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Executives

John Vincenzo - Media and Investor Relations

Robert Y.L. Mao - Chief Executive Officer, Director

Jay Zager - Chief Financial Officer, Executive Vice President

Ronald A. Sege - President, Chief Operating Officer, Director

Analysts

Manny Recarey - Kaufman Brothers

Jeff Evanson - Sanford Bernstein

3Com Corporation (COMS) F1Q09 Earnings Call September 22, 2008 5:00 PM ET

Operator

Good day and welcome to 3Com's quarterly earnings announcement conference call. As a reminder, today’s conference is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Mr. John Vincenzo, head of investor relations. Please go ahead, sir.

John Vincenzo

Thank you and thank you, everyone, for joining us to review our financial results for the first quarter of our fiscal 2009. Before I turn the call over to our Chief Executive Officer, Bob Mao, I would like to inform you that the remarks to be made on this conference call contain forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These include forward-looking statements regarding integration activities, strategic initiatives, future financial performance, financial condition, and cash flows, future expense controls and savings, product and solution development plans and strategy, and market position. These statements are neither promises nor guarantees but involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. These risks include without limitation the risks detailed in the company’s SEC filings and the earnings press release of today.

On this call, we will also discuss several non-GAAP financial measures. The most directly comparable GAAP measure and required reconciliation can be found in tables at the back of the press release announcing our results, attached as an exhibit to our 8-K for this earning’s release, or on the IR portion of our website, www.3com.com. The press release is also available on the investor relations section of our website.

With that, let me turn the call over to Bob Mao.

Robert Y.L. Mao

Thank you, John and thank you, everyone, for joining us on the call as we review our results for the first quarter of our fiscal year 2009. I am hear today in Beijing, China with our Chief Financial Officer, Jay Zager, as well as our President and Chief Operating Officer, Ron Sege. Today we’ll be walking you through the business highlights for the quarter and sharing specific details regarding our financial performance.

I would like to spend a few minutes talking about what was an outstanding quarter for 3Com. The best place to start is reviewing the three main objectives I outlined for you during my first earnings call last quarter -- one, increase top line revenue; two, accelerate the integration of our worldwide operations to achieve further operational efficiency; and three, generate cash.

From a revenue perspective, we exceeded our revised guidance, achieving revenue of approximately $343 million. This represents growth both sequentially and year over year. The key to this accomplishment is not just that revenue growth; it is that we did it while improving our profit margins and achieving non-GAAP operating margin of more than 10%.

3Com reached profitability on a GAAP and non-GAAP basis through a combination of the revenue growth along with significant gross margin improvement of nine points year over year. The primary driver for the increase in gross margins were the efficiencies we gained from our integration efforts and a shift to a more favorable product mix. Finally in Q1, we generated approximately $39 million in cash from operations.

We executed and delivered these strong results while operating in what has become a very difficult economic environment. When budgets get tighter during times like these, customers turn to companies that can help them get more for less. I believe this quarter in particular showcased just how well 3Com's value proposition is resonating with customers. Not only do we have a complete end-to-end portfolio of advanced networking solutions that are easy to deploy and manage, our platforms are based on open standards and deliver what we believe is an industry-leading price performance ratio. Customers looking to get more value from their networking investment are increasingly turning to 3Com. We are one of the few companies in the industry that can deliver a complete range of products and solutions, from the data center to the edge of the network. These solutions provide customers with a strong return on their investment.

Our products offer better price performance than our leading competitor’s products and are interoperable with the customer’s existing infrastructure and leverage the latest technology. They also are more energy efficient -- this is a very compelling set of attributes for today’s value-conscious enterprise customer.

The great thing about this value proposition is it translates well in each of our markets. As I have stated before, while we want to maintain our market share in China by growing at least at the market rate, we have an even greater opportunity to grow our business in the rest of the world. Let me talk about how we performed in our key markets.

Our strong revenue performance in the quarter was largely due to continued growth in our China sector. Direct touch sales grew 20% year over year, while sales to Huawei were essentially flat for the same time period. However, Huawei sales finished the quarter stronger than we anticipated, which was the primary reason for our revised revenue guidance.

