3Com F2Q07 (Qtr End 12/1/06) Earnings Call Transcript

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3Com Corporation (COMS)

F2Q07 Earnings Call

December 20, 2006 5:00 pm ET


John Vincenzo - Investor Relations

Edgar Masri - President, Chief Executive Officer

Donald M. Halsted - Chief Financial Officer, Executive Vice President


Matt Shimao - Bear Sterns

Jiong Shao - Lehman Brothers

Mark Sue - RBC Capital Markets

Jeff Evenson - Sanford Bernstein

John Marchetti - Morgan Stanley

Manuel Recarey - Kaufman Bros.


Good day and welcome to this 3Com quarterly earnings conference call. This call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to John Vincenzo. Please go ahead.

John Vincenzo

Thank you, and thank you, everyone, for joining us today. 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 our announced transaction with Huawei, including the approval and closing process, our funding plans and bank commitments, employee retention at H3C, H3C integration and transition efforts and plans to leverage H3C, cash requirements for and GAAP accounting effects of the transaction and transaction costs in related retention matters, and our Huawei relationship, goals for future growth and profitability, plans to reduce costs, H3C sales expectations and future performance, and technology solutions. 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.

On this call, we will also discuss several non-GAAP financial measures. The most directly comparable GAAP measure and the required reconciliation can be found in tables at the back of the press release announcing our results. This press release is available on the investor relation section of our website, www.3com.com.

With that, I am going to turn the call over to Edgar Masri, President and CEO of 3Com.

Edgar Masri

Thank you, John. Good afternoon, everyone. Thank you for joining us today as we report our second quarter results for our fiscal year 2007.

In addition to providing you with an overview of our financial results for the quarter, over the next few minutes I am going to focus much of my comments on our recent announcement that we won the bid process to buy Huawei’s 49% ownership stake in our joint venture, H3C.

At this juncture, I am prepared to touch on several of the points that I understand are top-of-mind with you, in an attempt to give some clarity and context regarding this transaction. Those key points include the following:

  1. An overview of how we intend to finance the transaction;
  2. Progress we are making with regard to employee and management retention plans in H3C;
  3. The value in 3Com owning 100% of H3C; and
  4. Our initial plans for more closely integrating H3C and 3Com.

At the conclusion of my remarks, I am going to turn the call over to our Chief Financial Officer, Don Halsted, who will review in more detail our consolidated financial results for the quarter.

Let me talk first about the consolidated results. I am very pleased with the performance of both H3C and our Secure Converged Networking, or SCN, operating segments. The company as a whole showed some encouraging signs that our focused approach is gaining traction. That being said, while our performance certainly has improved, we still have plenty of work to do to ensure that we build a profitable business that can sustain growth.

In this Q2 quarter, we achieved consolidated revenue of $333 million, which is an 18% increase compared to the same period in fiscal 2006, assuming we consolidate H3C in the prior year period, and an 11% sequential improvement. The sequential improvement was driven not only by continued growth from H3C but also growth in the overall SCN segment, particularly in our three key areas of focus.

The improvements in SCN were led by expanded networking sales, including an increase in our sale of H3C products around the world, strong sequential growth in our security line of products, including TippingPoint, as well as growth in our voice over IP business.

In addition to the top-line improvements in the quarter, we also continued to make positive strides in other key aspects of our financial performance. To give a couple of examples, we were able to achieve a 55% improvement in our operating loss on a sequential basis and our net loss in the quarter improved by 75% sequentially to $4 million.

With that, let me now comment on key highlights from our operating segments. We will start first with the H3C performance.

H3C continued its strong performance, with revenue of $190 million in its quarter ended September 30, 2006. In addition to growing in China, sequential sales of H3C products outside of China increased, predominantly driven by sales through 3Com.

As I have mentioned to you several times, the next logical phase of growth at H3C is global expansion of sales of H3C's products, and we will be working with the management team at H3C to build a strategy that leverages the strength of 3Com's global infrastructure and increases growth outside China.

Now, let me turn to some other issues related to H3C that are top-of-mind.

First is the integration of H3C. This is a major transaction and the point of integration is an important one I want to touch on. In preparation for the approval of the transaction by the People’s Republic of China, we are creating an integration task force which includes members from both segments of our company and represents a cross section of functions. This is IT, sales, supply chain, service and support, et cetera.

This team will be responsible for facilitating a smooth transition, including identifying ways to leverage and/or merge best-of-breed practices within H3C and 3Com, particularly around areas such as sales, supply chain, service and support, and IT.

One of the first steps in the integration process will begin in our Asia-Pacific region. Upon closing of the transaction, we intend to integrate our enterprise focused sales team to best capitalize on the sales experience, enterprise channel partners, and market opportunities in the region. I also anticipate the sales integration work in APR to be largely complete by the end of our fiscal year in the end of May, 2007.

From there, we will continue to find the synergies in the businesses and align the resources in the most appropriate and efficient ways to spur growth around the world.

