3Com F4Q07 (Qtr End 6/01/07) Earnings Call Transcript

| About: 3Com Corporation (COMS)
This article is now exclusive for PRO subscribers.

3Com Corporation (COMS) F4Q07 Earnings Call June 28, 2007 5:00 PM ET



John Vincenzo - IR

Edgar Masri - President and CEO

Don Halsted - CFO


Matt Shimao - Bear Stearns

Manuel Recarey - Kaufman Brothers

Long Jiang - UBS

Jenifer Tenenbaum - RBC Capital Markets


Good day and welcome to 3Com's Fourth Quarter and Annual Fiscal 2007 Earnings Announcement Conference Call. Today's conference is being recorded. At this time for opening remarks and introduction, I would like to turn the call over to John Vincenzo, Head of Investor Relations. Please go ahead John.

John Vincenzo

Thank you and thank you everyone for joining us today, as we report our fiscal year 2007 Q4 and year-end financial results. Before I read through our Safe Harbor statement, I want to let you all know that we are conducting the call today from Hangzhou, China.

Given our location, we ask for your patience in the unlikely event that we experience some delays particularly during the Q&A portion of the call.

Remarks to be made on this conference call contain forward-looking statements made pursuant to the Safe Harbor provisions or the Private Securities Litigation Reform Act of 1995. These include forward looking statements regarding H3C integration activity, leveraging H3C, the purchase accounting impact of the H3C acquisition, strategic initiatives, including our intent to separate the TippingPoint business from 3Com, future financial performance, financial condition and cash flows, future expense controls and savings, products 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.

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 or on the IR portion of the website www.3Com.com. The press release is also available on the Investor Relations section of our website.

With that, I will turn the call over to our President and CEO, Edgar Masri. Edgar?


Tech-Stock Prospector seeks out promising small- and large-cap technology stocks offering a combination of growth and value. The research service is made up of Daily Online Updates at TechStockProspector.com, Action Alert e-mails and a 12-page monthly newsletter.

Editor Robert DeFrancesco, formerly senior writer at Louis Rukeyser's Wall Street, has covered the tech market for 15 years. He uses both fundamental and technical analysis to put together two long-term model portfolios. Tech-Stock Prospector also offers Trading Ideas and maintains a Watch List of potential additions to the portfolios.

To sponsor a Seeking Alpha transcript click here.

Edgar Masri

Thank you, John, and thank you everyone for joining us on the call, as we review our fourth quarter and fiscal year '07 results. As John mentioned, we are conducting this call from China. While I did the call from China last quarter, this time I am joined by several members of the management team. And this is a reflection of the time commitment being made by 3Com to China, as well as the ongoing efforts in the integration of H3C in particular.

Before I get too far in to my comments, I would like to introduce Jay Zager, who is here with us in China. Jay joined our management team this week as Executive Vice President and CFO.

Don Halsted will discuss the details of our financial performance for the full fiscal year and our fourth quarter. But moving forward, Jay will assume this responsibility. Welcome Jay.

Now let me share my thoughts on fiscal 2007, our fourth fiscal quarter financial performance and the integration of H3C. In fiscal 2007, we were focused on two priorities, improving our financial performance with specific attention on profitability and cash flow, as well as, laying the foundation for our long-term strategy. I believe that we have taken several positive steps to address these priorities.

This past fiscal year, 3Com made the strategic decision to focus our resources on reinventing the company as a leading global networking provider. We acquired H3C, and now have annual revenue of $1.3 billion. This represents an increase of 11% year-over-year on a pro forma basis, assuming the consolidation of the H3C business.

Through H3C, we now have a robust portfolio of enterprise networking solutions, that we can leverage to grow our business, and we have access to a highly talented team of engineers to help us deliver high quality, low cost products.

We also reached a major financial milestone generating $27 million in non-GAAP operating profit for the year, including three consecutive quarters of non-GAAP operating profit.