In China, we continue to have success with both high-end networking deployments, as well as some of our new solutions, such as IP video surveillance and IP storage. For example, in the quarter we participated in the Safe Hangzhou Project, the largest safe city project to date in China. For those of you who do not know, Hangzhou is a city with more than 6 million people and is the headquarters of our China operations.

Our customer wins include the Bank of China, where they are using our high-end core routers and switches in their data center, as well as the National Library, which is using both our wired and wireless routers. We also provided a variety of products and solutions for the recently completed Beijing Olympics.

Outside of China, we continue to see encouraging results from our increased emphasis on Direct Touch sales to enterprises and service providers. As most of you know, we have faced significant challenges in North America, particularly during the first half of our last fiscal year. While we still have much more work to do, in Q1 we did see sequential revenue improvement in the region, growing 12% to $34 million. We improved our performance by increasing our focus on enterprise Direct Touch sales to key vertical markets, such as education, healthcare, and manufacturing.

Historically Q1 is a strong quarter for the education market in North America and this quarter was no exception, particularly in the higher education segment. We won significant deals, including Sanford University and Jacksonville University.

We also made progress in the healthcare market as we won a major core to edge deal with [South Spain] Medical Foundation. We will continue to emphasize this vertical market strategy as we look to build on the recent traction we’ve gained.

Moving on, one of the regions we have pointed out over the past several quarters as an example of success outside of China is our Europe, Middle East, and Africa region. Last year we achieved double-digit year-over-year growth in EMEA. In Q1, however, we had flat revenue. While the overall results weren’t what we anticipated, I would like to highlight two significant customer wins that illustrate the potential we have to further expand our enterprise sales in EMEA.

First, we announced that Switzerland’s leading telecommunication carrier, SwissCom, has implemented a 3Com solution for their internal management and billing system. We were able to leverage our H3C enterprise product brand to showcase the functionality, high quality, and price performance advantage of our solutions.

Another key win is our new customer, SNCF, the National Railway of France. This three-year deal covers upgrading [land] infrastructure in 3,400 train stations in France, plus headquarters and subsidiary locations. Our Direct Touch sales in France and the engineering team in China worked closely with our partner, BT, to separate ourselves from the competition in terms of product breadth, price performance, and responsiveness. This win is an excellent example of the flexibility and responsive 3Com offers to customers. During the bid process, we deployed a dedicated engineering team to support the customer, which turned out to be a key factor in closing this deal. The customer was impressed by the quality, the speed at which we worked and we emerged as the vendor of choice.

We also continue to make strong progress in Latin America, showing 26% year-over-year growth. During the quarter, we increased our focus on selling our higher margin enterprise network solutions. Our Latin America customer that recognize the value in working with 3Com in the quarter is [Teneguia], the Public Water and Sewage Utility Authority for Mexico. They were looking to update their networking infrastructure and add voice-over IP to new branches throughout Mexico. Once again, our price performance advantage was a key driver for the customer.

In Asia-Pacific, we had another strong quarter, achieving 50% revenue growth year over year, with key customer wins including Nexus Corporation, a leading manufacturer in Korea, and the University of Malaya in Malaysia.

Overall, I am very pleased with our performance in China, Asia-Pacific, Latin America, as well as the improvements made in North America. I am also optimistic that we can return EMEA to its previous performance levels.

I am confident that we have the right people and strategy in place to execute and deliver positive results throughout the world.

Finally, let me talk about a few key aspects of our business I know are of interest to our shareholders. First, TippingPoint -- in Q1, our TippingPoint segment revenue grew to $28.2 million, which is an increase of 11% year over year and the business was profitable on a segment basis. Key customers in Q1 include Citi-Street, Hilton Hotels, Ithaca College, and Duke University. We continue to move toward operating TippingPoint as an autonomous business unit, since it primarily serves the high-end of the standalone IPS market.