The next point I want to touch on is the impact of the ownership uncertainty and integration on H3C. In October and November, I spent several weeks in China and I saw the impact the ownership uncertainty had on H3C and the employees. The team there did an admirable job maintaining focus, but it was inevitable that the uncertainty of not knowing who would ultimately own 100% of the company did cause some disruption.

As you know, in its third fiscal quarter, H3C once again achieved strong revenue growth, increasing 12% sequentially and 71% year over year. That being said, when you combine the uncertainty of ownership with the typical disruption caused when companies work through an integration process, as well as the seasonal impact of the Chinese New Year, we anticipate that H3C revenue may be relatively flat for the next one to two quarters. This will take us to the H3C quarter ending March 31, 2007.

This is not surprising to anyone involved in this, but we wanted to be up-front with you, since anything but high growth will be a change from their established track record. I have been in close contact with H3C management and I have indicated that the team is relieved that the uncertainty is behind them, and they are focused on demonstrating strong growth in the future.

Now, regardless of the potential impact in the next quarter or two, we are confident that once we receive approval from the People’s Republic of China and work through the transition to 100% ownership, H3C and 3Com share a very bright future.

Now, let me move on to some highlights on our SCN segment. There is still much to be done in the SCN business, I agree. But we need to walk before we can run. That is why we clearly stated that once the significant portion of the restructuring was implemented, the first step in our SCN recovery is to stabilize revenue.

In Q2, we saw our first sign of our overall SCN revenue performance stabilizing as the team achieved revenue of $167 million, compared to $156 million in the previous quarter. This growth was realized in our three key areas of focus -- security, voice over IP, and network infrastructure products.

TippingPoint had high sequential growth, and what is even more encouraging was in the general TippingPoint growth story is the fact that revenue outside North America increased sequentially and year over year. This is a sign that the need for in-line intrusion prevention systems is expanding around the world.

On the voice front, the improvements were driven by an increase in demand for our NBX product and our VCX platform, which was recently enhanced by the November announcement that the integration of VCX with IBM’s System I series is now generally available. We are excited about this relationship and we believe it bodes very well for VCX product sales.

Within our networking sales, we increased the growth in our gigabit managed switching line, as well in our modular core product set. In terms of our enterprise sales of H3C products, we continued to gain momentum, recording $48 million in revenue, which is an increase of 34% sequentially and more than 100% year over year, with growth in all product categories.

Now, beyond the positive story with our SCN revenue performance, we also continue to maintain our expense controls. We have lowered our operating spending by $27 million year over year. Reducing our cost structure remains a priority for us, and we will continue to find ways to reduce expenses while increasing productivity. Don will actually discuss this in more detail in his comments.

Also in the quarter, we strengthened our worldwide sales team when we hired a new Vice President and General Manager for SCN’s largest region, the Europe and Middle East and Africa, EMEA. I am pleased to report that earlier this month, Mike [Ansley], a former Cisco executive, joined 3Com to run our EMEA operations. Mike has extensive knowledge of the EMEA market. I have known him personally, but he also has a proven background in building a successful, go-to-market strategy around conversion to voice, data, and security.

So let me recap on SCN. I am pleased with the continued improvements we saw in the quarter, but I know one good quarter does not make a trend. The management team at 3Com is very focused on execution, and I believe that over the next 12 months, you will see consistent proof that we are capable of building a global technology leader.

Now let me move on and update you on the H3C transaction.

First, let me start with recapping that transaction. As I am sure most everyone on the call knows, on November 28th, we announced that 3Com agreed to buy Huawei Technologies’ 49% stake in H3C for $882 million, which represents an implied equity value of $1.8 billion. This of course is subject to customary approval in the People’s Republic of China.

At the time that we announced we won the bid process with Huawei, there were several questions that we indicated we would follow-up with you on as we moved along in the process. In keeping with that assurance, let me try to give you some more clarity around a few key points.

First, the financing. Don will touch on this more in a moment, but here is the high level view of how we intend to finance the purchase. Our current intent is to fund the purchase price with both cash on 3Com's balance sheet and external financing. From an external financing perspective, we have secured committed financing from our international banking partner for up to $500 million in Hong Kong based, senior secured bank debt. The remainder of the payment will come from our treasury. Again, Don will touch more on it in a moment.

The next key topic is H3C employee and management retention. As you will recall, when we announced that we had won the bid process, we indicated that one of our top priorities moving forward was to implement long-term retention and incentive plans for H3C employees. Our intent is to keep intact the team that built H3C into one of the fastest-growing networking companies in the world.

Upon completion of the bidding process, we immediately engaged certain senior management at H3C to help us design a compensation structure that would be attractive to key employees. We are working with them to finalize the distribution of the existing, long-term incentive program, which pays out through 2010, as well as certain other incentives.

We will offer the competitive salaries and long-term incentives designed to retain and motivate this high-performing team.