We generated $166 million in cash flow from operations for the full fiscal year, and we were cash flow positive for the year for the first time in four years. Other proof points of our financial improvements include; first, FY '07 revenue for our SCN segment was $643 million, with our sales of TippingPoint products and services contributing a record $90 million for the full fiscal year, which has an increase of 27% over the prior year period.

Also within SCN segment, we saw a 29% improvement in the net loss. At our H3C segment, we recorded record revenue of $731 million for the year, an increase of 44% over the prior year standalone results.

From a strategic standpoint, consistent with our emphasis on building a global enterprise networking leader, the combination of 3Com and H3C is now recognized by many analysts as the second largest provider in the industry.

For example, the analyst from Dell'Oro, who recently reported that 3Com is the second largest provider of enterprise stackable switches in the terms of fourth-tier, with approximately 13% market share.

Our emphasis on focus and execution is yielding positive results. The cornerstone of our plan to build a global networking provider is to leverage H3C and our OSN strategy. As a result, we concluded that the dedicated high-end security solutions of TippingPoint were not a core part of the strategy. And so, earlier today we announced that we intend to separate TippingPoint from our core business.

Due to SEC regulations, I cannot give specific details on the TippingPoint separation, and I will not be able to answer specific questions on this action.

Clearly we made significant progress in fiscal 2007, but our improvement was not just on a fiscal year basis. Our fourth quarter also yielded positive results. In Q4, our non-GAAP operating income was $12 million, an $18 million improvement over the fourth quarter of fiscal '06.

Another major achievement for 3Com was $71 million in positive operating cash flow for the quarter. This was driven by H3Cs' strong cash flow, reductions in SCN operating loss, as well as 3Com balance sheet improvement. Total consolidated revenue in the quarter was $311 million, down 4% quarter-over-quarter, but up 22% year-over-year.

Now, if we had consolidated the full three months of H3C a year ago, revenue would have been up 4% year-over-year.

Our North America business posted solid 7% growth year-over-year, largely driven by growth in our Networking and Security business, particularly sales of our Gigabit switches and our resale of H3C products which increased again this quarter.

Last week, I spent sometime with our North America and Latin America sales team at their kickoff meeting and it is clear that our ability to sell Secure Converge Networks and Voice Ready Networking Solutions is helping us win with customers.

One of our key differentiators is the investment protection that we provide customers. Because our products are based on open standards, applications such as voice and video, as well as Open Source and other best of breed applications can be added to the network without requiring forklift upgrades.

By leveraging the strength, I believe we are well positioned to capitalize on our differentiated product strategy, as well as our market leading position.

Now let's move on to TippingPoint and our other security products. As I mentioned earlier, due to regulatory rules, we will not be commenting or taking questions on the announcements that we made this afternoon in a separate press release regarding TippingPoint.

Our sales of TippingPoint, products and services this quarter were $25 million, up 32% year-over-year. TippingPoint signed a record number of new customers during the fourth quarter and we believe that IPS and NAC products aimed at large enterprises continue to be among the leading IPS technology products on the market. TippingPoint strategy remains centered on Bi-Planar networking and in applying overlay approach.

The 3Com sales team and channel continue to sell TippingPoint products such as the E-Series and Digital Vaccine Service. Additionally, earlier this quarter 3Com announced the availability of our X-Family Unified Security Solutions for the SMB and Mid-Enterprise market, which is based on TippingPoint technology.

Now from a general perspective, we will also deliver security solutions to enterprises through our OSM platform. H3C, also has a line of security products currently for the emerging markets and we will look to leverage these for the developed markets where possible.

Speaking of H3C, I want to spend a little time talking about H3C's performance and specifically our integration progress. I often get questions about how the integration is going. I can tell you that our integration efforts are making significant progress. Let me give you a couple of examples of the positive steps we are taking.

For example, in two weeks we will be announcing the completion of the first phase of the integration in Asia-Pacific. During the event, we will introduce the country managers, and sales and marketing teams in the region.

