Foundry Networks, Inc. Q1 2006 Earnings Conference Call Transcript (FDRY)

Foundry Networks, Inc. (FDRY)
Q1 2006 Earnings Conference Call
April 20th 2006, 5:00 PM.

Executives:

Jason Golz, Investor relations, Financial Dynamics
Bobby Johnson, President and Chief Executive Officer
Timothy Heffner, Chief Financial Officer, Principal Accounting Officer

Analysts:

Mark Sue, RBC Capital Markets
John Mark Duncan, Pacific Growth Equities
Jeff Flubber, Banc of America
Cobb Sadler, Deutsche Bank
Long Jiang, UBS
Subu Subrahmanyan, Sanders Morris Harris
Alex Henderson, Citigroup
Jason Ader, Thomas Weisel Partners
Mark Donohue, Ferris, Baker Watts
Andy Schopick, Nutmeg Securities
Samuel Wilson, JMP Securities

Presentation

Operator

Good day everyone and welcome to the Foundry Networks First Quarter 2006 Earnings Conference. During the presentation, all sides will be in a listen-only mode and afterwards, you will be invited to participate in a question-and-answer session. Operator instructions. As a reminder this conference is being recorded on April 20, 2006. I would now like to turn the program over to Jason Golz of Financial Dynamics. Go ahead please.

Jason Golz, Investor relations, Financial Dynamics

Thank you, Blake. And good afternoon, everyone. Thank you for joining us for the Foundry Networks First Quarter 2006 Earnings Conference Call. I'm joined today by Bobby Johnson, President and Chief Executive Officer and Tim Heffner, Chief Financial Officer of Foundry Networks.

Earlier this afternoon, the company issued a release reported its first quarter financial results. This release can be accessed from the Investor Relation section of Foundry's website at http://www.foundrynetworks.com/. For reference, we've arranged for a taped replay of this call, which may be accessed by phone. This replay will take effect approximately one hour after the call's conclusion today and will be available for seven days. The dial in access number for this replay is 402-220-6985. Once again that's 402-220-6985. This call is also being web cast live with a web replay also available. These may both be accessed again from the IR section of Foundry's website.

Before I begin, I would like to make a brief statement regarding forward-looking remarks. The call today contains forward-looking information regarding future events and the future financial performance of the company. We wish to caution you that such statements are just predictions and actual results may differ materially as a result of risks and uncertainties that pertained to our business.

We refer you to the documents that the company filed periodically with SEC, specifically with company's most recent annual report on Form 10-K for the year ended December 31, 2005 as well as the Safe Harbor statement and the press release the company issued today. These documents contain important risk factors that could cause actual results to differ materially from those contained in the company's projections or forward-looking statements. Foundry assumes no obligation to revise any forward-looking information contained in today's call. And I would like to turn the call over to Bobby Johnson, President and CEO of Foundry Networks. Bobby.

Bobby Johnson, President and Chief Executive Officer

Thank you, Jason, and good afternoon, everyone. I am pleased to announce that Foundry had a very good first quarter, posting revenues of $114 million, a 35% sequential increase from $84.6 million in the year-ago period. This represents a quarterly revenue high for Foundry Networks for any calendar Q1 in our history. Our book-to-bill ratio continued to be greater than one during the past quarter.

We've had many new successes during the last year, and we believe that these successes will continue to drive our performance for the rest of this year. Chief among those successes are increased sales headcount and many successful new product launches.

During Q1, we once again built upon these past successes leading to several new key financial highlights, which include the following. First, we had strong revenue and profit growth year-over-year. Second, our Q1 '06 revenue was nearly the same as our record Q4 '05 revenues. We are always concerned about seasonal softness in Q1 and we were pleased to show strength in Q1. Third, Japan was strong for us coming in about 13% of revenue. Fourth, revenue from the U.S. Federal Government remained reasonably strong, representing approximately 19% of total revenue in the quarter. Fifth, our gross margins continue to be strong for the line switching market. Sixth, we generated approximately $43 million in cash for the quarter, leaving us with nearly $790 million in cash. This leaves us with significant growth and investment options for the future.

Next, I'd like to address several key product and operational highlights of the quarter. The first highlight was the continued high level of interest in the XMR intros router family. We achieved revenue status on the XMR during the quarter and we additionally announced a new Metro MPLS router called the MLX. Both products shipped revenue during the quarter and we saw interest from both the service provider and a large enterprise markets for both platforms.

The second product highlight of the quarter was achieving volume revenue shipments of our new Layer 4-7 SSL security traffic management products. The third highlight of the quarter was the successful introduction in revenue shipments of new members of our Layer 4-7 product portfolio on both the low end and the high end. We successfully announced the ship for revenue lower priced units with smaller footprints and high-end industry performance leading units for the largest of our customer base.

