11ac spec calls for fewer channels for accommodating increased coverage with greater bandwidth and throughput.

Our microcell competitors who depend on a multiple channel approach would likely need to make significant adjustments to their architectures to get the most from this new spec, and their customers will likely need to do major planning revisions in their current deployment to get a smooth transition. We believe Meru’s single-channel architecture advantages will be even more evident with the 802.11ac standard as our approach is designed to deliver maximum coverage and bandwidth without major deployment planning issues and revisions. We’ll be talking a lot more about this development beginning this month in our marketing and sales efforts.

Now I want to add some color regarding our customer wins and growth of our new customer base. During Q2 we increased the number of customers that have purchased our products to date through the end of the quarter by approximately 7%, adding more than 400 new customers worldwide. These new customers came primarily from our traditional stronghold verticals of higher education, K-12, and healthcare. We also added more large enterprise customers from the retail, manufacturing and logistics, and the hospitality, sports, and entertainment verticals.

In the US and Canada we had solid wins in several categories. In Minnesota we closed a K-12 deal; in the South we were selected by a leading technology university to accommodate 3500 existing students and 500 new freshmen; a Midwestern state legislation replaced a microcell implementation with Meru in their House and Senate chambers as well as their supporting offices; and a major premium brand hotel but a complete Meru Wireless LAN solution.

Some notable wins in WINS include initial shipments of equipment to support 1200 schools in Northern Ireland; an English premier soccer league, a football or soccer club; a major microcell replacement at a magazine publishing company; the National Swedish Library; several universities and primary schools and a major premium brand hotel in the UK. [APAC] closed deals with major Chinese universities replacing [X3C]. Also a leading consumer electronics brand selected Meru for 26 warehouses in Japan and Meru will be replacing Aruba and Cisco at a noted Japanese university.

Talent retention is an important factor for our continued success. As you may have seen today we announced an option exchange program that will allow many of our employees who have stock options that are significantly underwater to exchange their underwater options for new options, reset investing and a lower exercise price. Over time we believe the new options will create stronger incentives for our employees to contribute to achieving our business objectives and ultimately building shareholder value.

To close, Q2 was a great quarter for us, proving what can be accomplished when we sharpen our focus, align our resources and manage not only for our growth but also for fiscal success. As promised in our last call we addressed product transition issues, implemented new processes to ensure superior product development and management going forward, and continued to assimilate and scale our sales capacity and focused on what we believe are our best growth segments in a well-defined vertical marketing approach.

This progress marks a beginning of a continuous improvement mandate. I will continue to be diligent regarding cost production coming from even more concentrated attention to productivity and efficiency, elimination of underperforming expenses, and a sharper focus on markets we believe we can best serve while spending less time on marginal opportunities.

I want to conclude by emphasizing what I stressed during our last call. Job #1 is to structure the company for improved financial performance. Some key near-term actions include deliver best of breed solutions with our differentiated products, verticalize our go to market approach for faster customer adoption, and relentlessly pursue cost management and improvement in productivity and efficiency.

In Q3 and Q4 we plan to continue to optimize our financial performance with the goal of having second half OPEX being lower than our first half OPEX for 2012. We know historically that Q3 is seasonally softer than Q2 and we expect revenues for Q3 to be between $23 million and $25 million. We remain confident about our future. Our category is projected to keep growing in double digits at least through 2015 according to IDC. BYOD, mobility and virtualization remain key issues for the CIOs in practically every part of the category, and Meru’s architecture is designed to very effectively address these trends. We believe 802.11ac will soon take the place of 802.11n as the de facto adopted standard and that Meru’s single channel architecture will meet its specs better than other competitive offerings.

Our Q2 2012 revenue performance combined with solid OPEX reductions and a better productivity from our sales and marketing investments is a good start and proof that we can manage to improve performance. Now I will turn the call over to our CFO Brett White to further detail our financial results.

Brett White

Thanks, Bami. Please note that the following discussions of our operating results will be on a non-GAAP basis, which excludes stock-based compensation expense, Chief Executive Officer transition costs, amortization of acquisition-related intangibles, litigation reserves expense, and amortization of common stock warrants issued in connection with debt financing. For a reconciliation of GAAP to non-GAAP results please refer to the press release issued today and the supplemental financial information which is posted on our investor relations website.