Now, let me move on to the value and strength of a combined 3Com and H3C. The merging of 3Com and H3C is a transformational event in the history of both companies. To be competitive on a global scale, companies in general need to adapt to a changing economic environment. We know that. As one of the fastest growing economies in the world, China presents unique business opportunities, which is why you see so many companies attempting to penetrate it.

At 3Com, over the past three years, we have gained an advantage through our work with H3C that we believe puts us in a position to build a global technology leader. With more than 820 sales and marketing people, approximately 2,300 engineers in over three sites, and more than 300 customer service people in China, H3C has the relationships and expertise to continue building on the momentum they have already gained since it was founded in 2003.

The H3C management team has built a successful standalone business and we are confident in their ability to continue growing this business. Additionally, transitioning from a majority-owned, joint venture to a wholly-owned business allows for complete alignment with 3Com's global vision of becoming a leading global networking provider.

Our joint venture partner, Huawei, is also a key partner and a contributor to the growth of H3C and both 3Com and Huawei benefit from the relationship and the continued growth of H3C.

As far as I am concerned, Huawei remains an important customer of H3C and we believe H3C remains an important OEM supplier of Huawei. Moving forward, we will look to maintain our positive relationship with Huawei, as well as look to find new partnerships that have strong potential for growth, both in China but also around the world.

Now, let me conclude with a few words. The global business climate gives me confidence that the new 3Com, inclusive of 100% of H3C, has an opportunity to deliver profitable growth. The market demand is there, and we have seen enterprises, particularly in our target market, continuing to look for new secure converged networking solutions.

From a technology perspective, we will offer differentiated solutions. I mentioned on our last quarterly earnings call that several initiatives were underway that will show how 3Com is harnessing its entrepreneurial culture to develop new technologies that deliver differentiated solutions to our customers and market.

One such initiative, for example, is what was launched in October when we released the industry’s first unified switch for small and medium businesses that converges wired and wireless networking functionality, and includes the power over ethernet to support voice over IP on a single platform. Early indications are that the software has been well received and we will continue to push this in the channel.

Some people share a view that data infrastructure products are being commoditized. We believe this notion presents us actually with an opportunity to lead through differentiation and innovation. Over the coming months, you will see us showcase examples of innovation as we plan to capitalize on emerging trends in technologies such as open source application and next generation technologies that leverage open architectures by integrating more functionality into our infrastructure products.

Additionally, we believe we will set 3Com solutions apart through our bi-planar architecture strategy, where we build network intelligence into the control plane. We will have a major update on this at the upcoming RSA conference in early February.

All of this innovation will be integrated with our infrastructure products from H3C and we will leverage a global service model that we believe ultimately will improve our customer support and improve our costs.

I understand that we will be judged by our shareholders, our employees, our customers and our partners based on how successful we are as a company at executing against a strategy and vision I outlined here today. That is why I encourage you to hold us accountable to see if we deliver in the following five areas:

  1. We will close the H3C transaction and show progress in our integration efforts in the Asia-Pacific Rim;
  2. We finalize employee retention and incentive plans for H3C;
  3. We continue to see improved performance in the SCN operating segment;
  4. We clearly articulate a strategy around open source and open architecture applications and show hard evidence around integrating this technology into our network infrastructure products; and
  5. We complement our attack, application and access control into the network control plane.

In closing, I believe the next few months will be very exciting for all of us. At the same time, I recognize that we also will face some challenges, as even positive change can place demands on our time and the way we operate. However, when all is said and done, it is my vision that the combined 3Com/H3C will become one of the world’s leading enterprise networking companies.

With that, I will turn the call over to Don Halsted, who will give you a more in-depth view of our financial performance. Don.

Donald M. Halsted

Thank you, Edgar. As in recent quarters, I will be reviewing 3Com's results, first on a consolidated basis and then the performance of our two operating segments. I will conclude by discussing key cash flow and balance sheet items.

Throughout my review, I will be using pro forma and pro forma non-GAAP measures of the historical results of H3C and 3Com as a consolidated entity to calculate comparative values. Please refer to our current quarter press release for disclosure of absolute values and reconciliation for these values.

As a reminder, we adopted FAS-123R effective Q1 fiscal 2007. We are excluding stock-based compensation expenses for the purposes of our non-GAAP operating profit metric, as well as excluding restructuring and amortization items, and certain unusual items that we do not consider to be indicative of our core operating results.

Let me start with a consolidated results review. The fiscal second quarter consolidated revenue was $333 million, an 81% year over year increase compared to 3Com's historical GAAP results. This increase is explained by the inclusion of H3C's results in the current quarter, partially offset by lower revenue in the SCN segment.

The more meaningful comparison is against a pro forma non-GAAP revenue that includes the actual H3C results for the prior year quarter as if we consolidated H3C from the beginning of the period. On this basis, the year over year revenue growth is about 18%, driven by increased sales in our H3C operating segment, offset in part by lower revenues from our SCN operating segments.

