Avocent Corporation Q2 2008 Earnings Call Transcript

Jul.17.08 | About: Avocent Corporation (AVCT)

Avocent Corporation (AVCT) Q2 2008 Earnings Call July 17, 2008 5:00 PM ET

Executives

Sam Saracino - Executive Vice President of Legal and Corporate Affairs

Ed Harper - Interim Chief Executive Officer and Chairman

Michael Borman – Chief Executive Officer

Teddy Blankenship - Senior Vice President of Finance, Chief Financial Officer

Analysts

Aaron Schwartz - JP Morgan

Mark Kelleher - Canaccord Adams

Harsh Kumar - Morgan Keegan

Manny Recarey - Kaufman Brothers

Tom Curlin - RBC Capital Markets

Eric Kainer - ThinkEquity Partners

Scott Zeller - Needham and Company

Operator

Welcome to the Avocent second quarter conference call. (Operator instructions) I will now turn the call over to Mr. Saracino, Avocent Corporation’s General Executive Vice President and General Counsel.

Sam Saracino

Welcome to Avocent Corporation’s quarterly conference call. I want to remind all participants that this call will contain forward-looking statements. These include statements regarding future business prospects and economic conditions in general, statements about our management transition, statements about our leadership strategy and IT operations management, statements about the future revenue, sales growth, expenses, margins, tax rates, and operational earnings per share, including our expectations for the third quarter of 2008, statements regarding the integration of the operations products and technologies of the companies we have acquired and the future revenue attributable to them, and statements about the development and introduction of new products and technologies, and the size, growth and leadership of the market for these products and technologies.

These forward-looking statements are based on current expectations that involve a number of risks and uncertainties which could cause our actual results to differ materially. These risk factors are described in our periodic SEC filings, including our annual report on Form 10K.

The information discussed today will include certain non-GAAP financial measures. These operational measures are reconciled to the most directly related GAAP financial measures in our earning press release which was distributed earlier today. That press release is also available on our website www.avocent.com and was furnished to the SEC on a form 8K.

As we have previously stated, Avocent Corporation attends to comply fully with Regulation FD and we have adapted our investor relations practices and procedures to do so. Any and all guidance given to analysts and investors will be done only during this conference call, either in our prepared statements or during the question-and-answer session that follows. Accordingly, we encourage you to ask any questions you have concerning Avocent or our business or prospects during this conference call, since we will not be providing additional material commentary or guidance during one-on-one conversations with analysts or investors.

I would now like to introduce Ed Harper, the Chairman of Avocent Corporation’s Board of Directors.

Ed Harper

I am pleased to join you on the call today as Chairman of the Board and as past interim CEO for Avocent. I’m also joined this afternoon by Teddy Blankenship, our CFO, Everett Brooks, our Vice President of Investor Relations, and our new CEO, Mike Borman, who joined us just this week.

This has been a very eventful quarter at Avocent. We have many subjects to discuss with you this afternoon, including our financial highlights for the quarter, our recent organizational changes, and an update on our latest acquisitions and our outlook for the third quarter of 2008.

I’m pleased to report record second quarter revenue of $159.1 million, up 6% from the second quarter of 2007. We experienced \ strength in international markets across our major business unites. Our Management Systems and LANDesk sales teams continue to capitalize on cross-selling efforts, closing on more than ten opportunities during the second quarter. We are pleased with the continued success and progress made in our synergistic sales efforts.

Operational earnings per share was $0.41 cents in the second quarter of 2008 compared to $0.41 cents per share in the second quarter of 2007. Our earnings were affected by both a shift in our product mix and by higher operating expenses we experienced during the second quarter. Teddy will provide additional details on these expenses later in the call.

It is our expectation, however, that our recently announced organizational changes and cost reduction efforts will lower our operating expenses, enhance our profitability, and allow us to increase our focus on higher growth revenue opportunities. We should see some benefits from these actions during the remainder of 2008 and realize significant benefits from those actions in 2009.

In the second quarter, we introduced several new products, including DSView 3 power manager. This product allows IT managers to monitor and measure power consumption and energy usage of datacenter IT equipment in real time. DSView 3 power manager is unique, because it calculates the cost of the energy being used which is critical information for planning and budgeting, infrastructure build-outs or expansions and support of our customer’s green initiatives.

