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3Com (COMS)

Q3 FY2006 Earnings Conference Call

March 23rd 2006, 5:00 PM EST

Executives

Ciel Caldwell - Director of IR

Scott Murray - President, CEO

Don Halsted - EVP, CFO

Analysts

Matt Shimao - Bear Stearns

Jiong Shao - Lehman Brothers

Jennifer Tennenbaum - RBC Capital Markets

Manny Recarey - Kaufman Brothers

Long Jiang - UBS

William Becklean - Oppenheimer

John Marchetti - Morgan Stanley

Jeff Evenson - Sanford Bernstein

John-Mark Duncan - Pacific Growth Equities

Nigel Frankson - Citigroup

Presentation

Operator

Good day, and welcome to the 3Com third quarter 2006 conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the Director of Investor Relations, Ms. Ciel Caldwell. Please go ahead, ma'am.

Ciel Caldwell

Thank you. 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, including forward-looking statements regarding our strategic direction, industry trends and changes in the marketplace, including the importance of China; our strategic plan to achieve profitability and grow our business; future growth of our H-3C joint venture; our relationship and collaboration with this joint venture and Huawei, our venture partner; the future ownership of H-3C and the consolidation of H-3C's results into our financial statements, and the method and timing of such consolidation.

These statements are neither promises nor guarantees, but involve risks and uncertainties that could cause actual results to differ materially from those set forth in the forward-looking statements including, without limitation, the risks detailed in the Company's filings with SEC, including those discussed in the Company's annual report filed with the SEC on Form 10-K for the fiscal year ended June 3, 2005.

On this call, we will also discuss several non-GAAP financial measures, as defined by the SEC Regulation G, including these measures non-GAAP operating loss and several financial measures that, when presented on a consolidated pro forma basis, as if our China joint venture H-3C were consolidated from the beginning of the relevant period, are considered non-GAAP financial measures.

For each non-GAAP measure discussed on today's call, the most directly comparable GAAP financial measure and a reconciliation of the difference between the non-GAAP measure, and its comparable GAAP measure, can be found in tables at the back of the press release announcing our results, dated today, which is available right now on the Investor Relations section of our website, www.3Com.com. References to the financial information included in the remarks to follow reflect rounded numbers and should be considered approximate values.

With that, I will turn it over to Scott Murray to start our call. Thank you.

Scott Murray

Thank you, Ciel. Good afternoon, everyone. As you know by now, my name is Scott Murray. I am very excited to have joined 3Com recently as its new CEO. I would like to start out today by outlining five main areas that I will address in my remarks, before turning the call over to Don Halsted, our Chief Financial Officer, to review our financial performance for the third fiscal quarter.

Specifically, I will provide:

  1. A summary of my background;
  2. Describe the elements of 3Com that attracted me to join the team;
  3. Highlight our results for the third quarter on a combined basis with Huawei-3Com joint venture, otherwise referred to as H-3C, as if it had been combined with 3Com as of the beginning of the third quarter;
  4. I'll give you a sense of my activities over the last 60 days as CEO;
  5. Last, I will outline our top four priorities that I have set for the Company.

Before reviewing these five topics, let me briefly share with you my perspective to date on 3Com and how we plan to move forward. We have a unique portfolio of businesses, including our traditional 3Com networking and voice businesses; our security offerings through TippingPoint; and our H-3C China-based joint venture with Huawei. Some of these businesses are growing, others are not. Furthermore, there are substantial changes occurring in our industry. Finally, I recognize the most fundamental issue is that 3Com is not profitable today. Over the next few months, we will be building a thorough plan to address our business model and performance. This is our top priority.

As you may know from my background, I have spent the last decade working with some of the leading private equity firms in the world. The lessons I learned from working with these firms have stayed with me. Growth without profit is not an option. We will focus on driving profitability and then, on top of that, work to build a sustainable growth model that will last many years.

Does that mean there is going to be change in the near-term? Yes, and frankly, there should be. Does that mean that we're going to make some tough decisions? Yes, and they need to be made. Over the next few months, I expect to complete my homework on our business and launch a comprehensive plan to return us to sustainable profitability.

The first topic of my discussion is a bit about my background. I've spent the last 20 years in the international landscape of the technology industry. My most recent role was CEO of Modus Media. Modus is a technology services and hosting business providing global services to Fortune 1000 technology companies.

The business is about the same size as 3Com, and while I was CEO, it faced many of the same issues that 3Com faces today. Modus has operations throughout the world, including North America, Europe and Asia, and particularly in China.

Prior to Modus, I led a number of technology businesses, including being president of Stream International, a global technical services business outsourcer with over 12,000 employees. Both Stream and Modus were privately-held and majority-owned by leading private equity investors.

Prior to that, I was CFO of The Learning Company, a leader in software development for the consumer and educational market. The Learning Company was publicly traded on the New York Stock Exchange, with over $800 million in annual revenues and a market capitalization in excess of $3 billion.

The primary focus throughout my career has been to create sustainable shareholder value through building profitable, global businesses that provide great technology and services to their customers and terrific opportunities for their employees and partners.

During the recruiting process with the 3Com Board of Directors, I identified several core assets of 3Com that led me to become very excited about the Company's situation. For instance:

  1. The Company has a deep history in technology, with strong intellectual property and a well-recognized brand name.
  2. It has a very successful franchise in the security space through its TippingPoint operation.
  3. It has a strong balance sheet, with over $700 million in cash.
  4. It has a growing and valuable networking operation in China through its H-3C joint venture, which we now own 51% of.
  5. Most important, a great deal of potential to create a strong, profitable operating model.