Table C in our press release provides geographic and product based supplementary revenue data. We added China to our geographical analysis as its sales continue to grow, and commencing with the consolidation, have become significant to our overall revenue.

China revenue grew 19% sequentially to $158 million, and represents H3C's direct sales, as well as the OEM sales to Huawei’s China hub. H3C's direct sales in other Asian regions are included in our APR region, and sales to Europe are included in EMEA.

Our APR region grew 16% sequentially due to increases in both SCN and H3C sales, and unique within this quarter was a large router deal that makes these results particularly strong.

The other three regions performed in-line with typical seasonal trends, with EMEA and Latin both rebounding off of the slower summer periods. North America declined 6% sequentially coming off of the summer education buying season. For the second year in a row, the North America percentage of sequential decline has reduced due to increased project business, especially in our networking and voice sales.

On a product basis, all three of our major product areas increased on a sequential basis and a year-over-year basis. Networking sales more than doubled over the prior year period, driven by the inclusion of H3C results. SCN sales decreased over the prior year, reflecting prior period share loss.

On a sequential basis, the 11% increase in networking sales is due to double-digit growth in H3C plus single-digit growth in SCN.

Security products increased by 51% over the prior year period, primarily driven by the increased sales of our SCN security products and inclusion of H3C's security offering. Sequentially, security growth was about 25%. This included a healthy sequential growth in our TippingPoint product sales, reflecting strong worldwide sales.

Voice products increased 17% over the prior year period, explained primarily by the inclusion of H3C in the current period with almost flat SCN voice solution sales. On a sequential basis, voice revenues increased 5%, with double-digit growth in SCN sales, partially offset by lower H3C voice product sales.

SCN voice sales increased sequentially for sales of our new NBX platform, as well as the general availability status of our VCX offering on the IBM I series platform.

Results at the gross margin in certain operating lines will be described in the discussion of the operating segments following this review of the consolidated results. On a consolidated basis, each of these lines were significantly impacted within the quarter by the inclusion of H3C's results relative to the same quarter fiscal 2006.

The GAAP operating loss for the second quarter was $9 million, compared to a $21 million loss in the first quarter of fiscal 2007 and a $42 million loss in the same period of fiscal 2006. The $33 million improvement over the prior year period is due to $12 million of operating improvements in our SCN segment and $21 million from the inclusion of H3C's performance in the current quarter. The improved sequential performance is explained by a $2 million improvement in SCN operating loss, as well as a $9 million increase in the H3C operating income.

In the current quarter, we had $7 million of stock-based compensation charges, compared to $3 million in the first quarter of fiscal 2007. This increase was driven by the inclusion of options from restricted shares issued in conjunction with Edgar’s hiring, as well as other grants, plus the recognition of certain performance-based vesting of restricted stock grants in the quarter.

In the current quarter, we recognized less than $1 million in restructuring expenses. This was driven by expense in the current period of almost $3 million for certain remaining aspects of our June 30th restructuring plan, largely offset by the recognition of a $2 million benefit for change in estimate of the required reserves for historical restructuring plans.

For the past three quarters, management has been reporting 3Com's non-GAAP operating income performance because we believe that this measure, which excludes unusual expenses along with restructuring amortization and stock-based compensation charges, is the best single measure of operating profitability. A reconciliation to GAAP operating income is provided in Table D of our press release.

With this definition consistently applied, I am pleased to report that in this quarter, non-GAAP operating income was positive at $10 million, a sequential improvement of $16 million compared to the first quarter of fiscal 2007 non-GAAP operating loss of $5 million, and a year-on-year improvement of $40 million compared to a second quarter of fiscal 2006 non-GAAP operating loss of $30 million.

The non-GAAP operating income increase was driven by improvements in both H3C and SCN. The SCN improvement resulted from margin on higher revenue combined with continued expense control. The improvement over the prior year period results from the benefit of the consolidation of H3C plus operational improvements in SCN.

In other income, we recorded a $1 million realized loss, which was primarily due to the sale of our venture fund portfolios. This quarter’s sale completes the sale of our entire venture fund portfolio.

Interest income net for the period was $11 million, which increased $1 million sequentially and is an increase over the prior year quarter of $5 million. This increase is driven primarily by the inclusion of H3C's results in the current period and increased performance for the SCN portfolio.

Other income net for the period was $13 million versus $5 million in the first quarter of fiscal 2007. This increase was primarily driven by an increase in the level of the software operating subsidies at H3C to $9 million, compared to $5 million in the prior quarter. The subsidy is funded by [inaudible] and accounted for on a cash basis.

Additionally, SCN had a $3 million accounting gain recognized on the insurance settlement for a legacy U.K. facility, as well as gains on the sale of certain patents. In total, about $5 million of this other income should be considered non-recurring.