Another area of interest for our investor is our relationship with Huawei technology. In Q1, sales of our 3Com products to Huawei increased sequentially and exceeded our projections. However, we continue to believe that revenues from Huawei will decline in terms of absolute dollars and as a percentage of our revenue. This downturn trend is consistent with our guidance.

Finally, I would like to provide an update on our worldwide integration efforts. We continue to make progress toward our objective of achieving $50 million to $100 million in annualized savings. To date, we have captured approximately $40 million in annualized savings primarily through R&D rationalization and through efficiencies we gained in our supply chain organization.

In closing, I am pleased with our solid financial results. In today’s tight economy, we are seeing clear signs of a flight to value, as customers look to get more for their networking dollars. There are few networking companies that can offer a broad, well-tested portfolio of products and solutions and the stability of a billion-dollar company. We are well-positioned to succeed in the current economic environment. In fact, we are starting to attract new enterprise customers who are looking for more value for their network investment. We have done it in China and we are successfully starting to do it now in the rest of the world. This is a powerful opportunity for 3Com.

With that, I now turn the call to Jay.

Jay Zager

Thank you, Bob and good afternoon, everyone. Today I would like to provide some insights on the first quarter results we just released and provide some guidance for our second quarter. Consolidated sales for the first quarter were $342.7 million, an increase of 7% from a year ago. Our first quarter results include a $70 million, or $0.17 per diluted share benefit from our previously disclosed resolution of a patent dispute with RealTek. We collected the $70 million of cash in the quarter and recorded the benefit in our P&L as an expense offset in our operating results. Primarily as a result of this benefit, we reported net income for the quarter of $79.8 million, or $0.20 per diluted share. This compares to a net loss of $18.7 million, or $0.05 per share, in the prior year. On a non-GAAP basis, net income for the quarter was $43.4 million, or $0.11 per diluted share, compared with $12.2 million, or $0.03 per diluted share in the year-ago period. This non-GAAP portrayal excludes restructuring, amortization, in-process research and development, stock-based compensation expenses, and certain unusual non-recurring items, specifically in the first quarter the RealTek patent resolution.

A full reconciliation between GAAP and non-GAAP financial measures and an itemization of exclusions for each period is included in the press release in Table C and in the IR portion of our webpage.

Before I review our performance, let me discuss 3Com's new reporting segments. We now have two primary businesses, networking and our TippingPoint security business. Within our networking business, we are reviewing our financial data in three segments -- China base sales, rest of world sales, which is made up of our North America, EMEA, Latin America, and Asia-Pacific regions, and a segment representing the central function costs for these two regions.

We are managing the China base and rest-of-world segments using three metrics -- sales, standard margin, which is sales less direct product costs, and contribution margin, which is standard margin less direct sales and marketing costs.

The central functions associated with our networking business include research and development, supply chain, indirect sales and marketing support, and G&A.

Inter-company eliminations reflect sales between the networking and TippingPoint businesses. These eliminations are significantly lower than the eliminations under our former presentation, which also had sales between our former DVVU and H3C units.

Let’s start by looking behind the networking business. Our networking business sales for the quarter were $315.7 million, 7% higher than a year ago and 8% higher sequentially. Looking within our networking business, our China based sales segment had revenue of $175.4 million, consisting of China Direct Touch sales of $101.8 million, compared to $85 million in the year-ago period and $100.6 million in Q4; Huawei sales of $65.8 million, compared to $61.8 million in the prior year period, and $49.2 million in Q4; and other sales of $7.8 million, compared to $9.2 million in the prior year period but flat sequentially. These sales include sales outside of China that are managed by our China based sales organization.

Overall, this represents a 12% revenue increase over the prior year period and an 11% sequential increase. The majority of the year-over-year increase is due to strengthening of the RMB relative to the dollar. The majority of the sequential increase was driven by increased sales to Huawei. Sales to Huawei were 19% of 3Com's consolidated revenue this quarter, the same percentage as a year ago but up from the Q4 level of 15%.

We were pleased with the sales of our new product initiatives in China, with sales of our storage and multimedia offerings increasing to approximately 6% of our total China based revenue. Our China based standard margin was 66.0%, a six-point improvement year-over-year and a one point improvement sequentially. Both the year-over-year and sequential improvements were driven by favorable product mix, as well as product cost reductions.