In addition to these new products, we announced the new offering with one of our largest OEM partners. IBM launched its new I-Dataplex, a customized rack system designed specifically for web 2.0 environment. The Avocent merge .5300 service processor manager will be an optional feature of that rack system sold by IBM.

We also announced the expansion of our relationship with Lenovo through the inclusion of LANDesk technology as the core of their new think management console. That console provides centralized inventory and reporting of Lenovo client hardware assets. This technology also supports management of Intel enabled devices.

Demonstrating our technology and our customer relationships, I’d like to highlight an important customer relationship with BTS Incorporated, a digital technology company located in California. Our relationship began in late 2007 when BTS employed our DSView 3 management software to manage their IT infrastructure, which was spread over seven global sites. BTS at that time chose our solution to enable remote management at the console level to save time and to cut operating expenses.

Recently, they have also deployed our new DSView 3 power manager, which enables them to monitor and measure the power consumption and energy usage of the IT equipment in their datacenters in real time.

These recent announcements demonstrate our ability to leverage our strong technical development capabilities with our ongoing customer relationships, thus providing innovative solutions to our customers that meet their changing needs.

Calculating energy usage is an integral part of understanding the total cost of operating IT infrastructure. As more of our customers focus on reducing power consumption and emphasizing green initiatives, Avocent technology is evolving to help them meet these challenges.

In the second quarter of 2008, we named Ben Grimes to head our newly combined position of Chief Technology Officer and Senior VP of Corporate Strategy. We combined key areas in our research and development and strategic planning to focus on an integrated product platform and improve the efficiency of our development efforts. Ben is now responsible for coordinating our research and development programs that are focused on providing products using the Avocent management platform. Ben is also responsible for strategic planning to align our vision for the Avocent management platform in our future product roadmaps.

We believe these actions will accelerate the availability of integrated Avocent products and bring us to a leadership position in IT operations management.

We also took steps in the second quarter to improve our operations and reduce our cost structure. These steps included reducing certain research and development investments in our lower growth product areas, integrating marketing functions, centralizing certain administrative and logistical functions to our corporate office in Huntsville, and shifting our Asia support operations from our Shannon facility to our new Singapore location.

The announced headcount reductions, which affected 200 positions within Avocent will result in a net decrease of over 110 positions within the company. As Avocent evolves into a more focused and responsive company, I wish to express how proud I am of all of our employees’ contributions and commitment to drive revenue growth and increase shareholder value.

We also announced our intention to sell the majority of our emerging connectivity and control business unit. We have divided this entrepreneurial business unit into its three product lines. The Equinox serial branded business, the broadcast business, and the pro-audio visual business. We are folding our broadcast product line into management systems and we intend to sell the other two parts of this business unit. Initial interest expressed from potential buyers has been encouraging.

Shortly after the close of our second quarter, we announced the acquisition of Touch Paper Group Limited, a privately held provider of IT business management solutions and also announced the agreement to purchase the assets and liability of Ergo 2000, a privately held provider of R. LCD console. As noted in our press release issued earlier today, the Ergo transaction has now closed and is part of our operation. These acquisitions create an exciting opportunity for Avocent in support of our focus growth area, IT operations management, as we continue to deliver on the vision of providing solutions that reach from the desktop to the datacenter.

In summary, we believe our focused strategy and targeted cost reductions will allow Avocent to shift investments to opportunities in the higher growth areas within management systems and LANDesk.

Combined with all the changes described earlier, we are now better focused to execute on our goal to be a leader in IT operations management.

Now allow me, please, to introduce our new CEO, Mike Borman. I’m very pleased to have led the company during this transition stage. I am extremely confident in Avocent’s strategic direction, especially under Mike’s leadership. I believe Mike is uniquely and superbly qualified because of his demonstrated transformational leadership within IBM where he led worldwide sales for the IBM software group, which generated over $15 billion dollars of annual revenue. Mike also previously was general manager of the I-series and P-series hardware businesses and held several other high level positions within IBM.

While Mike just came on board a couple of days ago, he would like to make a few comments before our CFO, Teddy Blankenship, gives a detailed overview of second quarter results and provides our outlook for the third quarter.