The provision for income taxes was $2 million for the quarter, versus $1 million in the prior quarter, primarily driven by the increased operating income of H3C. The provision increased $24 million over the prior year quarter, during which we recorded a $23 million tax benefit resulting from a settlement with foreign tax authorities regarding issues covering multiple years.

In our second fiscal quarter, we recorded a minority ownership charge to our results of $15 million as Huawei’s share of the financial performance of the consolidated H3C joint venture.

The net loss for the second quarter was $4 million, or $0.01 per share, of which restructuring, amortization and stock-based compensation expenses represented about $0.05 a share. This represents a $0.02 per share improvement over the prior year quarter net loss of $0.03, which included $0.03 per share of restructuring and amortization to stock-based compensation expenses, as well as a foreign jurisdiction tax settlement resulting in a gain of $0.06 per share.

The weighted average number of shares outstanding during the quarter was $393 million, a net increase of $1 million from the prior quarter, primarily reflects the exercise of stock options, employee stock purchase plan purchases, and divesting the previously issued restricted stock grants.

Let me move on to a review of our operating segments. Segment results can be seen in our press release in Table E. I will start by reviewing the SCN segment performance.

Revenue for the quarter was $167 million, an $11 million sequential increase and an $18 million decline compared to the same quarter last year, of which the decline in our connectivity products accounted for $5 million.

The 7% sequential increase resulted from a stabilization in the business after the implementation of our June announced restructuring plan, along with standard seasonal trends. We are pleased with the SCN segment’s continued increase in sales of the H3C source products, which grew by 34% sequentially, approaching $50 million in quarterly sales.

SCN gross margins were flat sequentially at 36%, yielding a gross profit that was higher sequentially by $3 million, due primarily to higher revenues. We continued to control expenses for sales and marketing, research and development, and general administrative in this segment which, as a group, were $86 million for the quarter, including stock-based compensation costs of $7 million.

The comparable expenses in the fiscal first quarter were $85 million, including $3 million stock-based compensation expenses. Compared to the same period in fiscal 2006, these expenses have declined $24 million, or 22%.

On a net basis, this results in sequential improvement in the SCN segment operating loss of $2 million. The SCN operating loss for the second quarter is $19 million, an $8 million decline over the prior year quarter 3Com loss of $11 million. This is explained by the absence of the prior year’s $24 million benefit resulting from a foreign tax settlement, offset in large part by $16 million of operational improvements.

Turning now to the H3C operating segment. To review H3C's performance, I am going to compare the reported segment second fiscal quarter financials against first quarter financials and the standalone performance for H3C in the same quarter the prior year.

H3C had a particularly strong revenue performance for the second quarter at $190 million, a 12% sequential and a 71% year over year improvement. H3C sequential improvement in sales was primarily explained by increased sales of switches. Compared to the prior year, Huawei and 3Com each increased their purchases by over 80%, while H3C's direct sales grew by over 50%.

H3C's gross margin was 48%, the same as in the prior quarter, and an increase of five percentage points compared to the same period in the prior year. The year-over-year improvement is primarily due to mix to higher-end product sales, as well as cost savings.

H3C's direct operating expenses for the quarter were $61 million, an increase of $1 million sequentially, and an increase over the prior year quarter of $17 million. This increase is primarily driven by the experienced and the anticipated growth.

H3C's net income before the Huawei minority interest charge was $31 million, or 16% of sales, including a $9 million, non-cash charge for amortization of intangible assets. This is an increase of $33 million over the prior year quarter comparable number, as well as a sequential increase of $12 million. Net income after the $15 million Huawei minority interest charge was $16 million.

The primary drivers of the year-over-year improvement are the 71% revenue growth at a higher gross profit margin, combined with the software’s operating subsidy that started in our fiscal fourth quarter of 2006.

Returning to a consolidated view, I will now review selected aspects of 3Com's balance sheet.

Cash, cash equivalents, and short-term investments totaled $869 million, representing a net decrease of $47 million from the balance at the end of the previous quarter. The change includes an increase in cash and cash equivalents of $4 million and a decrease in short-term investments of $51 million. Key components of the change in cash and cash equivalents are as follows:

  • Cash received for the net sales of investments was $55 million;
  • Cash used for the distribution from H3C to its shareholders resulted in a decline in 3Com's consolidated cash balance of $41 million, representing Huawei’s share of the distribution;
  • Cash used for capital expenditures amounted to $10 million;
  • Cash used in operations was $8 million, including $5 million for restructuring related payments; and
  • Cash received for the net issuance of stock was $5 million.

The quarter ending cash, cash equivalents and short-term investment balance of $869 million is composed of $737 million in the SCN segment and $132 million in H3C.

Closing the H3C share acquisition requires a cash payment of $882 million. As Edgar mentioned, we currently plan to fund up to $500 million of this payment with Hong Kong placed senior bank debt and the balance from our treasury. We selected our banking partner and they have committed to the funding, subject to normal closing conditions.

