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Executives

Erik Knettel - Investor Relations

Shabtai Adlersberg - Chairman, President and Chief Executive Officer

Nachum Falek - Vice President, Finance and Chief Financial Officer

Analysts

Vivek Arya - Merrill Lynch

Troy Jensen - Piper Jaffray & Co.

Edward Jackson - Cantor Fitzgerald

Eric Kainer - ThinkPanmure

Joe Parks - Oppenheimer & Co. Inc.

Jeff Meyers - Cobia Capital

Robert Katz - Senvest International

AudioCodes Ltd. (AUDC) Q2 2008 Earnings Call July 30, 2008 9:00 AM ET

Operator

Welcome to the AudioCodes second quarter 2008 earnings conference call. (Operator's instruction) It is now my pleasure to introduce your host Erik Knettel, Investor Relations for AudioCodes.

Erik Knettel

I would like to welcome everyone to the AudioCodes' second quarter 2008 earnings conference call. Let me begin the call today with a brief Safe Harbor statement concerning AudioCodes’ business outlook or future economic performance, product introductions and plans and objectives related thereto and statements concerning assumptions made or expectations as to any future events, conditions, performance or other matters.

These are forward-looking statements as that term is defined under U.S. Federal Securities Law. Forward-looking statements are subject to various risks, uncertainties and other factors that could cause actual results to differ materially from those stated in such statements.

These risks, uncertainties and factors include, but are not limited to, the effect of global economic conditions in general and conditions in AudioCodes’ industry and target markets in particular, shifts in supply and demand, market acceptance of new products and continuing product demand.

The impact of competitive products and pricing on AudioCodes and its customers, products, and markets, timely product and technology development, upgrades and the ability to manage changes in the market conditions as needed, possible disruption from acquisitions, the ability of AudioCodes to successfully integrate the products and operations of acquired companies into AudioCodes' business and other factors detailed in AudioCodes’ filings with the Securities and Exchange Commission. AudioCodes assumes no obligation to update that information.

In addition during the call we will refer to non-GAAP net income. We have provided a reconciliation of non-GAAP net income to our net income according to GAAP in our press release and on our website.

Joining us today from AudioCodes we have Shabtai Adlersberg, Chairman, President and Chief Executive Officer and Nachum Falek, Vice President, Finance and Chief Financial Officer.

I would now like to turn the call over to Shabtai Adlersberg. Mr. Adlersberg, please go ahead.

Shabtai Adlersberg

With me this morning is Nachum Falek, Vice President, Finance and Chief Financial Officer. Nachum will start up by presenting the financial overview of the quarter. I will then review some of the business highlights for the second quarter and I will describe some of developments in our business. We will then turn it into the Q&A session.

Nachum Falek

Before beginning the financial overview of the quarter, I would like to note that the following discussion will include GAAP numbers and pro forma numbers.

Our second quarter pro forma results reflect adjustments for the following two non-cash items; Stock-based compensation expenses which totaled $1.2 million in the second quarter of 2008 and amortization expenses relating to the acquisition of Nuera, Netrake and CTI, which totaled $800,000 in the reported quarter.

Full reconciliation of the pro forma results discussed on this call to GAAP results is currently available for review on our website and in the press release issued yesterday.

Getting to our quarterly results. In the second quarter, revenues were $45.7 million which represent 4.5% increase from the last quarter. As a percentage of our revenues, sales in America accounted for 52%, Europe 24%, Asia Pacific 16% and Israel 8%. We had one customer above 10%. Our top 15 customers accounted for 53% of our revenues compared to 49% in the previous quarter.

In terms of revenues by business groups, in the second quarter, our technology business group accounted for 31% of revenues compared to 35% in the previous quarter, and our networking business group accounted for 69% of revenues compared to 65% in the previous quarter.

In the second quarter of 2008, pro forma gross margin was 57.6% compared to last quarter pro forma gross margin of 57.8%. On a GAAP basis, gross margin was 56.2%.

Our total pro forma operating expenses were similar to the first quarter levels at approximately $22.5 million in the second quarter of 2008. On a GAAP basis, operating expenses for the second quarter were $23.8 million. Headcount decreased this quarter by 25 employees, which brings us to a total of 663 employees.