Mike Borman

I look forward to meeting with the Avocent employees, customers, partners, and investors in the coming weeks and months. Avocent second quarter results exemplify what attracted me to Avocent. That is the opportunity created by the investment customers are making to improve their IT operations. The company’s recent actions that Ed described as part of the company’s broader strategy will ensure that Avocent has a leadership role in IT operations management. Avocent is an exciting company and I am very pleased to have accepted the opportunity to lead this company forward and hopefully to the next level of success.

Teddy Blankenship

Avocent achieved record revenue of $159.2 million dollars in the second quarter. Our revenue was slightly above the updated range of between $155 and $158 million dollars that we provided on June 30. This represents a year-over-year increase of about 6%.

Branded sales increased 8% with the largest increase in Asia at 49%, followed by Europe at 11%, and the Americas at 1%. Our OEM sales increased modestly by 2% during Q2 as compared to 2007.

Our management systems business unit achieved Q2 revenue of approximately $121.7 million dollars compared to $115 million dollars in 07 for an increase of 6%.

LANDesk revenue increase 16% to $31.8 million dollars for the second quarter from $27.6 million in 07. This increase was primarily due to an increase in new license sales of LANDesk management sweep and subscription revenue from the LANDesk security sweep products.

Revenue from our connectivity and controls business unit of $4.9 million dollars declined by about $800,000 compared to the second quarter of 07. This includes $2.8 million dollars in revenue from product line that we plan to divest.

Our corporation and allocated revenue of $756,000 declined by about $1.4 million dollars as compared to the second quarter of 07. The decline relates to a one-time royalty catch-up in 07 in connection with the settlement of a patent infringement lawsuit.

Our gross profit was $102.9 million dollars for the second quarter of 08 compared to $98.6 million dollars in 07. Gross margin changed from 65.5% in the second quarter of 07 to 64.7% in the second quarter of 08, primarily due to product mix changes and increased freight cost.

Management systems gross margin declined slightly to 59.4%. This is largely attributable to the increase in certain secure products, which carry a lower gross margin than the average gross margin for other management system’s products. Increased freight cost were driven by higher fuel cost.

LANDesk accounted for approximately 20% of our revenue in the second quarter of 08 compared to about 18% in the second quarter of 07. LANDesk gross margin remained relatively constant with that of 07 at 87.5%.

R&D costs during the second quarter were $23 million dollars or about 15% of sales compared to $19.8 million dollars or about 13% of sales for the same period in 07.

The increase was primarily due to our continued investments in our Avocent management platform and our power management product. Our second quarter R&D expenditures were slightly higher than the $22.4 million dollars in the first quarter of 08.

We continue to invest in new product development and will continue to do so throughout 2008 with additional cost partially offset by the savings achieved from our previously announced restructuring activities.

Selling, general, and administrative expenses were $54.7 million dollars our about 34% of sales for the second quarter of 08 compared to $49 million dollars or about 33% in the second quarter of 07. The increase was primarily attributable to additional sales representatives added over the past year, increased commissions paid as a result of higher sales, increase tradeshow expenses, and increase legal expenses.

Excluding restructuring charges, our second quarter operating profit was $25.2 million dollars compared to $29.8 million dollars in the second quarter of 07. This resulted in an operating margin at 15.9% for the second quarter of 08 compared to 13.7% in Q1 of 08 and 19.8% for Q2 of 07. Our decreased operating profit as a result of the previously mentioned factors associated with product mix changes and operating expenses.

We incurred $2.8 million dollars in restructuring expenses for the quarter, excluding $1.9 million dollars in non-cash stock confrontational expense. The restructuring activities are designed to make our operations more efficient return Avocent to our targeted operating margins at 24 to 26%.

Net other expense was $1.2 million dollars for the second quarter of 08. This compares to $486,000 in the first quarter of 08 and $1.3 million dollars in the second quarter of 07. The sequential increase from the first quarter was primarily due to the impact of foreign exchange losses, a catch-up in certain China business taxes, and interest expense associated with our line of credit.

Our operational effective tax rate for the second quarter of 08 was 23.3% in line with that of the first quarter.

Operational net income for the second quarter of 08 was $18.4 million dollars compared to $21.1 million dollars for the second quarter of 07.

Our operational EPS was within our original guidance provided at $0.41 cents. Although revenue exceeded our original guidance, certain operating expenses and cost of goods sold also ran higher than expected, which resulted in the $0.41 EPS.