As Bami mentioned we are very pleased with our financial performance for the quarter, exceeding our communicated goals for revenue, gross margin, operating expense, and cash. Total revenue for Q2 was $24.5 million. This represents growth and products and services revenue excluding ratable revenue of 26% from last quarter and 10% from Q2 last year. Products revenue was $20.3 million, up 28% from last quarter and up 7% year-on-year. Support and services revenue was $4.2 million, up 17% from last quarter and 33% year-over-year. Ratable revenue was $42,000.

Approximately 55% of Q2 revenues were from the Americas, 37% were from AMEA and 8% were from Asia-Pacific. Excluding the impact of ratable revenues, Americas grew 22%, AMEA grew 60% and Asia PAC declined 28% from last quarter. 96% of our shipments were through indirect channels and the remaining 4% direct.

Total non-GAAP gross margins in Q2 were 65.1%, above our guided range of 63.0% to 64.0%, and representing a 60-basis point improvement over Q2 2011. In Q2 we increased our inventory reserve for some of our older products which had a 245-basis point negative impact on Q2 gross margins. Total non-GAAP operating expenses were $20.1 million down 6% from last quarter. The sequential decrease relates primarily to a reduction in G&A expense and marketing programs. Non-GAAP net loss was $4.6 million compared to a net loss of $945,000 in Q2, 2011. Non-GAAP loss per share was $0.26 using basic diluted share count of approximately 17.8 million.

In June we closed a $12 million growth capital debt financing to provide an additional cash cushion as we transition to our goal of profitability. We ended the quarter with $30 million in cash, cash equivalents and short-term investments and $11.1 million of debt on the balance sheet. As we highlighted in our last earnings call, we had approximately $4 million of one-time cash items in Q2 2012 which includes CEO transition costs, a litigation settlement and some CAPEX for our new India facility that we do not expect to repeat in Q3.

DSO improved to 46 days compared to 52 days last quarter. Deferred revenue was $15.6 million, an increase of 24% from last year excluding the ratable revenue element. Our fulltime equivalent headcount at the end of the quarter was 430 compared to 441 at the end of last quarter.

Now on to guidance: we’re currently estimating that total Q3 2012 revenues will be between $23 million and $25 million. We expect non-GAAP gross margins to be in the 63.5% to 64.5% range. We expect that the cost reductions we’ve put in place in Q2 will continue into Q3 and that non-GAAP operating expenses will be at or below Q2 levels. We further expect that non-GAAP operating expenses for the second half of 2012 will be less than the first half.

Based on these estimates we expect Q3 non-GAAP net loss of $4.6 million to $6.3 million or $0.26 to $0.35 per share based on a share count of approximately 18 million. These estimates include approximately $0.6 million of interest expense. We expect cash use to decline sequentially in Q3 and in Q4, resulting in a total cash use for the second half of the year of less than $10 million. This concludes our prepared remarks. Operator, can you please open the call for questions?

Question-and-Answer Session

Operator

Thank you. (Operator instructions.) Our first question comes from the line of Jayson Noland with Robert Baird. Sir, your line is open.

Jayson Noland – Robert W Baird

Okay, great. Thank you. I’ll start with the K-12 performance on the June quarter. Given it was the end of the fiscal year how did that finish up?

Brett White

It was very strong. We’ve historically had big K-12 Q2s. Sometimes it bleeds into the first part of Q3 as well but K-12 was very strong for us this year.

Jayson Noland – Robert W Baird

Okay, and the cost optimization, Brett – what are you doing there to reduce costs from the first half to the second half?

Bami Bastani

Jayson, let me just give the two major categories. First we look at the programs that we’re doing, a shift in marketing expenses away from media and brand. We had got a lot of leads so the brand recognition has done its job. We’re now following those leads – and when I say “a lot” I mean thousands of leads. And so that’s shifted from expensive media placements into vertical marketing. And the other one that you’ll notice is we had a reduction in headcount generally through performance management and attrition.

Jayson Noland – Robert W Baird

Okay. On the sales structure, Bami, you’ve talked about verticals versus regions. Can you update us on the progress there?