Pro forma net income for the second quarter was $3.6 million or $0.09 per share. GAAP net income for the second quarter was $1.6 million or $0.04 per share. Short-term and long-term cash balances were $147 million compared to $137 million last quarter.

The increase in cash balances is attributed mainly to a positive cash flow from operations and financing which were offset by a negative cash flow related to investment activities. During the quarter, bought back of AUDC's share in the amount of $7.2 million and received a bank loan in the amount of $50 million for five years. We have recently secured additional $15 million bank loan for five years in order to improve our balance sheet strength and which brings our total cash balances at this time to approximately $160 million. DSO came in at 59 days compared to last quarter DSO of 50 days.

As for our guidance, we wish to update our annual guidance for 2008. On an annual basis, we forecast revenues for 2008 to be in the range of $180 million to $185 million and now forecast that our non-GAAP earnings per share will be higher above of the range of $0.34 to $0.37 which we planned earlier this year. We also estimate our GAAP earnings per share to be in the range of $0.12 to $0.15.

I will now transfer the call to Shabtai.

Shabtai Adlersberg

We are very pleased to report record quarterly revenues second quarter 2008 growing throughout to 20% year over year and 4.5% sequentially over the first quarter of 2008, all that in spite of challenging environment including markets and region.

On the view of the first quarter of 2008 and maintaining growth for the fifth consecutive quarter, we believe we are on track with our plans to 2008. Even more, as Nachum noted earlier, we now believe that we should end the year in the higher end of the earning trend planned initially for 2008. The networking business which is now about 70% of product sales continue to use exhibit showing momentum with 10% growth over previous quarter and above 25% year over year. With our networking business growing at about 30% annually for the past 3 years and with a growing portfolio, new offerings and better infrastructure in place in our global presence, we believe that we are exhibiting these days all necessary ingredients for our continued future growth.

Operationally, we kept improving on several fronts. On the operating margin front, we grew to 8.3% versus 6.7% in the previous quarter and only 2.3% a year ago. Cash flow was positive in the quarter bringing $2 million. Overall cash position, as Nachum reported, was $147 million at the end of the first quarter close to $260 million today and all that versus $137 million at the end of the first quarter of 2008.

Headcount decreased 45 employees mainly due to completion of the integration of some of the acquired businesses in the year of 2006 and 2007 and adjustments in Neura business and more efficiency on business side was produced. Looking further, profit growth is $3.6 million compared with $3.1 million in the third quarter and $1.4 million a year ago. Most importantly, we believe that we actually close to finalizing the process of focusing our investment on a fairly tuned along the strategy in the current business where we see very healthy demands for our product and business all over the globe.

That, we believe, that we should keep performing on the operational fund for the coming quarters. Also, I would like to mention that we see the competitive environment quite comfortably for us. We are competing generally with smaller companies who face top science in view of the uncertainty and some of the slowdown in certain markets and inability to access financial strength. On the other side, we have larger companies who prefer these days and tend to also buy the products which we have manufactured. All in all, we believe, that we are in very good spot to take advantage of weakening competition.

All in all, first half of 2008 is quite inline with our plans. Our key focus remains and continues to be on the CPE side. We keep selling customer premises equipment to both the enterprise stage and the service provider stage and we solidified the infrastructure that reflects to that. We have strengthened our partnership with a few leading vendors in the enterprise market, most notably some of the names that you know, Microsoft with now some relationship with Avaya and few more leading enterprise market vendors. At the same time, we kept showing you our partnership with world class system integrators that deploy complete network solutions and I believe that all in all, we are positioning our self to be a fairly strong, reliable, committed partner to those large partners with the sale of complete network.

Some of our winning products especially in the low and mid-density media gateways space and those products kept growing in the quarter and we indeed see future potentials on the low-end size and also on the medium size. Also we saw a phenomenon of some of the top players in that markets abandoning and not developing new products. With new features that being required in the field and the need to support new applications and more interpretability with different network, we believe we are remaining one of the few parties in the market that keeps investing, keep delivering new products and therefore, I do believe that new opportunities are being opened for us as time goes by.