Our financing plan does not call for the use of acquired H3C cash to fund the purchase for the following reasons.

The closing will activate a participation program for all of H3C's 4800 or so employees that was implemented by the shareholders several years ago. Modeled after a private company ownership plan, this program, which we call the EARP, funds a bonus pool with a percentage of the appreciation in H3C value from inception to the time of an acquisition of 100% ownership, plus there is a cumulative earnings component.

The total value of the program is in the range of $190 million, of which about $36 million would be accrued by 12-31-06, and about $90 million in the future. Based on investing schedules, I anticipate at H3C, we will take a pre-closing charge of between $55 million and $65 million. This will match the expected cash outlay of approximately $90 million to $100 million following the closing. The unvested portion will be accrued in the normal course over the next three years, which serves as an excellent retention mechanism for H3C employees.

The balance is needed for operational reasons. H3C has a positive cash flow and we currently expect to see this balance build and support the servicing of this loan.

Other items of note compared to the fiscal 2006 year-end consolidated balance sheet include:

  • Accounts receivable increased $40 million, primarily by growth in the H3C segment;
  • Inventory decreased $6 million on higher revenue, driven primarily by management’s efforts to reduce inventory in the H3C operating segment;
  • Accounts payable decreased $31 million due to inventory focus, and;
  • The minority interest liability to Huawei decreased by $17 million, due to $41 million capital distribution to Huawei, as discussed above, which is partially offset by the year-to-date minority interest share of H3C income of $24 million.

So in summary:

  1. We achieved our milestone of delivering positive operating profit non-GAAP in the quarter, driven by reduced losses in the SCN segment and continued strong performance in the H3C segment;
  2. The loss per share on a GAAP basis was reduced to $0.01, the best in years; and
  3. We had good growth in key SCN product areas of security and voice.

Our fiscal Q207 results represents good progress across the board. We still have a lot of work to do, starting with a mission critical task of completing the H3C share purchase and moving forward with the integration plan.

The completion of the H3C share purchase will affect our financials in the following way:

  1. We expect to incur deal and financing related costs of approximately 3% of the total deal value, which will be capitalized and amortized and funded through the capital structure I described above. This does not include integration costs, which will be expensed as incurred;
  2. We mentioned above the EARP likely charge of $55 million to $65 million; and
  3. I want to comment on the near-term expected purchase accounting impacts. Despite the two-month lag in our recording of H3C results in our consolidated results, purchase accounting will be recorded in the period concurrent to our fiscal calendar closure of the acquisition. Therefore, if we acquire the remaining ownership of H3C prior to the end of February, 2007, we will record purchase accounting and deal structure related impacts into our third quarter fiscal results.

In addition to the various balance sheet impacts, this will result in certain P&L impacts, namely:

  1. We will see reduced gross margins in our H3C segment as all finished goods inventory on hand at the time of the acquisition closes will be marked up by 49% of the fair value for the incremental ownership. This will impact gross margins for approximately one quarter, which may be experienced over two fiscal periods;
  2. We will see some reduced margins on the recognition of deferred revenue in our H3C segment; and
  3. We are likely to see increased amortization charges on intangible asset valuations.

Let me now turn the call back over to Edgar Masri for comments before opening up for questions and answers. Edgar.

Edgar Masri

Thank you. We are open to answer your questions. Operator.

Question-and-Answer Session


(Operator Instructions)

We will go first to Matt Shimao with Bear Sterns.

Matt Shimao - Bear Sterns

Hi, guys, nice quarter. My question is about H3C's revenue trajectory. After the initial consolidation period, what kind of growth rate do you think H3C is capable of delivering over let’s say the next two years or so? What are some of the important opportunities you will focus on? Thank you.

Edgar Masri

Thanks, Matt. Great to have you on the call. Let me repeat what I said regarding the H3C performance going forward. The H3C management team has done an admirable job maintaining focus, but it was inevitable that the uncertainty of not knowing who would ultimately own 100% of the company would cause some disruption. Again, in the third fiscal quarter, H3C achieved growth, as I mentioned earlier, of 12% sequentially and 71% year on year. The market is not growing at that rate anywhere in the world. That being said, so you combine that with the uncertainty of the ownership with a typical disruption caused when you combine two companies together, so we anticipate that H3C revenue, as I said earlier, may be relatively flat for the next one to two quarters. This will take us, let me be clear, up to the H3C quarter ending March 31, 2007.

I am confident that the H3C and 3Com share a very bright future once we move past that initial impact of integration and transition, but I wanted to highlight that and make sure it is clear to everybody.


Thank you. We will go next to Jiong Shao with Lehman Brothers.

Jiong Shao - Lehman Brothers

I have a couple of questions, if I may. First, could you guys please provide an update on your resale agreement with Huawei, and also remind us the current percentage of sales for H3C going through Huawei as a channel?

My second question is, could you remind us what the incremental share count based on treasury method, once you are profitable, I guess on a GAAP basis? Because with the options you have, et cetera. Thanks.