Bami Bastani

Yeah, it is really the combination of introduction of BU or general managers to act as a focusing lens in terms of the horizontal activities that we have been doing. So our Sales Team still is geographical, territory-focused. In certain regions we’re very strong in K-12 and education; in certain areas, healthcare shines very strongly. We are making a very strong push into hospitality, sports and entertainment. In the last quarter we talked about the Caribbean Cruise Lines for example as very good evidence of that where we have made significant wins there.

So in terms of verticalization it’s an overlay of a GM structure and marketing on top of our Sales Team to create more focus. The outcome of that is much better collateral. You know you’re not going to talk to a school the same way you talk to a hospital, and you develop the collateral that resonates with those target markets, the solution that resonates with them.

Jayson Noland – Robert W Baird

So would products be bundled differently by vertical or would sales engineers be focused on a certain vertical?

Bami Bastani

So sales engineers, depending on their strength of their territory will be focused more on verticals. In terms of the solutions, yes – we are developing solutions that tailor to each vertical a lot [easier]. So at the end of the day I want doing business with Meru to be considered “This is a company to do business with.”

Jayson Noland – Robert W Baird

Okay, and the last question for me just on sales effectiveness: headcount and sales was doubled last year, and with these changes or overlay I guess how are you looking at measuring salesperson effectiveness?

Bami Bastani

The purpose of the Sales Team is of course to drive growth, so we have established minimum criteria for territories which are acceptable and we are performance managing to those minimum criteria. On the other side, criteria that are fresh territories but are showing a significant growth vector, we are reinforcing them and encouraging them. So the term I used was we’re going to be focusing on efficiencies and performance management with a view towards the long-term and medium-term growth.

Jayson Noland – Robert W Baird

Okay. Thank you, nice quarter.

Operator

Thank you. Our next question comes from the line of [Jason Willie with Talon & Company]. Sir, your line is open.

[Jason Willie – Talon and Company]

Hi, good afternoon, guys. Let me start with a question on revenue and maybe you can talk a little bit about how the revenue developed in the quarter. Obviously it’s a strong number. Was it just a situation where you were able to complete some deals maybe that had been in backlog for a while or did a lot of what you saw did develop and close during the quarter?

Brett White

So the way our sales process works is we build pipeline. We look hard at it four quarters out and then as it gets closer and closer we build into our forecast where we actually think it’s going to land, whether we think it’s going to close and in what period. So most of the business that we closed in this quarter had been originally spec’d for this quarter, so I don’t think there were material deals that rolled from Q1 to Q2. I think the majority of this business was always spec’d for Q2 because a fairly good chunk of it was K-12.

Bami Bastani

And then we had a better success rate closing against the competition.

[Jason Willie – Talon and Company]

I mean have you gotten any sense from the deals that have closed and the salespeople that are associated with them, are we seeing some of what has been (inaudible) looking for for a while in terms of increased effectiveness of the new hires? Or I mean the K-12 business is somewhat expected I guess in this quarter so [maybe] that’s kind of more of what you were already doing. So maybe talk a little bit about if you can the effectiveness of some of the people you’ve brought onboard.

Brett White

Yeah, I would say that absolutely we’re seeing increased productivity and effectiveness of the people that we hired last year and then through January of this year. Some of them are now starting to hit their stride. I think that combined with our strength in K-12 both kind of helped this with I think a real strong quarter. But yeah, definitely every day we’re seeing improved productivity from our Sales Teams and you know, the focus is pretty intense on getting the teams productive and I think it’s paying off.

Bami Bastani

Yeah, Jason, generally when you focus on something you affect change and so there’s a very, very heightened focus both at the Senior VP level and of course senior level in our sales process.

[Jason Willie – Talon and Company]

Okay, great. And then on the technology front you mentioned 802.11ac as something that you see being important for you guys. I wondered if maybe you could talk a little bit about the timing. Obviously there’s issues in terms of getting devices out there, the (inaudible) devices. So kind of how do you see that market developing over maybe the next twelve months or so?