Most important this year, in spite of keeping our OpEx quite flat, we are investing heavily in new technology development and in new architecture and thus we are readying products for 2009 and beyond for better cuts, structure and functionality, intense work of those right now in the R&D section of the Company to be ready with those new products for early next year. We have announced one very important initiative for us, the Multi-Service Business Gateway. I will get to that immediately and that represents an entry into a completing new market segment that size today at about $600 million to $700 million.

We are working on another initiative which we plan to announce towards the end of the year. At this time, as Nachum mentioned, we have seen no change in outlook for overall 2008 revenues above $180 million, representing more than 15% growth in the year and a substantial growth on the earning side. Based on inputs from a market research group, Synergy, in the first quarter of 2008, we were ranked number four in the combined low and mid density gateway market. We are capturing 14.4% of the market and we believe that as time goes by we should be able to increase that market share and with some of the larger players putting much, much less attention and efforts and we are focused into that space we should be able to fill that market share.

Most important as I have mentioned before, we are diversifying and accessing new market. So far, we had a [only play a pure voice play] which it does around voice and circles around media gateways. We are now diversifying our operations and have introduced already a converged voice and data products. That product which started both the SME, the Small to Medium Enterprise’s space and the SMB represents for us a large opportunity which is not less than the ones that we have been focusing these days. So, that represents the new growth engine for the company. That product will integrate in it besides the voice media gateway also a session border controller, enterprise level and also data services that include among others switching, developing firewalls, network user access, third party user applications and other media plus the control functionalities.

We believe that type of integration level is not available with many companies and we believe that due to our leadership in the voice space, we should be able to grab a nice market share in this space. All and all, the value proposition to service provider would be an easy-to-manage demarcation point for the services and the value proposition for enterprises would be for those who seek a simple migration path for inter-branch communication. We already introduced to the market a fairly limited version of the first product. By the beginning of the fourth quarter this year, we will release a more advance version that will deal with IP wide mediation, enterprise session border controller functionalities, broad network full-fledged broader active device and few more.

All in all, we target to capture about 5% of that market in this coming year.

And with that basic coverage, key developments in this quarter and with that I would like to turn with caller in the Q&A session.

Question-and-Answer Session

Operator

(Operator's instruction) Our first question comes from Vivek Arya with Merrill Lynch.

Vivek Arya - Merrill Lynch

Couple of questions, first some housekeeping question and then some product and strategy questions. First, in terms of housekeeping, Nachum how should we model the share account for Q3 and Q4? If I am not mistaken, your convert roughly start kicking in at this EPS level. So, how should we model the share account?

Nachum Falek

Yes, I will look first. It is true when and if the convertible kick in, we need to add the shares from the converted but remember that on the EPS calculation, we need to take out the interest that we obtained on the convert only on the calculations. So, basically, it will be a little bit dilutive but very linear and I do not believe it will have any significant influence in the next quarter in terms of following EPS.

Vivek Arya - Merrill Lynch

So, how many shares should we be adding and how much should we be clawing back?

Nachum Falek

I am not sure yet obviously it depends on the profits that we will make on the third quarter so it is too early for me to know if it will kick in. Assuming it really we will need to add $6.8 million shares.

Vivek Arya - Merrill Lynch

Okay and how much interest?

Nachum Falek

It is 2% over the $125 million.

Vivek Arya - Merrill Lynch

Got it and then how should we model the interest expense? I believe we have this new bank loans.

Nachum Falek

Yes, so basically we have been on, I do not want to get into the specific details but all in all since we deposit then so back to back the interest is very, it is not a significant on our interest income.

Vivek Arya - Merrill Lynch

Alright. Now, Shabtai, what is your view of carrier versus enterprise spending compared to your views from three months ago? What have been the positives? What have been the negatives so far?

Shabtai Adlersberg

Well, we really do not see much change and we really do not see different spending present between two different spaces. On the enterprise space, there are a lot of activities that goes on. On one side with products, on integrating more product into the solution and then working with global system integrators that says those solutions but no change on that part but on the other hand also, we sense it will work and responding to our season projects to service providers. Again, I think we have mentioned before that with the lot of activity in Latin America, in Europe, in Asia Pacific but all in all, if I have to judge it in the perspective, I do not see any major change.

Vivek Arya - Merrill Lynch

I see. Then on the activities that you have mentioned in Microsoft, Avaya, some of this tier-one enterprises players, how should we try and quantify the success of this activity like are all this representing a certain percentage of sales for you. How should we track the progress with these partners?