Edgar Masri

Let me start quickly on Huawei. The Huawei channel has represented for us 30% to 40% of the business. It remains strong. Huawei is a great partner and the resale agreement that started with the intention of the joint venture continues. I personally have come to know a lot of the executives at Huawei, Mr. Ren, Mr. [Wopin] and others, and I have great admiration for what they have achieved. I know that we will do our best to maintain that relationship, but also to satisfy their needs, because their needs are driven by their own customer’s needs.

I will turn it to Don to provide more specifics on this and the next question you had.

Donald M. Halsted

The only thing that I would add to what Edgar said is first of all, the percentages were obviously the percentages of the H3C revenue, and also that we have seen very strong growth over the last year on a year-to-date basis in both the OEM sales into 3Com, as well as the OEM sales into Huawei, so both of those have grown very well.

You asked a question regarding the stock option dilution effect when we become positive, based on the treasury method. I do not have the numbers in front of me, but we have published the distribution of all of our options by prices and most of the prices are sitting above the current price we have. Basically, other than some of the one set of grants a year ago and some of the grants associated of acquiring the TippingPoint.

I think if you run the math, it is not a very big dilution but I do not have the exact number with me.

Jiong Shao - Lehman Brothers

Could I just follow-up on what you said? Edgar, I thought you said that the agreement has expired. If that is the case, do you have any plan to renew that agreement or --

Edgar Masri

No, no, no -- I never said that.

Jiong Shao - Lehman Brothers

-- or when, and also the -- exactly what brand? I am assuming the 3Com brand you will have in China once the deal closes.

Edgar Masri

Jiong, let me make sure it is clear. The resale agreement has not expired. The resale agreement continues. The resale agreement was defined very early on. It is maintained and is driven by business consideration.

What Huawei, per the bid process, is committed to is to a non-compete period of 18 months. We are comfortable with that and this is the basis on which we went and bid for the remaining stake.

You had another question, which was about the brand. The H3C brand is phenomenally strong and it is again, H3C, phenomenally strong in China. We intend to continue with it. We will make very specific decisions as we engage on the global expansion with our sales team to use and leverage and promote the H3C brand, particularly in the large enterprise, but we are going to do that in a very methodical manner, because in some countries, specifically in emerging markets, this is a great opportunity for us to establish ourselves as an enterprise networking leader.

But in other countries, like specifically Latin America and certain countries in Europe, the 3Com brand sells very strong. We would like to make sure that the integration and the combination keeps track of that.


Thank you. We will go next to Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets

Thank you. Is it possible to extend the non-compete or not really? Edgar, I can understand the disruption for H3C for the December quarter, but if the uncertainty diminishes, why would the business not snap back sequentially in the March quarter? If some of the impact is related to the Chinese New Year, why would it have an impact next year if it did not have an impact earlier this year?

Edgar Masri

Right, so let me answer your second question first, and then you can remind of your first one.

You said why would it be over two quarters. Keep in mind that the calendar quarter Q1, which is the first quarter of ’07, will be factored in our not Q3 but Q4, so two quarters from now. This has been traditionally a soft quarter for H3C, and you mentioned it because the Chinese New Year is in that period. This is like two, if not three weeks of holidays or breaks, and that is what we are referring to.

Second, the uncertainty will completely disappear when we close on the transaction. I estimated four to six weeks. Therefore, until then, we could have all the plans we want regarding branding, regarding communications, et cetera, but the implementation of those plans cannot take place until this closing is finalized, which will go and spend part of the Q107 calendar year.

Mark Sue - RBC Capital Markets

Got it. The first question was, is it possible to extend the non-compete, or is that a foregone conclusion?

Edgar Masri

Anything is possible. We are business minded. Huawei is very business minded. We believe right now that 18 months is a fair amount of time, given the price we paid and how we see the market evolving.

We will take any appropriate action should we determine that it is in our best interest to do that and approach Huawei as need be.

Mark Sue - RBC Capital Markets

Okay, that is helpful. Thank you and good luck, gentlemen.


Thank you. We will go next to Jeff Evenson with Sanford Bernstein.

Jeff Evenson - Sanford Bernstein

I was wondering if any portion of the EARP expense is counted in the $882 million purchase price.

Donald M. Halsted

The $882 million purchase price is for the acquisition of the shares, and by acquiring the shares, you acquire all the cash of the company as well as acquiring the liabilities. The cash acquired is significantly above what the expected amount is of the cash payments of the EARP.

Jeff Evenson - Sanford Bernstein

Could you give us an idea what the average compensation per person is at H3C, annually?

Donald M. Halsted

I do not have that number.

Edgar Masri

It varies a lot. It varies a lot because you have employees in various grades, like over 10 grades that I have seen.