Our restructuring activities were designed in part to significantly reduce our cost base going forward.

As at the end of the second quarter of 08, we had approximately $117 million dollars in cash and investments. We generated about $34 million dollars in cash flow from operations in the second quarter compared to just under $5 million dollars in the first quarter of 08.

Our net account receivable balance at the end of the second quarter increased by about $800,000 compared to that at the end of the second quarter of 07, primarily in association with increased revenue for the quarter.

Our day sales outstanding declined from 67 for the second quarter of 07 to 64 days for the second quarter of 08.

Inventory returns increased to 7.6 during the second quarter of 08 compared to 6.1 during the second quarter of 07. This was primarily a result of the higher revenue for the quarter combined with our efforts to maintain lower overall net inventories, which declined by approximately $4.3 million dollars compared to the same period last year.

We repaid $10 million dollars on our line of credit during Q2, lowering the borrow balance to $130 million dollars. We subsequently borrowed on the line to help finance the Ergo and Touch Paper acquisitions in July.

Turning to guidance, we anticipate Q3 revenue will be in the range of $175 to $183 million dollars in the third quarter. At the midpoint, this would represent 10% growth year-over-year. This incorporates approximately $14 to $15 million dollars in increased revenue from the Touch Paper and Ergo acquisitions. This reflects ongoing concerns about the US economy.

We anticipate gross margins to be approximately 64 to 66% during the third quarter. We expect operating expenses to be within a range of $80 to $84 million dollars, excluding anticipated restructuring costs of approximately $4 to $5 million dollars for the quarter. This does include the increase in operating expenses associated with the Touch Paper and Ergo operations.

We have begun the integration activities for both Touch Paper and Ergo. We expect these to be slightly accretive to operational net income in  and more so in Q4 when we begin to realize the expected cost savings.

We expect our diluted weighted average shares to be approximately $45 to $46 million in the third quarter with the resulting weighed average earnings per share at $0.54 to $0.58 cents. The previous excludes estimates for sought base compensation and intangible amortization, pretax expenses, and about $6 to $7 million dollars and $10 million dollars respectively. Subject to the finalization of the purchase price allocations for both Touch Paper and Ergo.

These estimates are predicating on a stable economy within the US and in other markets where we operate and could change if instability occurs within that market.

On one final note, in 2009, we plan to change our quarter ends to be based on calendar quarters rather than our current 13 fiscal week quarters.

I’d like to turn the call over to the operator for any questions that you guys may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Aaron Schwartz. Your line is open.

Aaron Schwartz - JP Morgan

It looks like the branded business had a pretty good quarter and I was wondering if you could characterize what the negotiation is like there with the customers in terms of pricing, things like that. The environment is rather tough there and you guys did put up a good number. Just wondered if you could talk about that at all.

Sam Saracino

I’ll take that one, Aaron. The branded sales were up across the board, including LANDesk as well as management systems and, yes, we see some pressure and we see continued softness in North America, but on the other hand, we’ve been pleased that our average sales price particularly on the LANDesk products have held very well and we’re fairly confident that even in spite of the lower demand based on North America, we will continue to be able to make progress there.

Aaron Schwartz - JP Morgan

In terms of your assumptions going forward, I don’t know if you could talk qualitatively about close rate assumptions, whether they’re sort of flat with what you’ve seen in Q2 or the first half or how you’re taking into consideration the economy in the US.

Sam Saracino

It seems like things are pretty flat and the uptake and the conversion seems to be equally accepted across the board. So while we see the softness, we’re pleased to be able to maintain the flatness that we’ve had.

Teddy Blankenship

Aaron, the only thing I’d add to that is we’re fortunate that our business is fairly balance, that we have a good government business, and we continue to see good demand within the government business which is helping us counter a little bit of the weakness we’re seeing in the enterprise base in N.A.

Aaron Schwartz

Do you have any thoughts whether you’re looking at any of the strategy the company put together around A&P and some other initiatives, whether you look to do anything transformational outside of the body of the company or whether you’re coming in and really just looking to manage the assets.

Sam Saracino

My goal is to execute. They’ve done a number of things here over the past six months in terms of acquisitions as well as restructuring to deliver some synergies and cost savings. So I want to help the team execute all the things they’ve put in place. Second, I want to take the first 90 days to evaluate. Should we do anything else.