Also, earlier this month, we announced that we successfully integrated the sales team in Latin America. And North America integration is underway. We intend to begin the sales force integration efforts in EMEA this quarter.

Anyone, who has worked for a company that goes through an integration of this magnitude, knows that it takes a lot of work and cooperation from all team members, and I'm optimistic, about the growth prospects of the combined company as we move through FY '08.

For the quarter ended March 31, 2007, H3C reported $176 million in total revenue, that's up 13% year-over-year when compared to the non-GAAP, pro forma revenue for the prior year period. While revenue was slightly below what we guided, H3C did meet our internal profitability targets.

Overall, we are pleased with the direction H3C is heading. We have increased focus on higher margin products and sales of H3C's networking product by our SCN segment, which grew on both a year-over-year and sequential basis. We believe that H3C continues to be a growth driver for the company.

In summary, FY '07 was a year of positive achievements and improvements for our business. We achieved meaningful non-GAAP operating profitability, delivered positive cash flow from operations, and increased market share. While there is more work to be done. I am pleased with the overall progress we are making; and I'm very excited about our positioning and the market opportunity we see in front of us.

Now before I turn the call over to Don, for a detailed review of our financial results. I would like to personally thank him for his contribution to 3Com. Don has worked very hard during his tenure and he has put in place a great team that we will be able to leverage as we focus on continuing to improve our performance and efficiency on a global scale. 3Com enters FY '08 a much larger and stronger company compared to a year ago. Thank you, Don.

With that, I will turn the call over to Don.

Don Halsted

Thank you, Edgar. With the completion of our acquisition of the remaining 49% ownership in H3C, we will increasingly focus on the consolidated results of the company. But we will continue to provide limited news of segment performance. I will start today with a review of the full fiscal year, followed by the results of our fiscal fourth quarter.

Before proceeding through the financial review, it is important to note that there are four items that impact the presentation and comparability of our results. First, we completed the acquisition of H3C in the quarter. This $882 million acquisition results in substantial purchase accounting charges in this quarter and future quarters. The deal closed on March 29, one workday before the end of the H3C fiscal quarter. The most significant purchase accounting charge in this quarter is an in-process R&D charge of $34 million. In addition, there is incremental intangible asset amortization and a fair market value markup of finished goods inventory in the period which gets amortized as a charge into cost as the inventory is sold.

The impact of these last two factors on our operating results are small this quarter, because we only recorded one day of amortization consistent with H3C's period end. We will review these impacts further when addressing next quarter's (inaudible).

The acquisition triggered the initial EAR pay program vesting, a total of $94 million of payments vested as a result of the acquisition. 3Com and Huawei had initiated this program several years ago as an incentive towards increasing value prior to a shareholder buyout. This program was described in our last call and in our last 10-Q. This caused an incremental charge in the quarter of $57 million comprised of $6 million charge to cost, and $51 million in operating expense. This portion of a total cost of the program was taxed, typically to the change in control of H3C, when 3Com bought the remaining 49%, versus the unvested portion which vests over the next three years.

Because it's a one time event triggered by the transaction and we believe not indicative of our core operations, we've excluded this $57 million charge from our non-GAAP operating income. This vesting occurred immediately prior to the closing of the acquisition, resulting in the impact being included as a factor in the calculation of the final period minority interest of Huawei. The impact in net loss therefore is 51% or $29 million.

Thirdly, we started to consolidate H3C when we increased our ownership to 51% during our fourth quarter fiscal 2006. However, due to the timing of the acquisition and the two month difference in our consolidation of H3C results, we had only consolidated two months of H3Cs activity in that quarter.

Given the size of H3C relative to total 3Com, this makes the GAAP comparisons to prior years not as meaningful. I will therefore continue to use pro forma and pro forma non-GAAP results for a more meaningful year-over-year comparison. These pro forma results assume consolidation from the beginning of the relevant periods.

Absolute values and reconciliation for these values can be found on our web page. Starting next quarter, this will not be necessary as the comparison periods will include full consolidation of H3C.