I can tell you that at the high level, at the executive level, the salaries are going to start approaching U.S. salaries. They will be lower, because the cost of living there is lower, but they are going to approach there. People are working very hard there and they feel they deserve to be compensated, and they have unique skills.

At the lower levels, and the talent pool is very large, which is why we went to China in the first place, but the current cost of an engineer, average engineer in China relative to an average engineer in the U.S. is one-fifth. Is it fluctuating, is it increasing? Yes, but I have not seen that ratio change much. I have seen it across the board.


Thank you. We will take our next question from John Marchetti with Morgan Stanley.

John Marchetti - Morgan Stanley

Thanks. Not beating a dead horse here, but just getting back to the H3C guidance for the next couple of quarters. I understand the angst around the October/November timeframe, but this is an organization that you already had operational control of, so I am a little bit surprised. Granted, some of it is the New Year, fine, but I am a little bit surprised that you see it taking so long to have growth resume again, given that from at least an operational standpoint, this is something you already have control of.

Is it just a branding, or a refocusing of the organization into new areas? What really changes that you do not have operational control of today?

Edgar Masri

That is a very good question, John. First and foremost, over the past three months, these three months of H3C will be counted at our next quarter. We had 51%, but again, this was an organization that for all intents and purposes some people viewed as potentially sold to another third party, to another strategic investor or whatever. That uncertainty was something we could not fully control, because there is always a price. We have a fiduciary duty to our shareholders to ensure that we make our bidding consistent with the value that we have in our mind, but also somebody else could, a buyer could have a different perspective and a different price they are willing to pay.

That has affected the first, the three months that are going to finish December 31st. But even now with the decision to go and acquire the rest of the company, a lot of the branding, let’s say we agree on the branding. The H3C is going to be branded in these countries. We cannot make the change and make it happen until the closing happens, because we are only a majority shareholder. We are not a total shareholder.

We expect that closing to take place in four to six weeks from now, so by then, we will be able to implement a lot of those actions and a lot of the uncertainty will dissipate.

John Marchetti - Morgan Stanley

Okay, reading into that, should I anticipate some pretty significant changes either in branding or marketing right out of the gate, as soon as you guys close this deal, as opposed to just resuming business as usual until you get a quarter or two under your belt?

Edgar Masri

It will not be fundamentally drastic changes because it is more leveraging what H3C has. Keep in mind 3Com has not been very strong in the large enterprise for a variety of reasons. We want to leverage H3C, and so it is more propping the campaigns around that as opposed to doing 180 degree turn.

There will be some products that are to date sold under the 3Com brand that in some countries, we will see it more appropriate and more cost-effective to unleash those same products with just the H3C brand, and remove that two phases of testing, that two phases of branding that we currently undergo.


Thank you. We will go ahead and take our last question from Manuel Recarey with Kaufman Brothers.

Manuel Recarey - Kaufman Bros.

Thank you very much. Two clarifications, and one question. When you close with the transaction, the H3C, are they going to be on the 3Com fiscal year, I would assume? So once it closes, everything will be the same?

Donald M. Halsted

We looked at that very specifically, and because the closing actually happens within a three-month window, we are not under an immediate obligation to change it, so when we look at the things that we want to focus on, that does not come up to the top of the list. For the moment, we are going to probably keep the same staggered reporting period.

Manuel Recarey - Kaufman Bros.

Eventually, that would have to change, I would assume.

Donald M. Halsted

Eventually for operational reasons we may desire to have it change, but it is not actually a reporting requirement to have your subsidiaries all on the same period.

Manuel Recarey - Kaufman Bros.

Okay. The closing of the deal is four to six weeks from now, or when you announced it?

Edgar Masri

Again, it is a rough estimate, so the six weeks may end up being it, and it could be less. My view is it is going to be mid- to late-February, but this is again a rough estimate. It is all in the hands of the People’s Republic of China, the government.

Donald M. Halsted

I think the way to think about it is we have a definitive agreement per the contract, but now we are working through the approval process.

Manuel Recarey - Kaufman Bros.

Okay, and one last question. The sales of the H3C product through 3Com were very strong sequentially. Was there any particular region where you did particularly well?

Edgar Masri

Let me touch on that. A new set of products coming from H3C, specifically the 4500, started shipping late in the Q2 quarter. That went across all regions. So it is more of a new introduction of products from H3C. We are very proud of that and we are very thankful for what the H3C team has done, because now we have a whole set of offerings in the mid-range for the gigabit line that will put us in a very competitive position moving forward.

Manuel Recarey - Kaufman Bros.

Okay, thanks, and congratulations on a good quarter.

Edgar Masri

Thank you. We appreciate it.


Thank you. At this time, I would like to turn the program back over to Edgar Masri for any additional or closing comments.

Edgar Masri

I want to take this opportunity to thank everybody. We are very pleased with the quarter. We have a lot of work ahead of us. We appreciate your time and we look forward to continuing working with all of you. Thank you.


That does conclude today’s conference. You may disconnect your line at any time.

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