Bami Bastani

Yeah, you know, clearly our strategy is to be among the thought leaders if not the thought leader and being there early next year. The market in our view will fully develop in 2014; however, you want to be there with the right products with the right time to set the stage from that significant growth. So we expect some revenue in 2013 but primarily the market developing in 2014.

[Jason Willie – Talon and Company]

Okay, and then just one last one from me. I’m wondering when you kind of think about the headcount moving forward, are we looking at a similar strategy with maybe reduction through attrition or is there anything else that you can add on that?

Bami Bastani

Yeah, and I’ve been very frank and open with everybody. Excellence is the criteria that we have to measure ourselves against. So we will look at inefficiencies, we will look at underperforming assets, underperforming territories. I think everything is fair game that moves up the (inaudible) class. Along the way also we’re here in Silicon Valley and attrition is a part of life, so to me performance management, efficiency and attrition coupled with growth. I mean I’m as keen on you grow your way out of this, not save your way out of this; but at the same time we do have an OPEX which is higher than it should be so you do work on both fronts. And that’s a very delicate balance.

[Jason Willie – Talon and Company]

Alright, thanks guys. I appreciate it.

Operator

Thank you. Our next question comes from the line of Blaine Carroll with Avian Securities. Your line is open.

Blaine Carroll – Avian Securities

Thank you. Hi, Bami; hi Brett. Congratulations, guys, you must feel pretty good, huh?

Bami Bastani

Thank you. It was a good quarter.

Blaine Carroll – Avian Securities

Yes, yes. Brett, do I understand that almost 100% of the revenue this quarter came out of backlog? Is that what you were saying?

Brett White

No, no, sorry. What I said is we’re a book and ship business, so basically what we do is in the forecasting process we walk it through the sales cycle. We track everything in salesforce.com, we look out four quarters and we watch it come through the process. And so I think the question was did any of this roll from Q1 or was it all originally scoped for Q2, and the answer was it was all originally scoped for Q2 but the majority of this business excluding the support that ran off the balance sheet was booked and shipped this quarter.

Blaine Carroll – Avian Securities

So that begs the question what type of visibility do you have into the current quarter?

Brett White

Right, so I’d say our visibility… So what we have in the can is what rolls off the balance sheet primarily on the support line and then you know, we have a very rigorous sales process that we go through for deal qualification and close, etc. And then part of that is existing customers, they’re planning to buy more so as best as they’re able to estimate their deployment dates we can match our forecast up against that. So we put all that together and that’s how we derive our forecast, but at the end of the day we’re a book and ship business.

Bami Bastani

Blaine, we made a comment in our previous discussions and I believe that on the salesforce.com, so we constantly monitor the pipeline and whether the pipeline is growing or shrinking or staying constant – it is a good leading internal indicator to us. And we also indicated on the last call that the pipeline is strongest that we have seen in the past, so that was a good leading indicator as we were like one month into the quarter, looking at things.

Blaine Carroll – Avian Securities

Great. And then it sounds like K-12 was probably the strongest vertical. Do you care to give out what percent came from each of the verticals, or more specifically what came from K-12?

Brett White

So we haven’t historically broken them down but historically our top three verticals, which are K-12, higher ed and healthcare, have been two-thirds or slightly above for the quarter. In Q2 usually that number is higher because K-12 is higher, and you’re right, K-12 was our biggest contributor this quarter.

Blaine Carroll – Avian Securities

What about controls versus AP?

Brett White

We don’t really break that out just because they’re kind of part and parcel, and it’s all how you sell and price.

Blaine Carroll – Avian Securities

Okay, let me see what else do I have. Bami, you talked about the operational changes; you said that you’ve implemented a number of operational changes but then you didn’t say what they were. Do you want to focus on a couple of the big ones?

Bami Bastani

I think product management to me is the biggest one where you bring the discipline and reinforce the discipline of phase reviews, product lifecycle, when the product is released from engineering, how much QA rigor you build into it, the beta customer process. This is the direction I’d like to drive the company: easy to do business with with highest quality. And at the same time you want to optimize that with the timely releases so you catch the major waves or you’re in the leading edge of the major wave.

We want to be in the [bow wave] – so focusing on AC being up there early on, focusing on what we call a converged platform implementation, focusing on the beta process for robustness of releases. So these are things that we with our methods and disciplines, that if you know what you’re doing it’s quick to implement and plentiful, and we have seen the benefits of it very fast. And it results into better customer satisfaction.