And fourth and lastly, we have completed our first fiscal year after adopting FAS 123R, prior periods are reported prior to the adoption of FAS 123R.

Let me turn to the detailed review of our financial results, beginning with the consolidated full year numbers. Our GAAP revenue for fiscal 2007 was $1.267 billion, compared to $795 million for the fiscal year 2006. This represents an 11% growth over our pro forma revenue numbers of $1.147 billion for fiscal 2006, driven by growth in our H3C segment offset in part by declines in our SCN segment.

Our GAAP operating loss for the fiscal year improved $25 million over fiscal 2006, and our focus measure of non-GAAP operating income improved $129 million to a positive $27 million for fiscal 2007. This improvement was driven by non-GAAP operating loss reductions in SCN, operating profit increases in H3C, and the inclusion of a full year of H3C results.

Cash flow from operations for the fiscal year 2007 was $166 million compared to a negative cash flow from operations in fiscal 2006. Our GAAP net loss was reduced by $12 million in the current fiscal year, comprised of operational improvements of $75 million offset in part by $63 million of in-process R&D charges, and our portion of the change of controlled ERP charges. The fiscal fourth quarter consolidated revenue was $311 million, a 22% year-over-year increase compared to 3Coms' historical GAAP results.

The more meaningful comparison is against a pro forma form of revenue that includes the full three month's of H3Cs' results for the prior year quarter, as if we had consolidated H3C in the beginning of that period.

On this basis, the year-over-year revenue growth is about 4%, comprised of 13% growth in H3C, offset by a 2% decline in SCN. Table C in our press release provides geographic and product-based supplementary revenue disclosures.

China revenue declined 8% sequentially to $142 million. As a reminder, China sales consist of our direct sales as well as OEM sales in the Huawei's China based hub, both of which declined sequentially reflecting the seasonal impacts in the reported periods for Chinese New Year.

Our China-based sales did increase over 10% on a year-over-year basis, compared to the prior period non-GAAP pro forma H3C results. Our APR region sales declined sequentially 11% driven by H3C sales, which like their China sales were seasonally soft due to the Chinese New Year.

North America revenue grew 5% sequentially, more than offsetting the absence of a $4 million revenue sharing payment included in the prior quarter. In addition, North America increased 7% compared to the prior year period, despite the prior year period including $4 million in Legacy Connectivity product sales.

Our Connectivity product sales have essentially gone to zero. Sequential and year-over-year increases were seen in networking, security and voice product sales. We believe this healthy year-over-year and sequential growth in North America significant, as it demonstrates a return to growth after implementing and maintaining a significant expense reduction taken in our go-to-market infrastructure announced in the restructuring plan one year ago.

Our Latin America regional sales declined sequentially 6% and year-over-year of 10%. EMEA was about flat sequentially into the prior year quarter results. The focus of the restructuring in EMEA in the past six months has been on rationalizing the sales with higher margin business. While the revenue is about flat, the quality of the revenue has improved, and is contributing to the continued SCN margin improvements.

On a product basis, all of our ongoing product areas delivered year-over-year growth. Networking sales increased over 27% over the prior year period, driven by the inclusion of a full three months of H3C results plus growth of 5% in product sales.

On a sequential basis, networking sales were down 3% driven by lower sales in China. Sales of H3C networking products outside of China grew year-over-year at just under 40% on a pro forma basis, with the strongest growth regions been North America and EMEA.

Security product sales increased by 31% over the prior year period and 6% sequentially. The increase over the prior year period is primarily driven by growth in our sales of our TippingPoint products and to a lesser extent inclusion of a full three months of H3C.

The sequential increase was primarily due to a return to higher level of sales in our embedded firewall offerings. In the period, sales of our TippingPoint products and services were $25 million, a 32% increase over the prior year period sales of $19 million and up marginally sequential.

In each quarter of the past fiscal year, our sales have grown compared with the same period in the prior year, with full year 2007 sales of TippingPoint products and services of $90 million, representing a 27% year-on-year growth.