The fourth highlight was the successful introduction and initial revenue shipments for our new SecureIron permanent and SecureIronLS switch security devices. These represent new product categories from the industry, and we are achieving great initial interest. These products are essential for our ongoing security strategy which includes the following steps: continually adding security checks with features involve all existing family of Iron switches, creating a new class of SecureIronLS switch for hardening critical users and servers, and creating a new class of security traffic manager that offloads firewalls, VPN devices, and IDS/IPS devices for functionality that they are not well architected for, with the eventual goal of assuming key elements of their functionality as well.

The fifth set of product highlights for the quarter included a record number of ten Gigabit Ethernet port shipments and a record number of powered Ethernet port shipments, enabling Voice-over IP and wireless deployments. We continue to carefully implement key product transitions as well as that we pressures. Every year, we introduce more new products than the prior year. Our R&D in intelligent investments are continually increasing and we are experiencing excellent reception for our new products. I'll now turn the call over to Tim Heffner, our CFO. Tim.

Timothy Heffner, Chief Financial Officer, Principal Accounting Officer

Thank you Bobby, and good afternoon to all. I will now present our financial results for the first quarter ended March 31, 2006. Foundry's total net revenue in the first quarter of 2006 was $114.0 million, up 35% from $84.6 million in the first quarter of 2005. And due to a typical seasonal trends, down slightly from the $116.1 million in the fourth quarter of 2005. We continued to generate a profit, posting GAAP net income in the first quarter of $11.4 million, or $0.08 per diluted share, compared to $9.9 million, or $0.07 per diluted share in the first quarter of 2005 and net income up $20.6 million or $0.14 per share in the fourth quarter of 2005.

Included in our operating results for the first quarter of 2006 was $6 million of tax-affected stock-based compensation expense as a result of our adoption of FAS 123R. FAS 123R requires companies to recognize the non-cash compensation costs associated with stock-based awards on the income statement beginning January 1, 2006.

Net income in the first and fourth quarters of 2005 did not include stock-based compensation because we elected to use the modified perspective transition method, which did not require financial statements prior to 2006 to be restated to reflect the expensing of stock options. Excluding this non-cash charge, non-gap net income for the first quarter of 2006 was $17.4 million, and earnings per diluted share were $0.12.

During the first quarter of 2006, our Federal business decreased slightly, representing 19% of total revenue compared to 21% in the previous quarter. Our overall domestic revenue was 68% of our total business and our international business represented 32% of total sales. This compares to 70% for domestic and 30% for the international sales in the fourth quarter.

Sales in Japan increased in the first quarter, representing 13% of revenue, up from 12% in the fourth quarter. Our Enterprise business was again our primary source of revenue. Enterprise customers accounted for approximately 80% of our total revenue during the first quarter. Revenues from our chassis-based products increased slightly compared to the fourth quarter representing 71% of revenue in the first quarter of 2006.

Our gross margins on a non-GAAP basis improved slightly from the fourth quarter by 20 basis points representing 61.5% for the first quarter compared to 61.3% in the fourth quarter of 2005. The product gross margins of 56% for the first quarter represent a slight decrease from the fourth quarter levels. Service gross margins of 89% in the first quarter were a slight increase in the fourth quarter levels.

Next I'd like to review our operating expenses. But before I begin, I want to make a general observation regarding the increase in our operating expense in Q1 2006 over fourth quarter 2005. The total quarter-over-quarter increase is approximately $5 million, of which more than $3 million are payroll-related costs, primarily associated with payroll taxes and employee benefits.

Employer payroll tax threshold are reset at the beginning of each year, and so we typically see a spike in the first quarter, which diminishes during the course of the year as these limits are met. This year, the normal cycle of higher payroll taxes in the first quarter was magnified by a large number of employee stock-option exercises in the first quarter. This is because when an employee exercises a stock option, the gain is treated as compensation to the employee and the company must pay its share of employer taxes on that option gain.

Having said this, I'll now review the operating expense by functional area, highlighting the primary reasons for any fluctuations. All of the numbers I refer to exclude any costs associated with stock-option expensing, which may make the quarter-over-quarter comparisons easier. Foundry's research and development costs were $14.1 million, or 12% of revenue in the first quarter compared to $12.2 million or 11% of revenue in the fourth quarter.

R&D expenses increased primarily due to payroll-related costs I just mentioned, and prototyping materials associated with new products to be introduced over the next several months. Going forward, R&D expenses are likely to be relatively flat over the short-term and increase in absolute dollars over the longer-term.

Our sales and marketing expenses were $26.6 million, or 23% of revenue in the first quarter of 2006 compared to $25.2 million or 22% of revenue in the fourth quarter. The increase was primarily due to the payroll-related costs, which includes increased head count. The number of employees in sales and marketing increased by a total of 15 during the quarter.