The China based contribution margin was 47.1% in the period, a year-over-year improvement of three points but a sequential decline of two points. The year-over-year contribution margin improved largely due to the improved standard margin, while the sequential decline was largely explained by an internal expense reclassification.

Our rest-of-world segment had sales of $140.3 million, a year-over-year improvement of 2% and a sequential improvement of 3%. Within rest-of-world sales, North America had sales of $34.3 million, a 22% decline over the prior year period but a 12% sequential increase. This represents the second quarter of sequential improvement for our North America region since the business suffered a significant decline in the first half of our last fiscal year.

EMEA had sales of $61.5 million, essentially unchanged over the prior year period but down sequentially by 4%. Latin America had sales of $23.4 million, a year-over-year improvement of 26% and a sequential improvement of 16%, and Asia-Pacific had sales of $21.1 million, reflecting year-over-year growth of 50% and a sequential improvement of 2%.

The standard margin for our rest-of-world segment was 57.7%, a three point improvement year over year and a one point sequential improvement. As in China, these improvements reflect favorable product mix and lower product costs. The contribution margin for the rest of the world was 37.7%, approximately flat to the prior year period and an increase of 1% over Q4.

Central functions costs for our China based and rest-of-world segments were $98.8 million, down both 10% year over year and 4% sequentially. The sequential reduction reflects savings from our integration efforts, while year-over-year improvement is due to the integration savings, as well as to lower customer service delivery costs.

With respect to our integration efforts, we have now captured on an annual basis more than $20 million of reduced R&D expenses. We have also captured an additional $20 million in annualized savings through reduced product procurement costs. We believe that we are well on our way to achieving our objective of $50 million to $100 million in savings.

Overall the networking business had a gross margin of 54.1%, a seven-point year-over-year and a one point sequential improvement. The networking business operating income of $36.7 million was a 243% improvement over the prior year period operating income of $10.7 million.

Our TippingPoint segment had sales for the quarter of $28.2 million, an increase of $2.7 million or 11% over the prior year period but a sequential decline of $1 million, or 4%. It is important to note, however, that the prior period had included a $1.4 million non-recurring revenue benefit.

Within this total, product revenue was $18.4 million and maintenance revenue was $9.8 million. This compares to year-ago product and maintenance revenues of $18.1 million and $7.4 million respectively.

TippingPoint’s gross margin in Q1 was 69.4%, a four point year-over-year improvement and a three point sequential improvement. These improvements are due primarily to lower support costs and favorable product mix. The lower support costs also reflect improvements in overall product quality. TippingPoint’s segment operating profit was $300,000 in the quarter, an improvement of just under $1 million from the prior year period segment loss of $600,000, and essentially flat sequentially.

I would now like to focus on our consolidated results for the quarter. From a consolidated viewpoint, 3Com's gross profit was $189.6 million in Q1, or 55.3% of sales, the highest level in our history. This is a nine-point improvement over the corresponding period last year and one point higher sequentially. As we have discussed, this year-over-year improvement was largely driven by favorable mix of product sales, as well as by product cost reductions in our businesses.

R&D expenses were $44.9 million on a non-GAAP basis, or 13% of sales. This compares to $51.6 million, or 16.2% of sales in the prior year period. This significant reduction results from the integration savings we previously discussed.

Sales and marketing expenses were $84.5 million on a non-GAAP basis, or 24.7% of sales. This compares to $73.4 million, or 23% in the prior year period. This increase was driven primarily by increases in China based and EMEA region direct touch sales investment reflecting our strategy of making selective investments in sales and marketing to grow our business.

General and administrative expenses were $24 million on a non-GAAP basis, or 7% of sales. This compares to $19.7 million, or 6.2% of sales in the prior year period.

Headcount at the end of the period was 5,933 people, a reduction of approximately 170 people in the quarter. The reduction this quarter was primarily the result of our integration activities, particularly in R&D.