Voice products increased 16% over the prior year period, driven primarily by the growth in the SCN voice sales and the inclusion of a full three months H3C. Sequential voice revenue was down 10%, driven by softer China-based sales offset in part by single-digit growth of the SCN voice sales.

Gross margins declined sequentially 2 percentage points from 47% to 45%, but increased over the prior year period by 1 percentage point. The current period margin is adversely affected by 2 percentage points, due to a $6 million in cost associated with the ERP change-of-control [investing], which impacts the sequential and year-over-year comparisons.

Sequentially, margins also declined about 1 percentage point for the absence of a 100% margin revenue sharing arrangement in the third quarter.

Given the significance of the impacts reviewed above, I'll be reviewing our operating expense on a non-GAAP basis, excluding the impact of ERP charge, the in-process R&D charge, as well as stock-based compensation, which was $5 million in the quarter.

Reconciliations in the GAAP to non-GAAP values are available on our web-page and are on table D of our press release. Our non-GAAP operating expenses were in aggregate $133 million and comprised of sales and marketing, research and development, and general and administrative cost, without ERP charges and stock-based compensation.

This compares to a $117 million for the prior period, which only included two months of H3Cs' operating expenses. The $16 million increase is explained by the inclusion of a full three months of H3C operating expenses, partially offset by a $10 million reduction in ongoing business expenses. The prior quarter's non-GAAP operating expenses were $144 million. The sequential decline of $11 million was primarily due to lower expenses in H3C, consistent with the seasonally soft revenue in the quarter ending March 31. The timing of certain H3C incentive accruals, and a continued decline of expenses in SCN.

Amortization for the period was $8 million and restructuring charges were less than $1 million. The reduction in amortization charges of $2 million sequentially is due to the completion of amortization of certain three year life intangible assets from the original formation of the H3C joint venture.

The GAAP operating loss for the fourth quarter was $93 million a $84 million sequential increase and a $72 million increase over the prior year period. This increase in our loss was due to the $91 million of in-process R&D and the ERP charges described earlier, offset in part by improved operations.

For over a year, management has been reporting 3 Com's non-GAAP operating income as the single best measure of operating profitability.

The reconciliations to GAAP operating losses loss is provided in table D of our press release. Non-GAAP operating income was $12 million in the fourth quarter, representing the third consecutive quarter of positive non-GAAP operating income. This is a year-on-year improvement of $18 million. The non-GAAP operating increase over the prior year period results from improvements in SCN's non-GAAP operating results and the inclusion of the full three months of H3C.

Interest income net for the period was $8 million, which is a decrease of $3 million sequentially and $1 million over the prior year. Sequential and year-over-year declines were both driven by the lower cash on hand in the SCN segment, following the acquisition of H3C.

Other income net for the period was $12 million, versus $10 million in the third quarter of fiscal 2007. This increase was driven by a net $4 million gain on the final portion of our insurance settlement, associated with the explosion last year that destroyed our Hemel, UK facility, partially offset by a decline in the level of H3C operating subsidies funded by software VAT taxes. Provision for income taxes was $5 million in the quarter, which is up sequentially.

In our fourth fiscal quarter, we recorded a minority ownership benefit to our results of $13 million as Huawei shared the financial performance of the consolidated of Huawei -3Com joint venture, for his it's performance in the period.

The net loss for the fourth quarter was $66 million or $0.17 per share, of which restructuring, amortization, stock based compensation expenses, are a portion of the ERP change control charges and in -process R&D represented about $77 million or $0.19 per share. This compares to a prior-year quarter net loss per share of $0.04, which included $0.04 per share of restructuring, amortization, stock based compensation expense and in process R&D.

Weighted average number of shares outstanding during the quarter was 396 million. The net increase of 2 million shares in the prior quarter is primarily due to the issuance of restricted stock units and of our semi-annual employee stock purchases plan purchases.