However, we fully recognize that this potential has not been realized to date. We expect to change this situation in the near term. Our number one priority over the next year will be to drive this business to a profitable, sustainable model that creates significant shareholder value for the future.

Toward that end, I will be working closely with our management team and Board of Directors to design the specific plans for this business model. I will highlight that process that we intend to follow after a brief consideration of 3Com's summary fiscal third quarter performance. Don Halsted will review this performance in more depth after my comments.

As I comment on the business today, I will be focusing on our combined results with H-3C. As we announced earlier in the quarter, we completed the purchase of an additional 2% of H-3C, bringing 3Com's ownership to 51%, a controlling interest. We will begin to consolidate H-3C into our fourth quarter results, commencing with its February 1st results onwards. Don will explain in his remarks the specifics around the consolidation process.

In this interim period before consolidation impacts our GAAP results, we believe it is informative to provide you with financial information about 3Com on a combined basis, as if H-3C had been consolidated from the beginning of the reporting periods.

Today, the operations of 3Com and H-3C are increasingly coming together. We are working together in certain geographies to align our go-to-market resources. We are also collaborating on product development and leveraging H-3C's China-based manufacturing capabilities.

An example of a region in which we are launching joint go-to-market efforts is Russia. In Russia, we already have direct H-3C sales representatives leading the sales cycle for our networking products. I'm outlining these examples of business integration to demonstrate why we believe that you should look more and more at this relationship as one combined business. It is being increasingly operated and marketed in this manner.

On a combined basis, revenues for the third quarter would have been $305 million versus year-ago revenues of a combined $242 million. This is a 26% year-over-year increase. Stand-alone non-GAAP operating loss was $30 million for the third quarter, as compared to $40 million for the prior year period.

Our balance sheet remains strong at the end of our third fiscal quarter, with cash of approximately $706 million, working capital of $572 million and shareholders' equity of approximately $1.2 billion. Don will have more to add on our financial performance during his part of his remarks.

During my first 60 days, I have been learning firsthand about the value of our assets and the challenges that we need to overcome to deliver on our primary goal of achieving sustained profitability. I have traveled to our many locations, speaking with 3Com employees at all levels of the Company. This has enabled me to build my knowledge base of the business firsthand.

Specifically, over the last 60 days, I've spent time in our Austin operations reviewing our security business; in our Santa Clara, California operations; in EMEA at our UK location; and in China and in Singapore.

My most recent visit to Asia has included sessions with the executives of H-3C and Huawei in Shenzhen and visiting our development operations in Hangzhou, China. I see strength in the continuing relationship between 3Com and Huawei in the future and great promise in our joint venture operations, as demonstrated in its results during the most recent quarter.

We expect to continue our discussions with Huawei to determine the outcome of future ownership of H-3C. This will be based upon a number of factors, which include continued strong performance of H-3C, a strong management process and alignment with 3Com's strategic plan.

As I visit our operations, I have made a number of observations. Firstly, we have some terrific people. They are all very dedicated to our success.

Second, we are in a marketplace that is rapidly changing. Increasingly, the networking industry is becoming more global. For example, China has become and will continue to be a very important market for all players in the networking and security space.

Third, our TippingPoint business, acquired just over a year ago, has performed very well as the cornerstone of our security practice. Our security business delivered revenues of $25 million in the third quarter of '06, as compared to approximately $15 million in the prior year, had TippingPoint been included for a full quarter.

Finally, as I have traveled to our operations, I have seen clearly that our business processes and cost model is not optimal. The combination of these factors reaffirms my initial evaluation of 3Com's potential to become a strong, profitable company in the future.

We have not completed all the work to identify the specific plans yet for 3Com's future. As you know, I've only been on the job as the new CEO for a short time. However, we have been building a management process to complete our strategic plan in the next little while. This will allow us to better filter and identify avenues for delivering on our top level goals.

Based on our work to date, we have identified four key near-term priorities for 3Com, and I would like to list those now.

  1. Create a world-class go to market strategy for our business.
  2. Continue to invent; new technologies are a must for our future.
  3. Leverage and enhance our relationship with H-3C.
  4. Design the appropriate business model and infrastructure to reach sustained profitability for 3Com.

All of these priorities are important for the future success of our business, but profitability is our foremost focus. We will have more details on these plans over the next few months to share with you.

As this work is completed, we will continue to build a world-class management team. For instance, we recently added to the team by hiring a new VP of Marketing, Deborah Keeman, and a new Chief Information Officer, Jerry Kelly. Both of these executives have worked with me in the past and is very experienced in driving profitable business models.

To reiterate, I see that we will be making changes to transform 3Com into a profitable, growing business. Over the next few months, I will be giving you more details on our specific plans. My final message to leave you with today is optimism. Assets are in place. We now need to unlock the value.

At this point, I'm going to turn the presentation over to Don Halsted, our CFO, to talk about our most recent quarter's financial performance. Don.

Don Halsted

Thank you, Scott. Before I start reviewing our fiscal third quarter results, let me set the stage for the discussion by describing the two views of the business we will be using.

First, we will start with a pure GAAP measurement of the business. In this part of the discussion, I will be reflecting the Huawei-3Com joint venture on an equity basis, since our third quarter results reflect the effects H-3C through its calendar fourth quarter. We will be discussing a single non-GAAP measure of operating loss that management thinks best reflects the underlying operational results.

Secondly, we will be discussing a pro forma view of the consolidated results of 3Com and the Huawei-3Com joint venture as if we had consolidated its results for the entire period and in comparison periods.