As we continue to bill our sales and marketing organizations, we expect sales and marketing expenses to increase in absolute dollars. In the first quarter of 2006, our G&A spending was $8.8 million, compared to $7 million in the fourth quarter of 2005. This increase was primarily due to costs associated with the relocation to our new headquarters in Santa Clara, California, and increased legal expenses this quarter.

We moved all of the various functions, except manufacturing, out of our previous headquarters, allowing us space for additional growth and increased manufacturing capacity.

Again, I want to point out that the profit numbers I'm about to provide are non-GAAP and exclude any expense associated with stock-option reward pursuant to FAS 123R. Foundry delivered $20.6 million or 18% operating margins and net income of $17.4 million in the first quarter 2006. This compares to an operating margin of $26.7 million, or 23% of revenue and net income of $20.6 million in the fourth quarter of 2005.

Earnings per diluted share were $0.12 for the first quarter of 2006, compared to $0.07 for the first quarter of 2005, and $0.14 for the fourth quarter. Our non-GAAP tax rate for the quarter was 37%.

Let me move on to the balance sheet. Our cash and investments at the end of Q1 totaled $790 million, which is an increase of $43 million from the fourth quarter. DSOs were 67 days up from 61 days in the fourth quarter, due to left linear shipments during Q1 as compared to the previous quarter.

Net inventories increased by approximately $4 million, mostly due to the introduction of new products. As we introduced more new products, we carried both new and old inventory on hands to support our sales. Our book-to-bill was again greater than one; we ended the quarter with a total headcount of 741 employees, compared with 719 in the fourth quarter of 2005, an increase of 22 people.

Most of the increase in headcount was attributable to our growing sales organization. We have stated our overall corporate financial goals a number of times. Our objective is to grow the revenues quarter-over-quarter, post gross margins in the 60% to 65% range and operating profits in the 20% to 25% range. We are pleased with our revenues this quarter, which is typically our most challenging quarter of the year, with a less than 2% revenue decline from the fourth quarter of 2005.

To remind everyone, Q4 2005 was our all-time best revenue of any quarter in the company's history, and our revenue for the quarter just completed of $114 million is the highest level of revenue ever achieved in calendar Q1 by Foundry, and the second best quarter in the company's history.

Stepping out of the detail and reviewing our business from the 50,000-foot level, we have a strong pipeline of business, we continue to add new products to our portfolio, we are driving deeper into adjacent markets, we continue to add to our sales footprint. So overall, we are very pleased with our performance this quarter. Thank you, and I’ll now turn the call back to Bobby.

Bobby Johnson, President and Chief Executive Officer

Thank you Tim. During this, the second quarter of 2006, we will once again be introducing many, many new products into all target sectors in both the enterprise and service provider markets. We will have more new product introductions during the next few months than we have had in any comparable period in our history. We will introduce new enterprise LAN switches, new service provider routing products, new Layer 4-7 traffic manager products and features, new wireless products, and new security solutions.

We have an installed base of approximately 9700-gigabit Ethernet customers and is estimated that we lead the 10-gigabit Ethernet entry market. Additionally, the largest consumers of Layer 4-7 switches are standardized and also, we have among the largest installed base of Layer 4-7 ports. We have consolidated and concluded now more than seven consecutive years of net profits, and we are continuing to invest in Foundry. We've added a significant amount of headcount in the last 12 months, and foresee 2006 as a continued investment year for Foundry in both sales footprint and R&D new product rollouts during the year. I would now like to turn the call over to the operator for questions and answers.

Questions & Answers

Operator

Operator instructions. Looks like our first question comes from the side of Mark Sue of RBC Capital Markets.

Q - Mark Sue

Thank you. I was hoping if you could just give us some clarification on the guidance for the June quarter?

A - Timothy Heffner

Mark, this is Tim. We did not provide specific guidance for the Q4. I think we gave just a general tone of business and we're pleased where we're at. But at this time, we've elected to continue not to provide guidance.

Q - Mark Sue

Got it. And then separately, how do we ensure revenue growth which translated to earnings growth, and how should we see OpEx in absolute dollars over the next few quarters, if we look at your comments on the payroll-related taxes and benefits and separately, if you could help us understand what's fixed and what's variable when it comes to OpEx?

A - Timothy Heffner

Okay. Well, you'll see our R&D expenses are fairly consistent quarter-to-quarter. They do have a little bumps depending upon the prototyping materials that we consume in that particular quarter, but relatively stable. Sales and marketing, it's been increasing because we've been increasing our sales footprint. It does have that ends and flows from quarter-to-quarter and that's primarily dependent on trade show activity and advertising. So what we typically see in Q2 and Q4 is higher costs because those are the trade shows are concentrated.