Operator

Your next question comes from Mark Kelleher.

Mark Kelleher - Canaccord Adams

I want to talk about the $2.8 million revenue that you’re divesting. Is that included in your revenue guidance for next quarter?

Teddy Blankenship

We do not at this point anticipate closing those divestitures during the third quarter.

Mark Kelleher - Canaccord Adams

Could you perhaps size the amount of revenue in the third quarter that’s coming in for your new acquisitions?

Teddy Blankenship

Yes, it’s roughly to $14 to $15 million dollars for Touch Paper and Ergo combined.

Mark Kelleher - Canaccord Adams

On the personnel cuts, are those across the board or focused in any one area?

Teddy Blankenship

They’re across the board and in several geographic sites, although they are more focused in the more mature areas versus the growth areas, so it would be more within management systems than LANDesk. They are roughly about two thirds in SG&A areas, really marketing and administrative areas, and then the other third will be split with a portion of that being in our operations group which rolls into cost of sales and a portion within R&D.

Mark Kelleher - Canaccord Adams

Did you give the percent of revenue international?

Teddy Blankenship

We did not, but we can get that in just a minute. Did you have another question while we locate that real quick?

Mark Kelleher - Canaccord Adams

I was looking at the deferred revenue. That kind of stayed flat quarter-to-quarter. Is there anything unusual going on there?

Sam Saracino

Really not much. Our numbers vary from quarter-to-quarter on the amount of deferred versus current and so nothing that stood out as being unusual.

Mark Kelleher - Canaccord Adams

Great, that’s all I got.

Sam Saracino

Thanks Mark, for your question. I think they’re close to having the answer for you.

Teddy Blankenship

The US business, US revenues were about 55% and international was about the other 45%.

Operator

Your next question comes from Harsh Kumar.

Harsh Kumar - Morgan Keegan

Your guidance when I run through your number, maybe a question for Teddy. I sort of get the $64.7, $64.5 number again for gross margins, why would we not think of margins picking up as we get into September.

Teddy Blankenship

The third quarter for us seems to be a good government business quarter and we have a couple of new secure switches that we introduced this year that includes some added features that the government agencies asked us for and those added some costs and we’re in the initial ramp up stage of those products and haven’t quite yet reached the volume scale to recognize an increased gross margin in that. We’ll see that in coming quarters and also with the secure nature of these products, most of the effort is handled within the US, so it’s not a case of where we get offshore production to Asia for cost savings that we typically seen from our other products.

Harsh Kumar - Morgan Keegan

My next question, we think longer term, maybe December, maybe the next year, we have a shot of getting back then in the 56% range, right?

Teddy Blankenship

Yes, particularly as we see the integration activities for Touch Paper and Ergo really pay off as we combine those operations with ours and the restructuring activities that we’ve announced take place. For instance, as we combine the operating side that’s currently in Redmond with our Huntsville location.

Harsh Kumar - Morgan Keegan

I was going to ask about cost cuts in Touch Paper, both at the margin level, gross, and then also operating. Do you think there is significant room for you?

Teddy Blankenship

Yes, with Touch Paper, yes. It’s modestly accretive for us this quarter already because it is a profitable business, but being a software business that are LANDesk group is very familiar with, because they partnered with them over the past few years, they know each other very well and a lot of revenue and cost synergies that we can achieve through combining efforts.

Harsh Kumar - Morgan Keegan

Your 82 at the midpoint million of operating expense, does that take into account any meaningful sort of the restructuring effort that you’re going through. Not talking about the $5 to $6 million for the second half. Are you getting any benefit of that at all in the September quarter?

Teddy Blankenship

We are. About 200 positions that we talked about being eliminated in the restructuring, about 50 of those have been eliminated already. So we will see some savings. There’s another 50 positions that will go away over the course of Q3, so we’ll start to see a little bit of savings there, but the real impact comes for us in Q4 in 09 as the remaining 100 positions or so are eliminated and we transfer those functions and roles to other Avocent sites.

Harsh Kumar - Morgan Keegan

You’ve always had a very good relationship on LANDesk, so there was commentary about something positive, some kind of a new deal you’ve struck with Lenovo. How should we think about that and what’s so different about this deal with Lenovo than the previous deal you have in place?