During my comments, I will be using the term pro forma to describe certain measures of our business as if H-3C had been consolidated from the beginning of the relevant period. However, these measures are used in a manner consistent with the GAAP purchase accounting disclosures required by FAS 141, which will appear in a footnote to our financials in the 10-Q.

This pro forma presentation is a required disclosure for sales, net loss and EPS. We will discuss additional line items, specifically operating loss, on a consistent basis in the income statement and certain summary balance sheet data. These measures are technically non-GAAP financial measures, because they are not specifically required by FAS 141.

Now, let me start the GAAP review with a discussion of revenue. The fiscal third quarter revenue was $178 million, a 4% sequential decline and a 10% increase compared to the same quarter in fiscal 2005. On a geographic basis, we had sequential declines in the EMEA region, North America and Asia Pacific region of 7%, 2% and 1% respectively. These declines were offset in part by continued growth in Latin America and South America of 2%. Softness in the networking sales, particular switches and in voice, drove the declines in the EMEA, North America and APR regions.

As can been seen from the table in the press release, all regions except EMEA showed growth compared to the same quarter in fiscal 2005. The primary driver of the EMEA softness is declines in networking and connectivity devices, offset in part by growth in security and voice.

On a product basis, strong sequential growth in the security business was more than offset by sequential declines in networking, voice and services. The 23% sequential growth in security was driven by strong TippingPoint sales, which more than offset a sequential decline in our embedded firewall products. The 12% sequential decline in voice was in the NBX line, partially offset by growth in the VCX line. In networking, the decline was primarily in the Layer 2 managed and unmanaged switches, offset in part by growth in the Layer 3 switches sourced from the Huawei-3Com joint venture.

Revenue from Huawei-3Com sourced products in total sold by 3Com grew sequentially to about $30 million. This growth results from continued traction with the 5500 line of Layer 3 switches and the introduction of the 4500 line of switches.

Revenue from connectivity devices was $12 million, a 38% sequential growth resulting primarily from $3 million received from a revenue-sharing arrangement related to sale of certain intellectual property rights, which is essentially the same as the same period in fiscal 2005.

Gross margins were 41%, a 1 percentage point sequential improvement and a 5 percentage point improvement over the same period in the prior year. The sequential improvement resulted from favorable product mix, driven by growth in securities sales, cost reductions and the revenue-sharing payment described above, offset in part by continued pricing pressure. The improvement from the prior year is primarily due to having a full quarter of the TippingPoint products in the current year period.

Sales and marketing, research and development and general and administrative expenses were $112 million for the quarter. This includes $9 million of expenses for unusual operating costs, specifically executive transition costs related to replacing the CEO and the impairment of an asset. These expenses were $5 million in the general and administrative expense line, and $4 million in the research and development expense line respectively. Other operating expenses included restructuring and amortization charges, totaling $8 million, which were consistent with recent quarters.

The operating loss in the third quarter was $47 million, compared to $42 million in the second quarter and $56 million in the same period of fiscal 2005. The primary cause of the sequential increase in operating loss was the $9 million in unusual expenses associated with the CEO transition and the impairment of an asset and lowering of gross profits, offset in part by lower operational expenses.

Management believes that a non-GAAP operating loss measure that excludes these unusual expenses, along with restructuring, amortization and the write-down of in-process R&D, is the best single measure of the underlying business operations. When we adopt FAS 123R in fiscal 2007, we will exclude these costs as well, as they are non-cash expenses. The reconciliation to GAAP operating loss is provided in the press release.

With this definition consistently applied, the non-GAAP operating loss was $30 million in the third quarter of fiscal 2006, a sequential improvement of $5 million compared to a second-quarter non-GAAP operating loss of $35 million, and a year-on-year improvement of $10 million compared to a third quarter of fiscal 2005 non-GAAP operating loss of $40 million.

There were essentially no gains or losses on investments in our third quarter of fiscal 2006, compared to a realized gain of $4 million in the previous fiscal quarter.

Interest and other income net was flat sequentially at $7 million. The provision for income taxes returned to a typical level of $1 million for the quarter, versus the $22 million benefit in the prior quarter for a settlement with a foreign taxing authority.

One of the highlights this quarter was the performance of the Huawei-3Com joint venture. During its calendar fourth quarter ending December 31, 2005, the Huawei-3Com joint venture revenue was $145 million, a sequential increase of 30% compared to its calendar third quarter of 2005. Compared to the same period in the prior year, revenue grew 66%. Gross margin for the quarter was 48% and the net income was $18 million, after recognizing $7 million in expense for amortization of intangible assets.

In our third fiscal quarter, we recorded an equity income of $9 million as our share of the financial performance of the unconsolidated Huawei-3Com joint venture for its calendar fourth quarter. We have continued to provide in the earnings release a table that summarizes previously disclosed data for the joint venture, along with its fourth quarter results.

At the end of January, we acquired the majority position in the Huawei-3Com joint venture. We have determined that we satisfy the accounting definitions of control, and that we are required to consolidate the results of 3Com and the joint venture. In our fourth fiscal quarter, therefore, we will consolidate the results from the joint venture's fiscal February and March periods into our GAAP financial statements. Later in my remarks, I will discuss this on a pro forma basis.

Returning to 3Com's results, the net loss for the third quarter was $33 million or $0.08 a share, of which restructuring and amortization expense represents about $0.02 per share. The weighted average number of shares outstanding during the quarter was approximately 388 million shares. This net increase of 2 million shares in the prior quarter primarily reflects the exercise of stock options.