Shabtai Adlersberg

Okay, so at this stage sales level with those large partners is still not meaningful compared to the overall level of sales. So, all in all, I think the key parameters in using inside to measure success in those relationships is really on number of design wins and number of work initials very limited scale deployments. We do believe that with those who will see, actually already ramp up with one of them, but I think 2009 should be much more characteristic as to true contribution of those partners. All in all, it is growing and the measure is number of design wins but still not there a problem.

Vivek Arya - Merrill Lynch

I see so mostly it is 2009 in bank?

Shabtai Adlersberg

Right.

Vivek Arya - Merrill Lynch

And then finally, Shabtai if you just back step look at the Company, obviously the market GAAP has come down significantly. How do you think about AudioCodes in much more longer, 2 to 5 year point of view? Do you think you can continue to succeed standalone? You have done a very good job in the last year of doing so but when you look out 2 to 5 years, how do you see AudioCodes?

Shabtai Adlersberg

Frankly, I am more optimistic than before because much more a closed game few years back when the large players used to deploy complete solution and would rely mostly on in house developed solutions. I think with the telecom market under pressure and the large player under pressure also from the software company coming from the intimate space, there is a tendency among the large players to move more and more into a software on the applications and level of solutions and they focus basically on the network, the system integration and the application side and they tend these days to outsource and rely more on partners such as us who provides complementing if I would call intelligent hardware, type of hardware that we produce and we do believe that we add more and more opportunities opening for us that has been evident in the first half of 2008 where we start to get access to partners who in the past never dealt with us or did everything internally.

So, I believe AudioCodes' future lies in becoming a larger medium telecom market player and I think continuing to grow organically on the 15% to 20% annually is definitely an achievable target for us and if a good acquisition comes our way which will help substantially enlarge that, our goal at least for the next three years would be to become a 400 to 500 million company and I think that is achievable.

Operator

Our next question comes from Troy Jensen with Piper Jaffray.

Troy Jensen - Piper Jaffray & Co.

. I just want to focus on two questions primarily on the margin front so if you guys look at the gross margins September of '06, you had 59.9% and every quarter since then, they have been flat to downish. Now, at 57.6%, you are about 40 basis points below the low in the view targeted range. So, can you talk about what is going on in the gross margin line and do we see the 58% to 68% again or is the fact back of networks taken over, is that going to dilute the margins lower?

Shabtai Adlersberg

Yes, we definitely agree with your view that as the volume grow that we become larger Company, as we sell more, we should see incremental very much controllable. It is created in the gross margin. It is not that you should expect a jump of 1% to 2% but the thing, I have mentioned that trend, I think, already in 2005. We are reaching to be close to 200 million company and so as sales will grow, we will see some decrease in gross margin but we do not, as I had mentioned before, as competition is not really pricing, it is really more the volume, the type of prices and margins that our customers plan for themselves and therefore look to get from us.

Troy Jensen - Piper Jaffray & Co.

To that point is I mean, is 58 to 60 is still the target and do you think we are going to get back there?

Shabtai Adlersberg

Personally, I do not think we will get to the 60% gross margin level. I do not see large players holding that. I mean if we would have been a software company, we could ask to manage that. Being majority base on intelligent hardware, I think staying at the range between 55 and 60 is a good target to fight for and to continuously invest in cost reductions and I think we are doing this.

Troy Jensen - Piper Jaffray & Co.

Okay, you have done a great job obviously leveraging it to the operating line with some tight expense controls and headwind of the currency changes here. Is there and if you look a couple of quarters out, do you guys need to start accelerating any spending on R&D and sales and marketing given that you have kind of held back here for a while?

Shabtai Adlersberg

Well, we have I think we came to in the past few quarters, I think we have sets for our sales the range of investment that we planned for R&D, generally I would put that roughly in the range of 17% to 20% of our sales and we monitor that very closely. Now, if you spare that, we are celebrating 15 years of existence and we have invested a lot of the amount of incremental or acquisition of investments. It is needed this now that high end and we believe that with the efficiency and the challenge that we developed internally. We really do not feel that there is a need to invest substantially in R&D beyond the level that I have mentioned before.

Operator

Our next question comes from Ted Jackson with Cantor Fitzgerald.