On a GAAP basis, we had operating profits of $73.4 million, primarily due to the RealTek patent resolution benefit in the quarter. The prior year had an operating loss of $25.7 million.

On a non-GAAP basis, our operating profit was $37.0 million, or 10.8% of revenue, compared with a non-GAAP operating profit of $23.2 million, or 7.2% of revenue in Q4, and $10.1 million, or 3.2% of revenue a year ago.

Growing our business and improving our non-GAAP operating profit margins remain a cornerstone of our financial strategy.

Net interest expense was $1.3 million in the period, while other income was $12.9 million and primarily reflects the reporting of [VAT] software subsidy in China.

Our profit before tax was $85 million.

Our tax provision of $5.2 million primarily reflects tax expense in jurisdictions unable to leverage our NOLs.

As a result of these factors, we had net income in the quarter of $79.8 million, compared with a net loss in the prior year period of $18.7 million.

Let me now turn to our balance sheet -- at the end of the quarter, our cash balance was $541.4 million, compared with $503.6 million at the end of fiscal year 2008. During the quarter, we generated $39.3 million of cash from operations. This included the $70 million received from RealTek, offset in part by approximately $10 million in related legal fees that were accrued in our fourth quarter but paid in the current quarter.

We also paid out $45 million to our Chinese employees for the 2008 EARP and long-term incentive plans. To date, we have paid out $130 million of the $174 million EARP obligation and the remaining $44 million will be paid over the next two years.

Our net cash position improved to $240.4 million from $202.6 million at the end of the fiscal year.

Regarding our cash position, we recognize that our business has recently generated substantial amounts of cash in excess of our working capital requirements. We are currently looking at appropriate strategies for this excess cash, including share repurchase, loan repayment, and strategic investments.

We are particularly sensitive to the recent volatility in the financial markets and any decisions we make on potential cash strategies will take into consideration these external financial factors.

Notes receivable were $88.1 million, an increase of $23 million from year-end. This increase was due to Huawei purchases during the quarter, as Huawei often pays us in banker’s acceptances in China.

Accounts receivable were $143.1 million, a $26.9 million increase from year-end 2008. Our DSO in the first quarter was 38 days, compared to 33 days for the fourth quarter of last year. This increase was due primarily to the timing of sales in the quarter.

Our inventory was $108.4 million, a $17.5 million increase over the year-end. Most of this increase was in our H3C branded equipments.

Capital spending in the quarter was $7.6 million, compared with $4.6 million in Q4. This increase was largely due to certain infrastructure investments for our regional sales locations.

Now I’d like to provide some insights into our second quarter of fiscal year 2009. We expect Q2 to be another solid quarter for the company. We are projecting Q2 revenues to be slightly higher than Q1 in the $345 million to $350 million range. Within this total, we expect that on a sequential basis, Direct Touch sales in China will increase by about 20%. Sales to Huawei will decline by about 20%, consistent with our prior guidance.

In the networking rest-of-world segment, revenue should show a slight increase from Q1. TippingPoint segment revenue should also show a modest increase from the reported Q1 levels.

On a consolidated basis, we should see our gross margins remain essentially unchanged, while overall non-GAAP operating expenses will show a small sequential increase, primarily in sales and marketing. As a result of these factors, we anticipate that Q2 operating profits on a non-GAAP basis should show a slight sequential improvement.

With this forecast, we are projecting that first half fiscal year ’09 non-GAAP operating profits will exceed the non-GAAP operating profits for the entire full year results for fiscal year 2008, and earnings per share on a non-GAAP basis should be between $0.10 and $0.11.

We should caution that recent events in the worldwide financial markets could impact these projections. Our worldwide sales teams are still evaluating potential impacts on a deal-by-deal basis.

We expect to generate cash from our operations in the second quarter. We will, however, be making an $88 million principal payment on our outstanding debt. Of this total, $48 million of the annual prescribed payments and $40 million represents a voluntary prepayment. This voluntary prepayment reduces our interest obligations and gives us additional flexibility in moving cash between geographies. We will be also making an $8 million interest payment.