Cash, cash equivalents and short-term investments totaled $706 million, a net decrease of $48 million from the balance at the end of the previous quarter. The change includes a decrease in cash and cash equivalents of $21 million and a decrease in short-term investments of $27 million.

The key components of the change in cash and cash equivalents are as follows.

  1. Cash used in operations was $18 million, including $4 million for restructuring-related payments.
  2. Cash used to purchase an additional 2% interest in the Huawei-3Com joint venture was $28 million.
  3. Cash used for capital expenditures amounted to $3 million.
  4. Cash provided by the issuance of common stock was $1 million.

In our second view of the business, we're looking at a pro forma view of the consolidation of 3Com and the Huawei-3Com joint venture as if we had consolidated the results from the beginning of the respective reporting periods. These results are summarized in the fifth table in the press release.

Total pro forma consolidated revenue for the third quarter was $305 million, comprised of $178 million in 3Com revenue, plus the $145 million in Huawei-3Com revenue, offset in part by the elimination of $18 million related to intercompany sales. On a pro forma basis, revenues grew 8% sequentially and 26% compared to the same period in fiscal 2005, with comparable presentation.

The pro forma consolidated operating loss in the third fiscal quarter is $38 million, an improvement of $25 million compared to the same period in fiscal 2005. For comparison purposes, we intend to continue using pro forma statements for prior periods. The pro forma consolidated net loss was $33 million, which is a loss per share of $0.08, essentially the same as the GAAP statements above.

In the press release, we have provided summary pro forma balance sheet data. This disclosure is not required by FAS 141, and therefore technically is non-GAAP. The consolidated pro forma cash and short-term securities is $847 million.

Before turning this call back to Scott, I want to address guidance. As Scott indicated in his remarks, we're taking a careful look at our business model and our go-to-market strategy, with the goal of driving profitability as quickly as we can. In the past, we offered guidance to the investment community. In light of this exercise to drive profitability, we will make certain decisions affecting our business, which today we're continuing to assess and do not yet fully know the outcome. Therefore, we have determined that it is prudent not to issue model guidance at this time to the analyst community. This means you should not use our prior guidance.

That being said, there are certain business trends that I will highlight for you. First, our fourth fiscal quarter GAAP results will include two months of H-3C's results on a consolidated basis, offset by the 49% interest that Huawei has in the venture for those reporting periods. Our results will also include one month of 49% unconsolidated equity based results of H-3C.

We will increasingly focus on the combined operations of 3Com, including the Huawei-3Com joint venture. We remain committed to driving the combined 3Com operations to profitability. Over the next few months, we will give you more details on our plans.

I would like to turn the call back to Scott Murray for a couple of comments before we take questions and answers. Scott.

Scott Murray

Thank you, Don. Clearly, we have some work to do as an executive team and as a Company. The thought I would leave you with before we move into questions is that we are committed to return this Company to profitability as quickly as we can. We are excited about the prospects and opportunities in front of us, and we are committed to work very hard toward those goals.

Operator, I would like to now open the call to questions from the folks on the phone.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Matt Shimao, Bear Stearns.

Matt Shimao - Bear Stearns

Thank you. Can you hear me?

Sure can, Matt. How are you?

Matt Shimao - Bear Stearns

Very good. Great presentation of the numbers, I really appreciate the implementation. Our first question -- and I know you just started, but as you continue to drive towards profitability, when you look at the major operational initiatives that you need to execute on to get there, how important is revenue growth versus internally focused initiatives like optimizing certain infrastructure costs?

Scott Murray

That is a great question, Matt. I have carefully thought about that. We continue to look at our revenue basis. As I said earlier in my remarks, we have certain businesses that are growing, and frankly, certain that are not. We have an infrastructure today that is not optimal. We have processes that are not optimal. As you know, my background, I've spent a lot of time in the tech space, and in taking businesses to a level of profitability. We don't yet have all the answers on revenue growth and what that ultimately might look like. We're pretty encouraged with what we see happening in China. I recently spent a week there. There is increases in share, new products. We toured the facilities. It is pretty exciting.

As far as our core business, as I said, we've got some work to do. We are going to look at things like infrastructure, IT/IS systems, supply chain, support services, the type of resources that it takes our products to get to market in order to drive share.

Clearly, any business over time has to grow. I come from that background, but foremost, we've got to fix and drive the optimal infrastructure for the business that we have today, and be pretty realistic about it. Over the next pretty short while -- and I will have more to tell the investment community at our next conference call for the fourth quarter -- but we are going to put a very thorough plan in place in order to get there is quickly as we can.

Matt Shimao - Bear Stearns

Maybe I will push back on you a little bit, just with a follow-up. Is it fair to say, then -- because it sounds like you're focusing on a lot of internal operations costs -- that without substantial revenue growth, you think that it is possible to get towards profitability over the next few quarters?

Scott Murray

If I look at growth in this Company, and today I'm thinking about this business on a combined basis, this business has been growing on a combined basis. We have various go-to-market strategies with Huawei-3Com that we are focusing on, and particularly in countries in Asia and in Eastern Europe.

Our job one is to get to profitability. In order to do that, our first job is to optimize the infrastructure of our business for the business we have today. Too many times, companies fall in love with their revenue growth lines and they build too much infrastructure to support those revenue lines.

My initiatives and direction to the management team is, let's build the right infrastructure first. Then let's grow the business. I recognize we need to grow, but we need to get this business so it generates positive profit. That ultimately -- combination of growth, combination of profitability -- is going to drive shareholder value strategically.