Blaine Carroll – Avian Securities

Okay, sorry about that, Bami. If you listen to the chip guys – Broadcom, RFMD on their call the other night, Triclent last night – they’re all very excited about what’s going on in the AC market right now and actually revenue that they’re recognizing there. So I guess my question for you is how do you see AC rolling out? And without answering a question, is it fair to assume that right now it’s routers and CPE equipment maybe in the home market that is receiving devices, and then you’ll get smartphones and devices next year; and as you said the 2014 rollout will sort of hit the wireless LAN – enterprise, education, healthcare verticals, etc., etc.? Is that a fair way to look at it.

Bami Bastani

It is fair. As you know I spent ten years in that world, so [Ralph Qunicy, Bob Frongsworth], they’ll all good old friends. So-

Blaine Carroll – Avian Securities

Yep, yep. You’re not (inaudible) in wireless LAN anymore, Bami.

Bami Bastani

Yeah, so you know all these consumer devices, literally even go back to let’s say the history of 3G – you always have your consumer devices must have that capability a year ahead of the infrastructure deployment, which is still consumer-oriented before it becomes a commercial implementation. So what you see is very par for the course. Today, the chip makers, tomorrow the introduction of the smartphones; and then after that it becomes the universe of 802.11-ac in the various verticals and enterprise. It’s a good sign, by the way, a very good sign.

Blaine Carroll – Avian Securities

No, no, without a doubt. Alright, great guys. Thanks and good luck.

Bami Bastani

Thank you.

Operator

Thank you. Our next question comes from the line of Rajesh Ghai. Your line is open.

Rajesh Ghai – ThinkEquity

Yes thanks, and congratulations from my side, too. Bami, when I last spoke to you we spoke about the vertical strategy of your specific three verticals, and obviously that takes a little bit of time to operationalize in terms of solutions, in terms of the sales and marketing side. But I would imagine that the sales and marketing side has [probably already] made progress and if you talked about it I apologize, I have been jumping between two calls. But on the sales and marketing side how far ahead are you and on the products side, the solutions side, how far ahead are you on that strategy of tailoring solutions for specific verticals and go to market?

Bami Bastani

Yeah, I think probably the best way to address that, I have on the call Sarosh who is our GM for the Education vertical BU. And he can just share with you some of the thought processes and some of the things that he has already implemented in a very short time since he has taken the rein of that BU. So Sarosh, why don’t you start?

Sarosh Vesuna

Thank you, Bami. So what we’ve done is we’ve taken our marketing and sales tools and laser focused them on the requirements of the customers in the verticals. The key requirements for Education are connectivity and mobility, and all the smartphones and tablets that come to campus are adding density and driving capacity on the wireless network.

So as you’re aware, Meru’s single-channel architecture is ideally suited to do channel layering which allows the campuses that we serve to add capacity, which is [RF] capacity. It allows them to separate the traffic [over the air] and does provide the quality of service, a class of service for students, for teachers, for guests, etc. So we’re taking our focus from a customer standpoint and driving to basically have all the sales collateral for that.

Bami Bastani

So we are already, that was kind of a sampling of sharpening our focus in education. You really want to go there, talk education language, talk education tools. When I go to higher ed and I visit three major universities, the first thing that came across is “Something changed somewhere in Fall of 2011.” Well, what’s happened is that every student showed up with a tablet and an iPhone probably, plus their laptop so you’ve had a tripling of trying to connect and video streaming. If you looked into [John Chambers] in the context of tele-presence, 90% plus of the data traffic soon is going to be video so it’s no longer an email coming through.

So we’ve seen the first effect of this both change in use cases, a heavy bias towards your video traffic, a heavy bias towards mission critical applications. You know, professors give online test in lecture halls now, so these are mission critical. It’s no longer nice to have, it’s no longer good to have; and moving from mission critical even to fall tolerant applications. So you’ve got to come with those solutions and that’s what Sarosh referred to – you go to a university, you talk about channel layering, how it can separate students, how it can track.