Sam Saracino

The relationship with Lenovo continues to blossom and they’re very interested in having our product base go out with their systems and so not only is it with LANDesk at this point, but it’s also expanding to other areas within Avocent. So we’re very pleased with the opportunity we see with our continuing expanding relationship with Lenovo.

Operator

Your next question comes from Manny Recarey.

Manny Recarey- Kaufman Brothers

Talk a little bit about the gross margins. Can you give any color which had more of an impact. Was it the mixed or in the freight cost that caused the drag there?

Teddy Blankenship

The biggest impact during the quarter was really from the product mix change, just selling more of the newer secure switch products.

Manny Recarey- Kaufman Brothers

Can you talk about the LANDesk operating margins? Seemed like they bounced back pretty nicely from the first quarter to over 12%. What was driving that and was that a sustainable level?

Teddy Blankenship

Thanks for pointing that out, Manny. We’re pretty proud of the 12% plus operating margin for LANDesk. As you point out, we’ve really been striving hard to improve that operating margin over time and we mentioned before that we have a target to get LANDesk to 12% for 08 and then improve that to closer to 20% level in 09. So we have expected to see continuing improvements steadily in that operating margin as we go through the quarter and through a combination of factors. One, it moves some R&D responsibilities to the site in Beijing where it’s a little bit lower cost. We’ve also taken some efforts with the reseller network to rely on our reseller partners more particularly on smaller deals and be able to cut back our level of involvement in those and do a better job achieving self force productivity as well.

Manny Recarey- Kaufman Brothers

So the Touch Paper. Is that at the same type of operating margins as LANDesk?

Teddy Blankenship

Not yet. Our goal will be to have them at that combined level of the roughly 20% for 09 as we integrate through the rest of 08.

Manny Recarey- Kaufman Brothers

Are they at 10% level now?

Teddy Blankenship

More like mid-single digits.

Manny Recarey- Kaufman Brothers

You mentioned cross-selling opportunities. Can you give any color on the size. Were they significant deals or any color would be appreciated.

Teddy Blankenship

Sure there are significant names within that group and we made significant progress in the cross-selling activities. Provided a meaningful amount of revenue I believe. It was in the region of a million dollars or so. We’re more exciting about looking forward. You may recall, Ed discussed the strategic account process back in April that we were starting. We started with ten accounts and then increased that to about 20 during the quarter and we got plans now to increase that further. We’re getting some really good feedback from the accounts, that they get together and share contacts, provide introductions, develop account plans, and look at the opportunities we have in those key accounts.

Ed Harper

And will characterize it as early at this point, because we continue to refine the methodology and the message that we give to these strategic accounts with the idea that it spreads further as we refine the process.

Operator

Your next question comes from Tom Curlin.

Tom Curlin - RBC Capital Markets

Can you remind us how the DSView software reporting works out. Is that at the MSD stuff or LANDesk?

Ed Harper

It’s still on the management system side.

Tom Curlin - RBC Capital Markets

Do you think it’s appropriate to continue that or should you be considering an integration of that software from a reporting perspective and chain of command perspective with the LANDesk division just to make sure everybody is marching to the same tune on the software.

Ed Harper

Tom, as you see us move forward, the first thing we have done is we’ve consolidated our marketing to give a unified message to our customer base and through the world about the fact that we are one company and that’s Avocent. We have assets across both of the product portfolios and we are best equipped in the industry to provide both software and hardware that allows us to provide effective tools from the desktop to the datacenter. So as we continue the strategy of our advanced management platform effort, you will see those things continue to get closer and closer together and at some point it’ll be very hard to distinguish whether one group or another is hardware versus software and the opportunity toward both of those across the desktop to the datacenter will become blurred as we move forward.

Tom Curlin - RBC Capital Markets

On the operating margin target for next year, to what degree has Mike Borman been involved in the plan for getting to those margins?

Mike Borman

Well, I’ve only been here two days, but we reviewed these. We reviewed these yesterday and we’re setting a model in place to be able to achieve those.

Ed Harper

The targets were reviewed extensively with our board back in the second quarter when we were presenting our restructuring plans and the various actions that we wanted to take and how we were going to get to the 20% operating margin for LANDesk and how we were going to get to close to 30% operating margin for management systems and we have a lot of activities, a lot of initiatives underway to get there, and Mike has already I think had a pretty good briefing the last couple of days on the open activities and initiatives that are being driven to get there.