The other one of my initiatives was continue to invent, and our Chief Technology Officer, Marc Willebeek-LeMair, recently presented at RSA, and we are continuing to develop and will be continuing to launch new products. We've got a significant share of the security space and intrusion protection, and that is an area where we are seeing a lot of growth right now, frankly.

Matt Shimao - Bear Stearns

It sounds like it is a very good, financially disciplined approach. It looks good. Just a quick housekeeping question. How many employees in the JV?

Scott Murray

Right now, there's about 3,500 employees.

Operator

Matt Shimao - Bear Stearns

Thank you.

Scott Murray Thanks, Matt.

Operator

Next is Jiong Shao, Lehman Brothers.

Jiong Shao - Lehman Brothers

Thank you very much. Scott, congratulations and welcome onboard. I have a housekeeping question for Don and a couple of questions for Scott, if I may. First, could you talk about the resale revenue from the joint venture product for the quarter, and how many options are outstanding exiting the quarter?

Don Halsted

The resale revenue, I think in my comments I mentioned that in our quarter we sold about $30 million of revenues that was from Huawei-3Com joint sourced products. Let me give you the options and then you can ask a follow-up. The very last table, I think, in the press release was the options, and there's a total of about 65 million options outstanding as of the end of the quarter.

Jiong Shao - Lehman Brothers

The 30 million, I think last quarter was 20, 28, was that sequential growth --

Don Halsted

Actually it is a significant sequential growth. I don't remember exactly -- we didn't give a precise number, but it is up pretty significantly.

Jiong Shao - Lehman Brothers

Right. So my mistake, I think last quarter was -- our model is around 26. Okay. Great. Thanks, Don. A couple of questions for Scott. Scott, you mentioned that the future ownership -- again, I think we know this coming November both parties could potentially start negotiations. Could you just talk about what are some of the scenarios you think are options for you? If it is up to you, what do you think the best options would be for 3Com shareholders? That is my first question.

Scott Murray

Sure, a good question. Also a question that is top of my mind, and our partners in China. Clearly, it is a little premature for us to have a point of view fully formulated. Suffice to say we have been very satisfied with the performance.

There are obviously a number of factors that go into ultimate ownership of the joint venture, and our point of view on it. We have met with Huawei and we have met with Huawei-3Com over the last few weeks, starting to think that through. It is complex.

But there is a number of things as I think about it, and I've talked to my management team, is around obviously the management process. How integrated are these businesses? How do we go to market, to our customers?

Second is the continued performance of Huawei-3Com. Third is as that fits into our long-term strategic plan as a Company, and the ability to leverage. Many of these elements are being leveraged today around research and development, manufacturing, and go-to-market.

We're going to continue working together over the next few months. I have met with the management team there. I will be back there in the next few months, as will other members of our management team, and continue to evaluate it over that period.

Jiong Shao - Lehman Brothers

Just a quick follow-up on it. Is there a timeline you think you will have a little bit better idea of where the direction is going?

Scott Murray

Yes, I wouldn't see the November timeline as a hard stop. That is an opportunity for us as partners to look at the business. I think Huawei and 3Com are both very satisfied. We've got a good management team there. We've got some good products. China is a very fast-growing market. We have a very large market share of that market, we believe.

I think when we get together next at the end of the fourth quarter, when we announce results, I will have a better point of view. I'm still doing my homework as the CEO of this business. I'm spending a lot of time in the field, both with our employees and many of our partners around the world -- whether that be SI, VAR partners, or partners like Huawei -- and building those relationships.

Jiong Shao - Lehman Brothers

That sounds good. My second question to you, Scott, is that like you suggested earlier, you have very strong experience working with private equity firms, and strong experience in cutting costs. This is a question on a lot of people's mind; I was just hoping to just get it out there. Is getting the Company in shape, potentially looking to private equity, is that strategy on your agenda?

Scott Murray

My primary focus today is to build a profitable enterprise as a business. In order for a company to create choices over the long term and create value for its shareholders, it needs that franchise value. We have not yet thought about step three, step four of our business, frankly. I am wholly focused on how we drive value for our shareholders. I recognize we've got a ways to go. We're going to go and put that plan together.

It is not all about cutting costs. It is about developing a go-to-market strategy. It is about continuing to invent. It is about redefining processes. At one point, this Company was a much larger company than it is today. We need to create that entrepreneurial spirit and frankness in our Company as we build it. That is my goal, is to energize the organization, communicate with the employees, leverage our relationships across the globe, work with our partners. I spent some time with the leadership team at Huawei and I was really impressed. That is a pretty dynamic group of executives. I'm really excited to work with them over the next few months.

Jiong Shao - Lehman Brothers

Great, thanks.

Scott Murray

Thank you.

Operator

We go next to Mark Sue at RBC Capital Markets.

Jennifer Tennenbaum - RBC Capital Markets

Hi, this is Jennifer Tennenbaum dialing in for Mark.

Scott Murray

Hi Jennifer, how are you?

Jennifer Tennenbaum - RBC Capital Markets

Good, how are you? Welcome aboard.

Scott Murray

Thank you.

Jennifer Tennenbaum - RBC Capital Markets

Just a couple of questions on competition. Obviously, you missed on the top line versus guidance. Just wondering if you are seen Linksys One from Cisco out there, and also NETGEAR?

Scott Murray

Surely. They are in the marketplace. This is a competitive market today. Cisco is a big player, obviously. North America markets have been under some pressure. But as I think of this business, more and more it is a global business. We operate in a global industry. Cisco and others, we are seeing them. We are seeing them in China, and that is a pretty exciting spot for everybody.