Q - Mark Sue

Okay. And separately, just your comments on gross margin declines on the product side. If you could help us understand that if you have a better mix of products, I would imagine it would improve instead.

A - Timothy Heffner

Yeah, but you didn't let me finish answering the last question. On the G&A side of things, we -- our increase was about 1.8 million, about a million of that should not repeat itself quarter-over-quarter. It was due to higher legal costs. Now, legal costs do go up and down quarter-to-quarter. It's difficult to predict what quarters have higher activities until you are there. But in terms of some of our (indiscernible) related costs, they won't repeat. In terms of overall payroll cost -- or if I told you the total costs or total operating expense were up $5 million, of which $3 million was payroll related. Now that will diminish during the course of the year. I can't tell you the whole $3 million is going away next quarter, but certainly a portion of it will. It may, some are probably reduction related to payroll will be $1 million to $2 million. Difficult to predict because of the stock option exercise activity, we don't know -- that's not easy to plan. So I've answered your, I completed my operating expense explanation. On the gross margin side, as our -- as the newer products get up to higher volumes, we should be able to enjoy some benefit from that. That's on the product side. On the service side of things, we've increased our service revenues, and we've kept our costs relatively flat. Our margins are pretty high at 89% at the moment. As people start to utilize their service contracts and utilize their support organizations, we may see our costs slightly increase. But I still think, expect our service margins to stay in the, somewhere around the mid-80s. So, hopefully we can continue to move that total gross margin line forward. This quarter was 200 basis points, but it's certainly in the right direction.

Q - Mark Sue

Okay. Thank you.

Operator

Our next question come comes from the side of John Mark Duncan of Pacific Growth. Go ahead please.

Q - John Mark Duncan

Hi, can you talk a little bit about the federal government vertical. It was down about 11% this quarter. I presume it was seasonally soft. Can you talk about the pipeline that you have there and what you expect throughout the year?

A - Bobby Johnson

Okay. This is Bobby. I think the pipeline remains very strong. I think we go through seasonality a little bit, we go through budget crunches, but in general, we're adding to our federal teams and in general we think if we look at the whole year, the federal business will be really good. The issue always be, what are the quarter-to-quarter fluctuations. So overall remain fairly bullish on our overall government business.

Q - John Mark Duncan

And then in terms of Japan, you've experienced some pretty nice traction there the last couple of quarters, can you explain a little bit about what's driving that? Is it the new products, would it be routing products driving that or just a general maybe some market share gains in that area and how do you view that shaping up the rest of the year?

A - Bobby Johnson

Unlike other parts of the world, we've remained mainly a service provider in the Japanese market. If we go back to 99 and 2000, Foundry on balance was a service provider oriented company. And after the decline of 2000, 2001 went more towards enterprise worldwide with the exception of Japan. So, the new products and the increasing service provider build outs in Japan have attributed to remaining fairly strong in that market.

Q - John Mark Duncan

Okay. Thank you.

Operator

It appears our next question comes from the side of Tim Long of Banc of America. Go ahead please.

Q - Jeff Flubber

Good afternoon. This is Jeff Flubber dialing in for Tim. You mentioned a number of new products would be coming out targeting both the enterprise and service provider markets. Can you talk a little bit more about where you see most of the growth opportunity coming in 2006 and 2007? Whether it's more in enterprise or service provider and then what regions you see that growth coming from.

A - Bobby Johnson

It's our goal that everything grows, both from geography, from enterprise, from service provider from switching, from routing, from Layer 4-7, overall our goal is everything increases.

Q - Jeff Flubber

Can you maybe expand a little bit -- over during the quarter you've talked about a number of new opportunities, I mean, I guess you've passed some compliance tests with Avaya, and expanded your relationship with Mitel. Can you talk about the new opportunities that may be related to these partnerships with these vendors?

A - Bobby Johnson

Well, we have had ongoing relationships with almost all Voice-over IP vendors. We provide the powered LAN infrastructure. We continue to have good relationships with almost all. In the enterprise, our Power over Ethernet ports continue to rise. And so, I wouldn't say that there's anything particularly new there, other than we keep trying to strengthen all relationships and come to Interop site Las Vegas.

Q - Jeff Flubber

Okay. Thank you.

A - Bobby Johnson

Okay.

Operator

Operator Instructions. It looks like our next question comes from the side of Cobb Sadler of Deutsche Bank. Go ahead please.

Q - Cobb Sadler

Thank you guys, thanks a lot. Quick question, Bobby you mentioned the federal government business, you may see kind of lumps from quarter to quarter, but traditionally March has been the bottom, or the worst spending. Do you think that will be any different this year?