As a result, we expect that our Q2 loan obligations will decrease to $213 million at the end of Q2 and our cash balance will decline to about $500 million. Our net cash position, however, will improve.

And now I’d like to open the meeting to questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll go first to Manny Recarey with Kaufman Brothers.

Manny Recarey - Kaufman Brothers

Thanks. Congratulations on a good quarter. You mentioned you are evaluating the situation, the economic situation so it’s kind of fair to conclude that it’s really too early to tell what enterprises are kind of -- how they are reacting to the turmoil in the financial markets and credit markets?

Jay Zager

Yeah, I think that’s right, Manny. Obviously we have the benefit as we give this guidance of virtually having the entire China quarter, which ends September 30th, close to being behind us, so we do have some increased visibility there but in the rest of the world, the projections I gave you reflect what we see today but we did want to caution that obviously with this economic environment, strange things could happen as we go through the end of the quarter.

Manny Recarey - Kaufman Brothers

Okay, and a couple of questions then -- you had mentioned with the integration of H3C, you’ve captured about $40 million of annualized savings. What’s left to get to the $50 million to $100 million? Is that going to take -- how much longer is that going to take or you’ve kind of gotten the low-hanging fruit so far?

Jay Zager

It’s really a continuous process. Obviously we’ve tackled two of the major items, R&D and procurement costs. We also see savings in the overall supply chain organization, in the product line management organization, in the IT organization, and in the other administrative functions but those will be played out sequentially. So basically we’ve captured two of the major items and we expect to see further savings as we go forward.

Manny Recarey - Kaufman Brothers

Okay, and then you had mentioned R&D -- for modeling purposes, that’s kind of a base rate to use going forward, on a pro forma, there was around $44 million or so?

Jay Zager

I think that’s pretty reasonable.

Manny Recarey - Kaufman Brothers

Okay, then one last question -- TippingPoint, it was down sequentially. Any particular reason for that?

Jay Zager

As we mentioned, in the fourth quarter we had a one-time revenue gain of $1.4 million, which was basically non-operational.

Manny Recarey - Kaufman Brothers

Okay.

Jay Zager

That’s the only reason why we were down sequentially.

Manny Recarey - Kaufman Brothers

Okay. Thanks.

Operator

(Operator Instructions) We’ll go next to Jeff Evanson with Sanford Bernstein.

Jeff Evanson - Sanford Bernstein

Thanks. First I’m wondering how your win rate in China has changed over the last year.

Robert Y.L. Mao

No substantial change -- we are getting more into the financial verticals. This is what we are doing in China as well as in the rest of world -- we go vertical by vertical.

Jeff Evanson - Sanford Bernstein

What percentage of Huawei sales is equipment that ends up being used in a service provider’s network?

Robert Y.L. Mao

Basically all of our sales to Huawei ends up in the service providers network.

Jeff Evanson - Sanford Bernstein

Okay, thanks. And what is your employee turnover rate in China right now?

Robert Y.L. Mao

We are seeing about 10%, 12% annual rate and this is typical in China. In a fast-growing economy, this is very typical and we see this in other economies when they went through rapid changes.

Jay Zager

I would just add, Jeff, that with respect to this senior management team in China, they’ve been on board since the joint venture and they remain a very stable core of our China business.

Jeff Evanson - Sanford Bernstein

Do you think the remaining incentive program is sufficient to keep it that way?

Robert Y.L. Mao

Yes, we do.

Jeff Evanson - Sanford Bernstein

Okay, and last question for me, what are your expectations on collecting the break-up fee from Bain Capital?

Jay Zager

We really can’t comment. You know, we have filed the appropriate legal documents and now it’s going through the legal process.

Jeff Evanson - Sanford Bernstein

Great. Thanks, guys.

Operator

(Operator Instructions) It appears we have no further questions. I would like to turn the call back over to management for any additional or closing remarks.

Jay Zager

Thank you all and we look forward to speaking with you again at the end of the next quarter.

Operator

And that does conclude today’s call. We do appreciate everyone’s participation. You may disconnect at this time.

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