Tom Curlin - RBC Capital Markets

If you think that strategically focusing on that leverage story is the right thing to do relative to the shifting of those investments more aggressively into the software side of your business.

Teddy Blankenship

Yes, that operating margin model leads us a lot of room for investing in R&D. You may recall from our R&D discussions on the restructuring activities that we are not setting out to reduce the overall level of R&D activity as much as we’re looking to reprioritize and move R&D investments away from the more mature areas where there’s less return possibility to the more growth areas like the software area, like power management, the Avocent management platform, the visualization and modeling software modules that we talked about coming out toward the end of this year. We’re definitely focusing on those growth areas and allowing room in our model to continue to invest in those areas and to potential do other acquisitions where it may make sense at some point in the future like Touch Paper and Ergo where they fit well with our strategy.

Tom Curlin - RBC Capital Markets

Stock buy backs, what is the approach now? You’re still at a negative net cash position. Are we still in the mode of buying back stock at or near a negative net cash position or are you going to look to build your cash balance from a cash flow perspective?

Teddy Blankenship

No, Tom, we’re not really buying back shares at this point. We really didn’t buy any back during the second quarter. You’ll see in our cash flow statement, we had a little bit of money in the quarter that was actually paying for shares we bought back in the first quarter, but we really aren’t buying back at this point. We’re using the cash flow to fund these acquisitions and to pay down the debt to create more strategic flexibility as you pointed out.

Operator

Your next question comes from Eric Kainer.

Eric Kainer - ThinkEquity Partners

One of the things that I’d like to understand is the joint sales that you had in the quarter, how did those come about? I assume generally the lead came in through the MSD group and then they engage the LANDesk folks and how does that model wind up changing as we get kind of a much thicker role for joint sales looking the overall enterprise.

Sam Sarcino

The pilot programs that we have in place are designed to give us customer feedback from a pilot program designed to find synergies that are there. The opportunity that comes about is as you pointed out right now mostly driven by having management systems where we have deep account penetration at the highest level in the datacenter has resulted in introductions of the LANDesk people into those accounts. The opportunity for us to have product specialists as we manage these accounts strategically to take advantage of both has been encouraging actually in both directions. So we’re pretty excited about what we found so far. We keep refining it and we keep moving forward and I think there’s a lot more to be had as we figure out the best method to continue to drive it lower, lower levels in our account base.

Eric Kainer - ThinkEquity Partners

The last I knew, the management system folks were allowed to sell LANDesk products, but the LANDesk sales force was not allowed to sell management systems products. Is that still true?

Sam Sarcino

Eric, we’ve tried several approaches to this and what we’re finding now gives us more success than any opportunity that we’ve seen so far and what it does is really allow our customers to tell us what they want to see in terms of how we approach them. As I mentioned earlier, we are putting the face on that we’re Avocent, that we have assets all across the board from the desktop to the datacenter and the opportunity to then bring in product specialists at the request of the customer base based on the account management and mapping that we have started is really responsive, and you’re right. We had some abortive attempts, if you will, to try to manage the way things were sold and we realized that the best way to do it is to let our customers tell us exactly how they want to buy.

Mike Borman

If I could add on that. This is Mike. So one of the things we reviewed yesterday was we started to develop an 8-point plan to make sure we get the synergies out of the two different divisions, both from manufacturing all the way to go-to-market. And so, several of the points involve sales enablement, sales incentives, and overall sales discipline that the two teams will work together on.

Eric Kainer - ThinkEquity Partners

Power products, it sounds like you’re gaining some traction there. I wonder if you can talk two things specifically. One, is there any color about how much of the power product you’re actually selling now? Maybe how quickly that could grow or how big that could be? Second, how do those opportunities arise?

Ed Harper

Eric, the revenue contribution during the second quarter from the new products was virtually nil. We just announced them the second quarter and they really launched in July, began shipping in July. I think we had one or two customers who asked for them early, but really the launch is happening right now as we speak. As far as the sales force goes, it fits very well with what the management systems group is already selling with the overall solutions of KBM switches and material appliances, and we had some smart power script that we were selling as well and this enhances that with the software layer, the intelligence of monitoring, and modeling the actual power usage going on.