A - Bobby Johnson

That is difficult to predict. I would certainly hope so, but I -- let's just say we hope so. And there is a lot of things in play. It's just a matter of when everything falls in the place. So you never know necessarily the quarter-to-quarter transitions.

Q - Cobb Sadler

Okay, do you think that the September quarter will be as seasonally strong as it normally is? Are we looking at something a new energy for the rest of the year, or something that's kind of unpredictability as it normally is?

A - Bobby Johnson

I think it's the kind of unpredictable, large rollouts and digestion that we typically see.

Q - Cobb Sadler

Okay. Great. Just moving on to the XMR router, you recognize revenue, it sounds like for the full quarter, that was – I guess that was a little bit ahead of what we were expecting or what, I think -- as we talking about kind of midyear, so could you talk about, I know you don't want to give guidance for one product in particular. But what levels of the revenue, can you give us some general level of revenue we might expect in the second half of the year, it sounds like things are going a little better than expected. And if you can, could you give us an update on trial activity.

A - Timothy Heffner

Okay. So we have kind of our big, beefy MPLS router and then a lighter weight more of a Metro-MPLS-Router. So, the XMR is the beefy one, and the MLX, we introduced and shipped for revenue all in the same quarter is kind of the lighter weight one. We shipped millions of dollars in each product line for the quarter. We have ongoing trials, but as you can understand, the bigger the trial, and the bigger the name, the longer the gestation period. And so I think really the answer on the MLX, and the answer on the XMR, really as we continue to add more futures and we continue to add new functions such as pocket over sonnet later in the second half of this year. The real question is where are we in the second half of '07 and beyond? We will be garnering more and more reference to counsel on the way. Our strategy is more like packman. It's get in, win some of the smaller names, continue in trial, and the larger names and really look at where we end over the next 12-24 months. But we did achieve millions of dollars on each platform during the quarter.

Q - Cobb Sadler

Okay, sounds great. Last question, just on the 10 gig side, where do you think we are on the 10 gig cycle if you had to put it in the reference of innings, what innings do you think we are to make upgrade cycle? Thanks a lot.

A - Timothy Heffner

I think we're somewhere around third or fourth inning.

Q - Cobb Sadler

Got it. Thanks a lot.

Operator

Our next question comes from the side of Long Jiang of UBS. Go ahead please.

Q - Long Jiang

Yes, hi. The first question is for Tim, you mentioned for several quarters that you're targeting 20% to 25% operating margin, yet this quarter you dipped below that following the previous quarter, which did pretty well. So, I just wanted to get a better understanding about how you manage operating margin in terms of consistency from quarter to quarter. Was there any surprise in the quarter that caused the operating margin to dip below 20% to 25% range?

A - Timothy Heffner

Apparently, you just dialed in, because I went through that explanation, but I'll do it briefly again. You can always go back and listen to the replay. It's results of the reset of payroll cost and payroll taxes at the beginning of each year, an employee starts all over again and the company has to match that. So we had approximately, of our $5 million quarter over quarter increase in expenses, approximately $3 million of that, a little more than the $3 million was related to increased payroll costs. And it wasn't due to a huge head count but it was due to the tax effect. And that was amplified by the fact that there were a large number of stock options exercised. And when, on the gain, which is the compensation to the employee, we must pay -- the company must pay payroll taxes on that also. So it's kind of an anomaly. You're not going to see a $5 million -- we're not going to keep it at that level, what we should back down from that level. To what degree, I can't give you a precision, but certainly several million dollars.

Q - Long Jiang

Okay. I appreciate that clarification. I listened to your previous explanation. The second question is about deferred revenue. You went up by meaningfully sequentially, can you provide additional comment on that and its nice any of your seasonality there. Thanks.

A - Timothy Heffner

Yeah. Could you repeat the question you said? I didn't quite understand what you gave.

Q - Long Jiang

The deferred revenue, you went up quite meaningfully in a quarter, so I know typically you have pretty good deferred revenue bookings in first quarter, do you see any other factors besides seasonality?

A - Timothy Heffner

You know, we did see an improved booking of support contracts. As we produce more sophisticated products, I think our customers feel more comfortable with what I would maybe like what we refer to as an insurance policy so they buy a support contract so that they can get help when they need it. So we are seeing more revenue coming from the service side of our business.

Q - Timothy Heffner

Thanks guy.

A - Timothy Heffner

Thank you.

Operator

Our next question comes from the side of Subu Subrahmanyan. Go ahead, please from Sanders Morris.

Q - Subu Subrahmanyan

Thank you. My question is on the carrier business in the Layer 4-7 business. As you look at the new product and the traction you're getting, through the course of the year, what kind of percentage of contribution are you expecting from the carrier business and the new Layer 4-7 products. I know there have been several new products, but it seems like the enterprise layer 3 percentage continues to be quite high. I'm wondering if there's a higher gross rate you're expecting from these newer products?