Ted Jackson - Cantor Fitzgerald

I missed the employee number. Could you just say that again?

Shabtai Adlersberg

Six hundred and sixty three.

Ted Jackson - Cantor Fitzgerald

I was curious if you give an update relative to the government project that you talked about last quarter, we are pretty excited about it, thought it could generate $10 million to $20 million in 2009. Do you still see that as on track and on base?

Shabtai Adlersberg

Yes.

Ted Jackson - Cantor Fitzgerald

The second question had to do with the cable market. You got some good exposure with the net marketplace. You have seen some of this cable providers actually starting to move out of offering property services due to the consumer and trying to make efforts to get into the enterprise, get into the small business, you have kind of given your product and said it seems to be well positioned to work with them on that front. I mean is there any activity on that level as you could talk about anything that would make us enthusiastic?

Shabtai Adlersberg

Well we do definitely have activity in that area. We do continued growth under residential side and we are engaged, even recently we got some reports that the number of server is growing so we have to keep ingesting in that. What is even more encouraging in that is indeed the fact that we see several cable companies in North America offsetting to invest in trying to deploy business communication services on top of their cable network and we have been engaged and if I am not trying to reveal to you that that initiative set to run of them and few more interactions with other companies. So, keeping sales to the MS in North America is something that we believe 2008 represents across the year and we will probably see growths of that in the coming year.

Ted Jackson - Cantor Fitzgerald

Okay, great and then my last two questions were pretty to Nachum. I was wondering if you could give some update relative to CTI Squared kind of where that business stands, kind of maybe a rough ball park estimate of what you are looking forward in terms of revenue for the year and then the same discussion for net rate con in standalone basis. Thanks.

Nachum Falek

So, to answer what you got to CTI Squared we really known use. They keep put falling at the same that we have seen about six months ago and at that stage we do not see any major development in that business. As far as metric is concern, we are working with them on acquiring, they need to drag in some of the session by the controlled technology as that has been acquired and integrating that since some of our products. Again, I am not in the position to tell you that we see any meaningful progress in that space.

Operator

Our next question comes from Eric Kainer with ThinkPanmure.

Eric Kainer - ThinkPanmure

Given that your competitors in the Voice over IP infrastructure space basically all reporting very weak results, I think you have a remarkably strong result here and you are to be congratulated. I wonder if you can talk about the business from the enterprise versus the business that you are getting from the carrier market. Where do you see more strength? Obviously it looks like you have got pretty compelling product coming here for the enterprise but I wonder if you can tell us about specifically to Q2, where did you see more strength?

Shabtai Adlersberg

I think everyone's result is that presently within answer that will be back. When you do not really see any meaningful difference between the two spaces then it surprise in more carrier. I think if you look for what makes it work really I think you need to basically the spreadsheet to two key points. One is results of other companies and not specifically pinpointing one of them, we kept our investment more in to the low and mid density area where relatively I think the market is rise. In the identity market, I think the market belongs really more to the large player and this is where all other companies are an aspect to be looking competing equally in that market.

The other point really here is the business model and I think the fact that which shows play best of words, best display which means that we will develop and sell the best maybe gateway but on the same percent we would ponder and sell it with all of such to each vendor. That is really open for us a lot of room for partnership and to enjoy different market segments that on and off ramp up in all the degree. Most of the other competition usually send to sell complete solutions and in that space, although we not play there, I would assume that competition is much more clear and also most of those complete solutions act more in the service provider stage really have no access to the enterprise business which is relatively dominated by large player such as Sisco, Avaya and Nortel and Nokia Siemens.

So, all in all I think it is really the business model and/or focus more on the revenue business area.

Eric Kainer - ThinkPanmure

Okay, did I understand your response earlier in the call where you seem to indicate that you saw less competition or maybe weaker competition than you had previously seen or maybe you are anticipating that?

Shabtai Adlersberg

Yes, that is correct. I think a lot of companies have lead financial resources that use to be confident at their investments for the future and therefore as you are aggressively looking to cause of lack of investment and cost reductions in getting the new generation of product coming up and going because of those products. At the same time, a lot of companies with lack interest and appetite to invest in relatively small niche market for them so all in all, we are getting crack in the winch from both sides.