The other thing is, and what is unique about Meru is that our APs talk to each other, and through our network management we can rewind the tape and know at what point things failed. This is a true testimonial from one of the satisfied higher ed customers of ours. He said “With your network, if there is something wrong with the network we can separate it – was it the Wi-Fi or was it the backbone? Where is the issue? With others we have a tough time because APs don’t talk to each other.” So this kind of capability is very unique to Meru and now it becomes part of our sales process to these higher education and higher demanding environments.

And even our pitch to higher education is different from K-12, which is a room maybe with 30 PCs or laptops and BYODs are not maybe allowed in the classroom yet kind of a thing. So we have also started to talking to certain ISPs in hospitality. We have made major progress there, looking to their needs and their language. So when you deal with a hospitality it’s low cost AP – access point is a lot more critical inside the room versus a high throughput access point that you need in a high density classroom or a lecture hall or symposium. So these are all the things that when you fine tune you see much better win rates against the competition.

Rajesh Ghai – ThinkEquity

Yep, okay. And do you have to hire more people in each of these verticals to make this message more effective when you talk to these customers? Historically you’ve been very strong in the education vertical and I am reminded that you have some experienced personnel in that vertical for example who can talk the language and who understand the customers’ needs. But in looking at the other verticals that you talked about, hospitality and healthcare, do you have the people over there or do you just need to train existing people, or what kind of strategy are you following as far as being effective in those other two verticals?

Bami Bastani

Yeah, I’ll use the same analogy that I used in our April call. A company which has got 400 heads roughly has a revenue capacity of somewhere in the $160 million to $200 million range. Our industry benchmark tells me that you know, $400,000 revenue per head, and the headcount that we have are not operators. These are all professionals – they’re engineers, they’re accountants, they’re marketers. So those kinds of things, my rule of thumb and validated by industry is $400,000 to $500,000 per headcount.

So I believe even as our sales count, if I just take a number of between 400 and 430 that we are today, we have better than $160 million to $200 million capacity. It’s a question of do you have the right mix, and absolutely we are making some mix adjustments at the same time that we are taking advantage of headcount reductions through attrition in certain areas, through performance management in certain areas; nonperforming assets, being tough on those. We are also investing in program management, stock management and in vertical marketing.

Now in these areas frankly one or two experts is all you need. It’s not that you need to go and hire ten people in hospitality and then ten people – all you need is one or two category experts and that makes a world of difference. And we have been fortifying in those areas.

Rajesh Ghai – ThinkEquity

Great. And my last question, Bami, obviously you’ve had some [turnaround] year. You are growing sequentially now and also you’ve seen the product line grow about 28% q-on-q. On a year-to-year basis you’re still [growing in the market 7%]. When do you think your changes will be fully ramped so that you at least start growing at the pace of the market to around 15%, 20%?

Bami Bastani

Yeah, I would take step number one when you’re in a turnaround, and the realization that you’re in a turnaround itself drives the need for change. What’s more germane is sequential progress and we had a phenomenal sequential growth of 26% or thereabouts. After the turnaround, which to me that cycle is around six to nine months and then you focus on transformation of the company, and that’s when you become more into now what’s the category growth.

Now, if you look at the 15% to 20%, probably education and especially K-12 is on the lower end of it, and let’s say enterprise on the higher end of it; and it’s the average of those numbers. So then we’ll be looking by category are we at or ahead? But right now, where we are in our turnaround, my focus is on sequentially do better every quarter.

Rajesh Ghai – ThinkEquity

Alright, congratulations. Thank you.

Bami Bastani

Thanks.

Operator

Thank you. Our next question comes from the line of Erik Suppiger with JMP Securities. Your line is open.

Erik Suppiger – JMP Securities

Congratulations. What did you say, did you say your cash usage in the second half will be less than $10 million? Is that right?

Brett White

Yes.

Erik Suppiger – JMP Securities

Okay. And then what is the interest expense outlook, like the new debt?

Brett White

Do you want to go through that just on a sidebar conversation? I can walk you through the whole model?

Erik Suppiger – JMP Securities

That’s fine, okay. The AMEA looked like it had a pretty strong recovery here. Is that where you got a lot of the new additions or was there a change in channel, or what was going on in AMEA in particular?