A - Timothy Heffner

I think percentage-wise, the growth will be higher. But as which in earlier we're investing in all sectors. I mean certainly not expecting that the SP business or Layer 4-7 which cuts across both businesses is going to outgrow our enterprise. It will outgrow on a percentage-wise, but we are expecting our enterprise business to grow as well. So basically, there will be some give and takes and percentages and hopefully everything goes -- everything goes up from me, to a total dollar figure, but we're reinvesting in our enterprise sector quite dramatically and you'll see that over the next few weeks as well. So I think everything should go up and that's our goal, to keep everything on a balanced attack.

Q - Subu Subrahmanyan

And this competitively I mean any changes you're seeing in the marketplace, I mean the strength that you've seen in the Layer 3 market, do you think it's the function of the market or is that market share gains and -- for the switch?

A - Timothy Heffner

Well, I believe we are gaining some market share, if you look at some of the other announcements by other companies. So I do believe we are gaining market share. And I think as related to the previous question, what inning are we in, in the 10 gig, as we get further up in the innings, our position in 10 gig should help our overall growth rate. So

Q - Subu Subrahmanyan

Thank you.

Operator

Your next question comes from the side of Alex Henderson of Citigroup. Go ahead please.

Q - Alex Henderson

Thanks, hey, guys.

A - Timothy Heffner

Hey, Alex.

A - Timothy Heffner

Alex.

Q - Alex Henderson

So just help me understand the mechanics here a little bit on this tax issue in the quarter. So you have a payroll expenses that are associated with stock options being exercised, but those are not considered stock option expenses that would be back out of the numbers under the stock option accounting profile, right?

A - Timothy Heffner

Totally different. One is compensation to the employee; the other one is just an estimate of value of the stock option granted.

Q - Alex Henderson

Okay. So second question, what was the dollar value of the cost of the headquarter move?

A - Timothy Heffner

$6,700,000.

Q - Alex Henderson

And the legal fees are 1 million higher and $3 million in option expenses, so I put those three items together, that's the entire five, right?

A - Timothy Heffner

Legal fees are about a $0.5 million higher, quarter-over-quarter.

Q - Alex Henderson

So, a 1 million in legal fees, but only 0.5 million higher?

A - Timothy Heffner

Only 0.5 million higher, yes.

Q - Alex Henderson

I see. Okay.

A - Timothy Heffner

So --

Q - Alex Henderson

But as far as it's four out of five of the million than associated with those three items, which were one time in nature.

A - Timothy Heffner

That's share representation. Yeah.

Q - Alex Henderson

So functionally your EPS otherwise would have been essentially flat excluding these quasi one-time items.

A - Timothy Heffner

It would have been, it certainly be in our 20% to 25% target range if we didn't have to include those, or if we exclude those items.

Q - Alex Henderson

Can you talk a little bit on a broader subject; you increased your sales force dramatically last year. Where are we in the productivity benefits of those salespeople coming on stream? I would assume that in the first quarter, since it's mostly a repeat business quarter as opposed to a quarter where you would see new salespeople able to generate a meaningful new book of business given the cycle of corporate expenditures that the sales generation would be more Q2 weighted than Q1 weighted from those hires. Is that a reasonable appraisal?

A - Timothy Heffner

Alex, (indiscernible) that's very reasonable. If we go back to the earlier baseball analogy, I don't know if we're in the first or the second inning on the newer sale hires. It's really going to be more second half oriented.

Q - Alex Henderson

I would think in the second quarter that haven’t if you were hired three or four quarters ago that the contribution would start to kick any more in a more meaningful way, even if they had a full year to do working and it’s a quarter that normally you would see that contribution.

A - Bobby Johnson

Right, we’ll have very few people in Q2 that would have been here that were the new as it been a year. So, we'll get some benefit in Q2, but the real benefit should come in Q3 and Q4.

Q - Alex Henderson

Okay, so secondary question, it sounds like your strategy on the cost side is basically, rather than drag the, or sharp acceleration in new product to the driven revenues drive your margins up, you're going to reinvest that aggressively in sales and targets for a fairly steady state 25% operating margin within overages on the revenue side utilized in the form of additional hires to drive additional sales expansion. Is that the right way to think about your strategy at this point?

A - Bobby Johnson

It's in the spirit of it. Our cash is moving quite strong, so what we're trying to do is do more internal funding of all R&D and all sales growth. And so as long as our cash can move up, we remain reasonably profitable. We'd like to move the top line and our market positions to internal growth.