We think we've got a head start, frankly, in that market. Now, our challenge and our opportunity, frankly, is to leverage the $305 million in revenues that we had this past quarter into continuing to grow this business.

Jennifer Tennenbaum - RBC Capital Markets

Do you think that increased competition was maybe the reason for the top line miss, or more due to execution on 3Com's part?

Scott Murray

I think it is probably a bit of both. This is a very competitive industry, when you move into the switching and router part of it. When we look at our security business, and as I said earlier, we've got parts of our business that are growing, parts that are not. The switching and routing business needs some work. Our security business is an area that we have continued to invest in, and frankly, if you look at year-over-year growth there, it's pretty impressive.

There are others coming into that marketplace. Cisco has announced initiatives to be a player in that space. That acquisition for us, and I have done a lot of them over my tenure, has turned out pretty well, to see that amount of revenue growth year over year. I spent some time in Austin. In fact, I had dinner last night with one of their executives. They are very excited about the direction we're taking the business.

Our challenge is now to harness all of that into a global business, and that includes the security practice, the switching practice, the routing practice, and the joint venture, which for us as a Company is pretty new. We've just got the extra 2%. It is now into an entirely evolving relationship with how do we work together, how do we leverage? Before, it was a 49% interest, so it was different.

I was with our sales team and our marketing teams over the last little while, and talking about how we go to our customers, how we go to our enterprise customers. Through Huawei, they have a very big carrier business. I think that is a real opportunity for us to leverage. But make no mistake, this is a competitive industry. There are a number of players out there, and we are looking to get our fair share.

Jennifer Tennenbaum - RBC Capital Markets

One last question. If you can break it out by region, Europe versus America, which do you see as being more competitive? Or where are you seeing more missed execution?

Scott Murray

I think it is opportunity. If I think about the Americas and Europe, both of those are under pressure. Latin America, we've got a strong footprint there, and we have seen some strong results. Both of those areas are significant pieces of our business. As we think of the strategic direction of this business and where we would like to take it, those are high on our list as to how we continue to hopefully build share and build share profitably.

There's so many companies that play the share exercise and don't do it intelligently. What we are building is mapping to intelligently run this business. Not to chase revenue for revenue's sake, but to think of this business as how do we build shareholder value? How do we do that on a profitable basis and compete with, in some cases, much larger companies than we are today?

Jennifer Tennenbaum - RBC Capital Markets

Thank you.

Scott Murray

Thank you.

Operator

Alex Henderson, Citigroup.

Scott Murray

Hi, Alex.

Nigel Frankson - Citigroup

Hi. This is Nigel calling in for Alex Henderson.

Scott Murray

Hi, Nigel.

Nigel Frankson - Citigroup

Hi, Could you offer some guidance? In what portion of your cost structure do you see the most excess? The way I'm looking at it is, I don't think it is possible for you to hit $230 million in revenue by the February quarter of fiscal 3Q '07. So clearly, if this company doesn't turn around within the next few months, I think the investor base will be very disappointed in that, and clearly that is something that you would like to avoid. Hypothetically speaking, where do you see the most fat on this operating structure?

Scott Murray

Let me give you kind of what I'll call my initial sense and as I said earlier, still doing my homework on our business. We have a number of areas around how we go to market that we can leverage better. We have areas around our site locations, our IT infrastructure, our supply chains, which are called the block-and-tackle part of our business.

We will continue to invest in the technologies for growth over the next little while. We will continue to leverage our global footprint, but there is some significant work to do. I'm not discounting that at all. We don't have all the plans worked out yet. I have been here as a CEO for -- I stopped counting a while ago, but it is about 60 days. This business has some significant work to do to get back to even. We will do that.

Our plans are beginning to be formulated. This is going to take a little while. But our goal is to get to profitability as quickly as we can. As we look at our go-to-markets, our products, our product lifecycles, many of the things that I would hope our investor base and shareholders would expect us to frankly look at is driving this business forward, driving profitability, ultimately driving growth.

As we said earlier, it is very difficult for us to give you immediate guidance in this business, just because we are still in the study mode. We will be in the study mode for a little while now. But the result of that is that we do it right, and we build a profitable business.

Operator

(Operator Instructions) Manny Recarey, Kaufman Brothers.

Scott Murray

Manny, how are you?

Manny Recarey - Kaufman Brothers

Okay. Good evening. You have been focusing a lot of your talk on the cost side, which is, I think, a very good thing. You're not going to be focusing so much on growing revenue first. Can you give me a feeling or an understanding of how you're going to stop the revenue from declining? You say that there are some businesses -- as you said, security -- that is growing and others that are not doing as well. The ones that are not doing as well seem to be resulting in a declining revenue.

Scott Murray

Sure. One of the initiatives that I mentioned was to create a world-class go-to-market strategy for our business. We are building the strategic plan that will incorporate that in many initiatives; in how we go to channels, the direct versus the indirect and the double-tiered business, enterprise versus SMB.

We will continue to look at new products. We announced a number of new products, the M60. We are continuing to develop new products through both our joint venture and our own development exercises. We continue to partner and look at profitable growth, profitable revenue, and build the system and the processes to frankly do that.

Manny Recarey - Kaufman Brothers

Can you just elaborate a little bit on the voice business, if you can give any more color on that?

Scott Murray

Can you be more specific on your question?

Manny Recarey - Kaufman Brothers

In your voice business there were softness. I think it was down sequentially. Can you give a little bit more color on why that was in the quarter?