Sam Sarcino

Again, Eric, the initiative, it tends from the desktop to the datacenter, because we do have initiatives on both sides. So the opportunity at this point, because we’d not made it widely known that we offer these solutions, has come primarily, as Teddy mentioned, really from customers telling us when you get something, we want to see it and we’ll have it. So that’s been what it’s been.

Operator

Your next question comes from Scott Zeller.

Scott Zeller - Needham and Company

The timing I understand Ergo has closed but Touch Paper, what is the anticipated close?

Teddy Blankenship

It closed on the same day we signed it. In the press release we announced that the way transactions are done in some parts of the world and in the UK where Touch Paper was, we actually signed and closed that deal the same day on June 30th.

Scott Zeller - Needham and Company

When you made the comments earlier about the impact to cost of goods with fuel and shipping, is it included in your guidance for Q3 that those costs remain high or are you anticipating an improvement?

Teddy Blankenship

We have included that. We have received notice from our freight vendors that there will be ongoing fuel surcharges in Q3 based on the current price of oil basically and we’ve included that in our guidance.

Scott Zeller - Needham and Company

There was a question earlier about opportunity to cut costs at Touch Paper, because of the closest to LANDesk, but what about the Ergo division? Are there are any opportunities there for cost cutting as well?

Teddy Blankenship

Definitely. We plan to combine that operation with existing Avocent operations and also to use existing Avocent supply chain. So we’ll be transferring things to our suppliers as well.

Scott Zeller - Needham and Company

When you look at the expected revenue contribution from the two acquisitions, the $14 to $15 million dollar range, that’s pretty close to what they’re operating at when they were acquired. When you look at the core business, pre-acquisitions, I guess you’d have to assume that there is a good degree of growth in both management systems and LANDesk organically quarter-to-quarter. Is that correct?

Teddy Blankenship

If it continues to grow in those businesses, LANDesk is growing at a faster rate currently than the managements systems business and as you pointed out, for the two acquisitions, we don’t expect as much growth in the third quarter since this is our first quarter to own them and we’re going through heavy duty integration activities right away and then we’ll be expecting more growth as we deploy those products through our sales forces around the world going forward.

Ed Harper

Scott, there is opportunity for significant growth simply because we have much better distribution opportunities than the folks at Touch Paper did, because they were primarily confined in their efforts to Europe and with our wider spread distribution, we believe that there can be significant growth. Also, on the Ergo side, if you think about our distribution mechanism and the relationship with our OEM customers, there can be potential good growth in that segment as well.

Operator

Your next question comes from Harsh Kumar.

Harsh Kumar - Morgan Keegan

Your guidance, should we look at that as being somewhat condoned as giving what you’re seeing domestically in the US here?

Ed Harper

Yes Harsh, we have factored in the ongoing economy, economic issues in the US. We are fortunate, of course, that Q3 for us is a good quarter typically and we have a solid line of products that we sell into our government customer base. So that will help us to offset some of the higher level enterprise spending weakness that a lot of people are seeing.

Operator

Your last question comes from Manny Recarey.

Manny Recarey- Kaufman Brothers

A quick follow-up. How much did you spend for the Ergo and Touch Paper acquisitions in total?

Teddy Blankenship

The Touch Paper acquisition was $23 million pounds, which is roughly $45 million dollars, I believe at the exchange rate when we closed that deal, and Ergo was $27.5 million dollars.

Manny Recarey- Kaufman Brothers

Did you pay that with all debt?

Teddy Blankenship

No, we were able to use cash. For instance, with Touch Paper, we were able to utilize a lot of cash that we had built up in Ireland, in Europe, which you probably know is kind of tough to repatriate to the US anyway. So that was kind of a neat opportunity for us to take advantage of the built-up earnings we’ve had offshore to reinvest in that operation and we borrowed under the line of credit to finance the Ergo transaction in the US.

Ed Harper

Thank you. If we don’t have more questions, I would like to give the opportunity for one last one if there’s one there. Otherwise, I appreciate the participant audience and your questions have all been extremely worthwhile. So Operator, do we have any more or is that it?

Operator

There are no further questions in queue at this time.

Ed Harper

Thank you all for your participation in this call.

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