Q - Alex Henderson

Okay. One other question. On the F5 conference call a few minutes ago, they said they saw a slowdown in federal in the last couple of weeks of the quarter, and then they also said they saw some delays and push outs in some of their enterprise business, which surprised them right at the end of the quarter. Did you see any of either of those?

A - Bobby Johnson

I can't say that we did.

Q - Alex Henderson

Okay. Thank you.

Operator

Our next question comes from the side of Jason Ader of Thomas Weisel. Go ahead, please.

Q - Jason Ader

Yes thank you. A couple questions for you. First, Bobby and Tim, you guys have been kind enough to offer at least some perspective on the pipeline and backlog. You did say book to bill was greater than one, but to just trying to get a sense of the absolute level of backlog let’s say it was a greater at the end of March than it was at the end of December, just an overall feel on the activity pipeline relative to the end of December when you exited Q4.

A - Bobby Johnson

Typically, we don't give interest, greater insight into what the multiplier is on the other side of greater than one. The, we are building backlog. Backlog exists in more the new product areas because of manufacturing ramp takes a while, in some cases we're using bleeding edge parts and we're one of the first, if not the only, users of them so we get allocation from some of our component vendors so we don't always realize the benefit of all the orders when we want. So, the pipeline is we're comfortable. The backlog grows. It doesn't always grow by our design. Sometimes we have other market forces, such as components shortages that limit what we're able to achieve in any given time period.

Q - Jason Ader

Do you have any component shortages this quarter?

A - Bobby Johnson

Yes.

Q - Jason Ader

Okay. So does that mean that there are, if you would have had some of those components, the revenue would have been higher?

A - Bobby Johnson

That's correct.

Q - Jason Ader

All right, and then the second question I have for you was, and I guess maybe Tim, you could respond to this. What do you think product gross margins can get back to you said it could improve with some of the new products? Is there a possibility of moving more manufacturing offshore to improve the gross margins?

A - Bobby Johnson

You know, we've never been a big fan of that, people that move products offshore, it's usually high-volume low margin products. Ours are very sophisticated, not enough volume probably to justify taking it offshore. What I was suggesting is the products, the newer product get to a, up to more volume levels where we can enjoy some benefit from reduced costs, it could help to push the margin forward. We've said in the past that, 60% to 65%, we're comfortable with that. And I think we are still sitting here today, we're still okay saying that. And we may be able to produce numbers, gross margins in that range for some period of time now.

Q - Jason Ader

But do you think the product gross margins will improve some Q1?

A - Bobby Johnson

We're going to try.

Q - Jason Ader

Okay. And last question for you is, I guess I'm just a little confused on the whole out backs discussion. Are you saying that it's going to increase at a much lower rate on an absolute level than it did in Q1, or are you saying it's going to be down going forward in the next couple of quarters because of the so-called one-time events in Q1?

A - Bobby Johnson

Well, it could be down, I said the anomaly is probably about $3 million. But I did also mention that in Q2, we have the trade show expenses that we didn't have in Q1, so some of those will be offset by those trade show and advertising costs. But I don’t, we were up $5 million, I don't expect it to stay at that $5 million. It will probably back down a little bit, but I don’t see it there, I can’t tell you how much.

Q - Jason Ader

Okay. So maybe just to put words in your mouth, maybe kind of a flattish for the June quarter because of the trade shows and then September, it could actually be down a little bit. Is that a fair way to be thinking about it right now, just generally?

A - Bobby Johnson

Depended on a number of factors in R&D prototyping costs and sales and marketing, the number of people we can hire, and G&A legal variances from quarter-to-quarter.

Q - Jason Ader

But that's a good starting point?

A - Bobby Johnson

It's a fair starting point.

Q - Jason Ader

All right. Thanks, guys.

Operator

Operator Instructions. It looks like for next question comes from the side of Matt Robinson of Ferris, Baker Watts. Go ahead please.

Q - Mark Donohue

Yeah, this is actually Mark Donohue for Matt. Just a quick question, I was wondering if you could give us some commentary on the body of BigIron RX and SuperX, I think you said 220 and 600 respectively last quarter and just how that changed. And then some volumes on some of your other products as well, whatever you can share. Thanks.

A - Timothy Heffner

I'm not sure what we said last quarter, I don't have that in front of me, but I would tell you that the RX and the SuperX are moving up to the right.

Q - Mark Donohue

Okay. How would you characterize the current state of the service provider that you want a private categories, I know you said you had revenue in some, but do you have any further commentary on that?

A - Timothy Heffner

I think overall the SP market is nothing like '99 or 2000, but it's a reasonably good market. There's a lot of new build outs, triple play is seeing new build outs and established plus new rising SP vendors. Metro continues to be a vibrant arena worldwide. And we still have a variety of products into that. We do $20 million to $30 million a year in SP business; we have $20 million to $30 million a quarter in SP business. I think, the important thing is to stay tuned of where we are, 12-24 months from now.