Scott Murray

Sure. Don, why don't you answer that question?

Don Halsted

As you point out, the voice business was down sequentially. As I indicated in my comments, that decline really was in the NBX business, because we did have an increase in the VCX business. The primary source of that decline was in the North America regions.

A couple of things happened. Part of that in the NBX was related to some competitive pressure, and part of that was related to some channel work and some channel challenges that we have to do. So I would say it really divides both execution and on competition. It is encouraging to see the continued growth of VCX. I think suffice to say that we are obviously analyzing as part of it, all of the studies that Scott has put in place, the ways to best leverage the assets that we have in the voice area.

Scott Murray

Let me just follow on as to the final comment on your last question as you look at revenue. This is something that we think very carefully about. Frankly, if I showed up here as the new CEO 60 days after and had all the answers, I'm not sure I would have a thorough level of credibility with our investors. My reputation and my background is to really build a sustainable, thorough model and work with our teams, work with our GOs, work with our customers in order to do that.

Over the next few months, we will have better and greater perspective on some of those issues as we look at the business model that is really necessary over the next few years with 3Com.

Manny Recarey - Kaufman Brothers

Thank you.

Scott Murray

Thank you.

Operator

Up next is Long Jiang, UBS.

Long Jiang - UBS

Hi Scott, how are you?

Scott Murray

Hey, how are you?

Long Jiang - UBS

My question is regarding the JV. I think the JV gross margin improved from to 48%, and what was driving the gross margin improvement sequentially? Secondly, it looks like the JV has achieved operating margin of double digits, excluding amortization of intangibles. Do you think the JV has already achieved a certain level of optimal operating model? Related to that question, when you manage the original 3Com business, what kind of a target operating model are you looking at for the original 3Com?

Don Halsted

This is Don. Let me answer most of those questions. First of all, it is a good question. The margin of 48% obviously is a very encouraging margin. The real reason that happened is the major areas that we have seen growth in the joint venture is in their high-end switching, which is frankly the most profitable line of products that they have. So we have ended up with the growth coming in the best parts.

They have had a favorable product mix. Remind you that on the order of 70% of their revenue is inside of China, and only about 10% of their revenue actually is sold to 3Com itself. So this is relating to the health of the entire joint venture business, which is now part of the combined 3Com-Huawei. That was on the margin. I am sorry -- what was the second question that you had?

Long Jiang - UBS

What is the target operating model for the original 3Com?

Don Halsted

No, actually, I think your second one was related to the profitability of the venture itself. What I think has actually happened, that dynamic you have had is we have had a very powerful growth in the past six months. Not all of the cost and the expense structure is completely caught up with the growth, and that ends up giving you a very, very favorable returns. We are very encouraged by the business, and we're encouraging them to continue investing and managing the business. There is still going to be change in the mix of products inside of the venture.

On the third one, about ours, that is the whole subject of the study and the work that Scott has talked about that he has commissioned, so we are not prepared at this point to talk about what that overall operating model is going to look like.

Long Jiang - UBS

Okay, fair enough. Thanks a lot.

Operator

We will go next to William Becklean, Oppenheimer.

William Becklean - Oppenheimer

Thanks, Welcome aboard, Scott.

Scott Murray

How are you?

William Becklean - Oppenheimer

My question has to do with operating expenses. My recollection is that you said the operating expenses were $112 million, including $9 million of the expense related to management change. If you take the $9 million out, that is $103 million of operating expense in the quarter. Prior quarters were $109.5 million and $109.2 million. How did you get $6 million of operating expense out in the third quarter?

Don Halsted

Bill, two things. The $9 million was the combination of CEO transition and impairment of an asset. So that was the total amount of that. If we look at the reduction from roughly $109 million down to $103 million, one of the major components was as we were reaching the end of our branding campaign, we had less expenses on the brand marketing in the third quarter than we had in the second quarter, and that was probably about $3 million or so, or $4 million, of the decline.

The other part was a reduction in our operational spending throughout the lines of our business and the completion of some of the restructurings that we had announced last year and some of the continuing pressure this year. So that is active run rate driving the business down, and it is a real number, at the $103 million level.

William Becklean - Oppenheimer

Presumably, that is not going to go back up in the fourth quarter if you're putting pressure on expenses.

Don Halsted

As I said, we're really not going to get ourselves pushed into giving guidance on the fourth quarter, but what I can tell you is that is an accurate run rate expense number for the level of what our spending is, as we finish the third quarter.

William Becklean - Oppenheimer

Thanks, Don.

Operator

We will go next to John Marchetti, of Morgan Stanley.

Scott Murray

Hi John, how are you?

John Marchetti - Morgan Stanley

Not to bad, thank you very much. Quick question for you on the North American business in particular. We had talked in 2Q with it being down, part of that was some of the other lines didn't make up for what is traditionally a weaker educational quarter. Can you talk a little bit about what happened specific to North America, and in particular, what Siemens did this quarter relative to around the $2 million that it did last quarter for you?

Don Halsted

I do not have an answer to the exact Siemens question in the quarter, but let me try to give you a view of the entire business. First of all, in the third quarter, the education market is still a bit soft in that quarter, so you do kind of get a pattern off of the second quarter.

What we said, as I referred to an earlier question, we did see a decline in our NBX voice business in North America in the third quarter, and that was a combination of execution and competition that we have to work on.

The other piece, if I drop back and think about my networking area, we are still working a lot of the enterprise sales, and we have not made as much traction as we hoped at this point.