Brett White

Well we are and have been quite strong in AMEA K-12 for quite a while especially in the UK and Ireland. We’ve built actually a very strong franchise there over the last I would say six to eight quarters, and so that just continues to build. And once you’re the chosen one the other schools jump onboard.

Erik Suppiger – JMP Securities

So you’re getting a stronger franchise there. Was this benefiting significantly from the changes you made last year or that you’ve made in the last nine months?

Bami Bastani

I’ll answer that. I think part of it is the focus that the company had in that region over the last nine months or so. So in Q1 we made an announcement that before we had one, like a Philadelphia school district and now we have the whole country of Northern Ireland. So then the second part of it is, I would call it the last three or four months a focus on execution. So you cross the finish line. To me, a pipeline is like saying that “I’m moving the ball up and down the field very nicely.” Now, delivering the quarter is to say “I’ve got my red zone offense in place and my special teams are doing what they’re supposed to do.”

So an important part of translating that nice funnel is your special team and the focus, and that’s where we see the fruits of our [labor]. I would say the Sales Team is very strong in the UK, the BU, which is adding more focus to it and execution to cross the finish line.

Erik Suppiger – JMP Securities

Okay. And you had talked about replacing options. How is that going to be reflected from an expense perspective?

Brett White

So it’s an exchange, so any employee choosing to do so would exchange their options. Their existing options would be cancelled and then they would have new options issued. And then the stock comp, and we don’t know the number yet because we don’t know how many are coming back in the price, it would be reflected in stock comp beginning the effective date of the change which would be August 23. So it’ll show up in stock comp starting August 23.

Erik Suppiger – JMP Securities

Alright. Now that’ll be starting in the September quarter we’ll see that.

Bami Bastani

Yep, and you know there’s nothing like a motivated workforce and I think this important step, you see the excitement already in the place. So it’s a retention and energizing the place, indeed.

Erik Suppiger – JMP Securities

Okay. And then lastly on the competitive front, have you seen any further competitors coming out with controller lists and lower cost architecture? Is that playing out in the market at all?

Bami Bastani

I’ll add some color and I’ll have Sarosh also answer to that. Through VMware we have introduced our virtual controllers, and if you have your servers going already just load the software. That’s a really good business model for us because really the value and IP is in the software anyway. So we deal with that through virtual controllers, and that was one of the things when I talked about further focusing on unified platforms. A lot of the controller-less architectures are aimed at very small deployments, and in K-12 it’s again small deployments. So either way we haven’t run head-to-head with many of them but for the deal sizes that matter we have a very good solution and for the much smaller deals, I refer to them as ankle biters. We haven’t had to do extraordinary things, but Sarosh, why don’t you add more color on that?

Sarosh Vesuna

Yeah, what’s key here again is what is the application and the application integrity that the customer expects. And it doesn’t matter where the software sits, whether it’s on an access point, a controller or a management platform. Those are, basically controller, management platforms, etc., are just different pieces of hardware by the same name running some software. What we are really focused on is looking at the profits by which our customers deploy their applications, manage their applications; and basically we have the option of them having a controller on premises or as Bami mentioned a virtualized controller in the cloud; or a virtual controller at a centralized location on the campus.

Erik Suppiger – JMP Securities

Okay, very good. Thank you very much.

Brett White

Hey Erik, and just for the benefit of everyone on the call, why don’t I give you interest expense for the next two quarters; and then the further out, people can either look at the filling or I can just talk to them one-on-one. So non-GAAP interest expense which includes the kind of cash interest expense plus the amortization of the various other elements of the debt – Q3 will be 592, Q4 will be 556. On top of that there’s the amortization of the warrants which would go as a GAAP number and that’s about $50,000 a quarter for those two quarters.

Erik Suppiger – JMP Securities

Very good. Thank you very much, Brett.

Brett White

Sure.

Operator

I’m not showing any further questions in the queue at this time. I’d like to turn the call back over to management for closing remarks.

Bami Bastani

Thank you for being with us for Q2 – revenue up, OPEX down, and increased focus on where we need to go. So thank you for staying with us and we’ll keep our focus on those parameters. Bye.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program; you may all disconnect. Everyone, have a great day.

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