Operator

Thank you. I think it appears our next question comes from the side of Andy Schopick of Nutmeg Securities. Go ahead, please.

Q - Andy Schopick

Thank you. Tim, I'm going to ask you a question or two on the stock comp. expense going forward. Can you give us some estimate to how that will look in the second quarter and for the full-year given what we have seen here in the first quarter?

A - Timothy Heffner

Not sure, Andy, because it was grant options, it's all-dependent upon how many grant quarter-to-quarter. I had expected it to stay in the range of 10. I don't know that it's going to fall. Yeah, it would fall off quarter-over-quarter; we never issued another option, but that in Silicon Valley and in the technology, if you want to attract good talent, you've got to issue stock options. So, I expect the levels that we're at will be generally where we'll be each quarter.

Q - Andy Schopick

And the non-GAAP tax provision will be 36%, 37%?

A - Bobby Johnson

That's correct. I believe it at where we stated it was this quarter at 37%. We don't have much to offset that, so we're going to be paying at that rate, I suspect.

Q - Andy Schopick

Bobby, Alex Henderson touched upon this, but I want to ask you the question specifically. How would you characterize enterprise spending domestically relative to the expectations you may have had coming into this new year?

A - Bobby Johnson

So far so good.

Q - Andy Schopick

Nothing you see that looks materially different from what you expected to see?

A - Bobby Johnson

So far, the U.S. enterprise has remained reasonably healthy.

Q - Andy Schopick

Okay.

Operator

It appears our next question comes from the side of Samuel Wilson of JMP Securities. Go ahead please.

Q - Samuel Wilson

Good afternoon, gentlemen. A few small questions but most have been answered. First for Tim, are you currently affected by the R&D tax credit? Is that one of the reasons the tax rate is up? And if Congress re-endorses that, does the tax rate come back down?

A - Timothy Heffner

We are affected by that. We can't take the R&D tax credit because it has expired, but it's not a material part of the tax calculation, so yeah, it will affect it slightly but I don't know if you'll be able to detect it, though.

Q - Samuel Wilson

It’s okay.

A - Timothy Heffner

Maybe as much as 1%, but that's it.

Q - Samuel Wilson

Okay. And then a question for Bobby, and I know this comes up often, but you currently have 182% cash on the balance sheet of your last twelve month sales. You typically say the reason you keep the cash around is because you're going to do acquisitions, but we don't do any acquisition, so what is your plan for cash, you are generating a lot. And you're looking more like a bank every day than a tech company.

A - Bobby Johnson

Well, that's a good thing. The -- I can say that I've ever said the cash is there only for acquisitions.

Q - Samuel Wilson

You typically cite that as a reason as to why you build it.

A - Bobby Johnson

One of many reasons. We have a lot of large customers that get comfort that we have the highest cash per employee ratio in the networking industry. Because of what's happened to some of their other suppliers. Secondly, we do keep it there as an option. And we do look at acquisitions and frankly, we passed on about three acquisitions last year. It has to be the right value proposition for Foundry Networks.

Q - Samuel Wilson

So, what is the proper amount of cash to have on your balance sheet and when do you start buying back shares to return that money to shareholders because you're not putting it to use more than 4% in a money market account?

A - Bobby Johnson

Well, Foundry is actually one of the few companies that has ever bought back shares, number one. Number two, who knows when the right value proposition shows up as an acquisition or other alternative.

Q - Samuel Wilson

So, basically what you're saying is, there's no set amount of cash you feel like you need to have. You're just going to keep building it as --?

A - Bobby Johnson

I'm going to keep building it until the right opportunity shows up. For instance, the argument that you present sounds a lot like the '99 and 2000 arguments that all investment bankers came to see me about and said here, buy this optical company.

Q - Samuel Wilson

I'm not implying you should buy anything, but I'm implying that you're sitting on a huge amount of cash that you're not putting to work, and it’s best use is to put it to work in something, or return it to shareholders so they can put it to work.

A - Bobby Johnson

Well, when I find the right opportunity, I will. Most acquisitions in technology have not produced the results that people desired. When I find one that I think will. Stay tuned.

Q - Samuel Wilson

Thank you.

Operator

It appears we are approaching the end of the hour, so I'll go ahead and turn the program back over to the speakers for any closing remarks.

Bobby Johnson, Chief Executive Officer and President

We want to thank all of those participating today for their time and for their questions. And we look forward to updating you on our progress in this calendar Q2, which marks our 10th anniversary, on our next call in July. Thank you.

Copyright policy: All transcripts on this site are copyright Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE CONFERENCE CALLS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S CONFERENCE CALL ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.