The last factor is that we had a slight change, or slight reduction, in our channel inventories in the quarter, so you get a small time shifting factor that goes. Those three things really end up being the majority of the dynamics of what happened in North America.

John Marchetti - Morgan Stanley

From a demand perspective, then, how would you characterize demand in 3Q relative to where you exited 2Q at?

Don Halsted

I think the overall demand that we were looking at, when I think of the kinds of deals that we were in, I think the demand was basically -- I don't think we saw a fundamental drop-off in the demand.

John Marchetti - Morgan Stanley

Thank you.

Operator

We go next to Jeff Evenson, Sanford Bernstein.

Jeff Evenson - Sanford Bernstein

A quick follow-up on the last question and another one. Don, as you listed out those reasons for the shortfall, which of those were surprising to you, and why weren't they incorporated into the forecast last time?

Don Halsted

I was a little bit surprised by the voice, and that is why we're doing some focus on that, and probably a little bit surprised that we didn't get some other closure on some of the enterprise business.

Scott Murray

This is Scott. Let me just clarify here. This is a market that is changing very quickly. As we look at our various markets around the world and continue to leverage, there continues to be increased competition, increased pricing pressure that should not be news to anybody in this space. Are we happy with where we are at this point? No, we have some work to do. We're going to continue doing that work, leveraging our assets across the globe, in order to drive profitability and ultimately growth in this business.

Jeff Evenson - Sanford Bernstein

Scott, over the last 60 days, how many customers have you talked to, what categories were they in and what did they tell you?

Scott Murray

I've spent the large part of my 60 days visiting our sites and our partners. I met with some of our big SI partners, and continue to do that both in Europe and the Americas and in Asia. My primary goal in the first 60 days was to start to understand some of the dynamics going on in our business, and frankly, to reach out to our employees. I have met hundreds and hundreds of employees of 3Com, and spent a lot of time on airplanes and in hotels. I'm going to continue doing that, and continue to extend out and meet more of our partners and more of our customers.

Jeff Evenson - Sanford Bernstein

What are the partners telling you?

Scott Murray

Not that much different than what we're talking about here. We continue to see a lot of competition out there. They are looking to us to be an alternative in the marketplace. They are looking to us to lead with our security products. There continues to be a lot of demand, but it is a pretty competitive space. There is a lot of interest in what we're doing in China, as we talk to customers, and our ability to leverage what we're doing there. Our customers are looking for global players.

Jeff Evenson - Sanford Bernstein

Thanks.

Operator

Up next is John-Mark Duncan, Pacific Growth Equities.

John-Mark Duncan - Pacific Growth Equities

After the past few quarters, you guys have spent a ton of money on brand awareness and marketing, and after looking at the networking business, which is clearly an underperformer, and the voice business, which has not grown and has declined over the past two quarters, I'm just wondering what you think that brand awareness and marketing spend is actually getting you?

Secondly, I would like to look at China a little bit, in terms of where you think gross margins could go, and then finally, what that growth trajectory in China could be, since that is such a key piece of the business going forward.

Scott Murray

Let me try to tackle that. As we think about the branding, the branding campaign, 3Com has a relatively strong and well-known brand. That is just TippingPoint. It is always difficult to address and assess the pinpoints of tying in brand to actual day in and day out sales dollars. What is important is we continue to be a recognized brand in this space. We are driving other brands. This is not just a 3Com brand; it is a TippingPoint, it is an H-3C brand, across the globe.

As we look at your second part and third part of your question, around growth around China, I think as Don had said earlier, we are evaluating the performance of our business and the elements of growth. At this point in time, we continue to evaluate that, and build the model. We have been very pleased with what we have seen in China. It is a growing market. We have a significant piece of the pie, from a share perspective. We are planning to work closely with Huawei and the joint venture partners and executive teams over the next few months, in order to deliver increased shareholder value and, frankly, increased performance.

It is a pretty exciting market. It is one of the reasons why I joined this Company. I have spent a lot of time in China throughout my career, and every time I go there, it is different. It's growing. It is a very dynamic place to be today, and we and many of our competitors want to be there, frankly.

John-Mark Duncan - Pacific Growth Equities

In terms of the gross margin, that is just a mix factor, and could swing one way or the other?

Don Halsted

The gross margins, depending upon whether you're looking at the OEM business up to their direct high-end switches, range from the 30% up to the 50% to 60%, so you do very definitely have a mix dynamic that is in there. They are expecting over time to get more sales outside of China, which includes more OEM sales. As we have said before, we think that is eventually going to provide a mix down margin percentage driving higher margin dollars, as you're going forward today.

Scott Murray

Operator, we're going to take one more question. We have pretty much run out of our time for today.

Operator

Actually, sir, that was your last question. I will turn it back over to you to make any closing comments.

Scott Murray

Again, thank you everybody. I appreciate you spending some time with us today. I will leave you with the thoughts that your management team is focused on building this business for the long term. We're focused on driving not just profitability but growth, and looking at our various business lines and our partners across the globe.

We will the back to you in the next 90 days with more on our plan as it continues to evolve, and I, as the new CEO of this Company, complete my homework exercise in understanding the business, understanding our channels, understanding our go to markets, the technology, and we're going to continue to leverage those, ultimately to create value for all of you, the owners of our Company. So thank you very much. I look forward to talking to you all shortly.

Operator

That does conclude today's conference call. Again, we do appreciate your participation. You may disconnect your line at this time. Have a great day.

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Source: 3Com F3Q06 (Qtr Ending Mar 3, 2006) Earnings Conference Call Transcript (COMS)
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