Eric Kainer - ThinkPanmure

Now, last thing that I wanted to touch on is the role out of OCS which obviously your primary beneficiary here. I wonder if you can tell us kind of whether you have seen, what kind of interest you have seen in actually getting some enterprise deployments there. I mean are we seeing it still only in the headquarters, still in the testing space or are we starting to see deployment and they are starting to go from the headquarters locations maybe to some of the regional branches or what have you?

Shabtai Adlersberg

Yes, I am looking to the primary data in that sense but from the results I get, it seems that more of the engagement of this presently still on the first deployment in one of two branches and you really have not seen yet companies adopting in a merger way. Also I would like to also make point in the OCS, there was much less focus on voice deployments and feel basically at this time of the year and therefore any activity regarding voice part in the OCS will be much more probably in 2009.

Operator

Our next question comes from Joe Parks with Oppenheimer.

Joe Parks - Oppenheimer

I was wondering if could you provide some more color regarding fashion you are seeing with MSBG and also we saw sequential improvement in OpEx in the percent of sales quarter over quarter. I just wanted to do whether a step of the Company might be taken to continue with this improvement and lastly, regarding exchange rate, I just wanted to get a better understanding of what your exchange rate guidance is based upon? Thanks.

Shabtai Adlersberg

So, coming to the exchange rate, so possibly this is most edged by follow conductions that we did going forward. Obviously the exchange rate circles this has impact us but as we mentioned before, we will do the target that we set for our self and we will be the higher range meaning closer to the $0.37 rather than to the $0.34.

Operator

Our next question comes from Jeff Meyers with Cobia Capital.

Jeff Meyers - Cobia Capital

How do you see July so far demand looking?

Shabtai Adlersberg

We see no changes. I mean it is just among the same line we have seen in the second quarter.

Jeff Meyers - Cobia Capital

Got you, okay and then what about in terms of next year let us say you continue the 15% organic growth, how much do you think your operating margin could move up going on to next year?

Shabtai Adlersberg

Well we have set targets for our selves to get into the range about 10% to 12%. We can typically keeping that and I think basically we should be able to stay in that level early 2009.

Jeff Meyers - Cobia Capital

Got you and what about in terms of the buy back, do you guys still planning buying stock and obviously anything would be pretty accredited to get 10 times earnings?

Shabtai Adlersberg

Correct. Yes, we have shown confidence in the future of the company more basically we believe that this time the short term still present a very attractive position and we keep purchasing it. We kept doing that in the month of July and we believe that in this point, we will probably basically complete all that process.

Jeff Meyers - Cobia Capital

Got you and what about just last question in terms of the MSBG, how is demand? Have you seen demand for that so far?

Shabtai Adlersberg

We like to leave the whole concept of the MSBG really came from inputs received from customers. We wanted to see data functionality and security features integrated into our media gateways so we have not thought of that and indeed we already see some, heard some contacts and actually all the one design win, and we do believe there is another very meaningful one on their way.

Operator

Our next question comes from Robert Katz - Senvest.

Robert Katz - Senvest International

Can you please review in detail the terms of the convert? What causes the convert to happen and how does it relates to what your earnings. I did not quite understand that.

Shabtai Adlersberg

Yes, so basically it is in the matter of whether it will be converted or not. It is actually it is about the input that we obtain for each share that can be rectified by the convert. When we reach certain level of profitability, we will need to add to the number of shares that could be converted and just by adding that, the shares concluding this from 42 to grow to $62 million on one hand but on the other hand on the calculation of the EPS, we will need to take out or to actually add to our profit the income that we base for the converts. Basically, on the EPS it will be very similar if we will add the convert or not and at this point I cannot say if we will need to add it or not but again although it is in on the accounting on treatment very usually straightforward and it will not affect the EPS at this time.

Robert Katz - Senvest International

What time does that happen or what EPS does that happen and are you able to force conversion at any point?

Shabtai Adlersberg

No, I mean, we have learned at this in the call option and the convert is basically due again to '09 noted before. That is the first time that we will put up a call option and again it has got nothing to do with the accounting treatment of adding as is converted to the number of shares.

Operator

There are no further questions.

Shabtai Adlersberg

I would like to thank you all for attending our conference call today and we look forward to see you in our on call next quarter. Thank you very much.

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