I will now move on to the liquidity review. Cash and cash equivalents totaled $559 million, which is a net decline of $397 million from the balance at the end of the previous quarter. The change includes a decrease in cash and cash equivalents of $284 million and a decrease in short -term investments of a $113 million. Key components of the change in cash and cash equivalence equivalents for the quarter are the following.

First, cash used in the acquisition of the remaining interest in H3C was approximately $891 million. Second, cash received for the issuance of debt at H3C level, net of debt issuance cost was $416 million. Third, cash generated by operations was a positive $71 million, driven by continued strong H3C cash flows, continued strong working capital management, offset in part by single-digit cash consumption of SCN. And fourth, cash received for the net sales of investments was $113 million at the SCN levels, as we executed our incremental acquisition of H3C.

The quarter ending cash, and cash equivalence equivalents in and short -term investment balance of $559 million is comprised of $230 million in SCN and $329 million in H3C.

We have included a full year cash flow statement in Table F of the press release. The full year cash flow from operations of $166 million, is comprised of $247 million in H3C offset in part by $81 million of cash consumed in SCN. The H3C cash flow is not comparable with prior year, since fiscal 2006 only included two months of H3C. The SCN operating cash consumption with a $37 million improvement compared to the fiscal 2006 and the fourth quarter cash used in operations in SCN, was less than $5 million.

Other items of note, compared to the fiscal 2006 year end consolidated balance sheet, include net inventory, decreased $40 million, driven primarily by continued managed inventory reductions in the H3C operating segment.

Intangible assets and goodwill increased $672 million, resulting from the incremental acquisition of H3C. And accounts payable and accrued expenses increased $75 million within the period, primarily for the accrual for the vested ERP payments tied to the a change of control.

I will now move on to a limited 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 a $163 million, a $6 million sequential improvement but a $3 million decline compared to the same quarter last year. The sequential improvement was lead by growth in our North America region. Year-over-year decline is comprised of an $8 million decline in the sale of our Legacy Connectivity products, and slightly declining networking sales, partially offset by growth in our Security and Voice offerings, which grew 28% and 13% respectively.

We believe that this demonstrates a return to growth in our core business at just after our significant restructuring last year. SCN gross margins decreased s four percentage points sequentially to 37%. About two percentage points of this decline was due to the absence of the $4 million revenue share in arrangement in Q3, with the balance primarily driven by costs and product mix.

Gross margins increased one percentage point compared to the prior year quarter.

A year ago, in our year -end 2006 call, we announced a restructuring focused on our non-TippingPoint SCN business to reduce expenses. Our SCN sales and marketing, R&D, and G&A expenses were $338 million in fiscal 2007, a reduction of $81 million or 19% compared to fiscal 2006.

Turning now to the H3C operating segment; I am going to compare the reported segments' fourth fiscal quarter financials, which was the quarter ending March 31, ‘07 against prior quarter financials in the pro forma non-GAAP segment results presented in our press release adjusted to include a full three months of activity.

H3C revenue for the quarter ending March 31, 2007 was $176 million, a 10% sequential decline, but a 13% year-over-year improvement. H3C sequential decline is due primarily to this period being a seasonally slower sales quarter in Asia due to the Chinese New Year in February.

H3Cs' gross margin was 45%, down 1% sequentially and down 4% year-over-year. The impact of the $6 million ERP charge to cost was about 3 percentage points in the quarter, which was partially offset by reductions in other costs.

H3Cs' direct operating expenses for the quarter were $107 million, a sequential increase of $43 million. This is made up of the $51 million expense tied to the change-of-control portion of the ERP, partially offset by lower ongoing operating expenses tied to the lower sales in the quarter.

Overall, our H3C segment contributed a net loss of $60 million for the quarter. The loss was driven by the inclusion of $91 million in charges for the ERP change-of-control and the in-process R&D.

With all of the recent changes, it is appropriate to give some business guidance and also to discuss the financial effects of the acquisition of H3C.

First the business guidance; in the first quarter of fiscal 2008, we expect to see single-digit growth in consolidated total revenue driven by sequential growth in TippingPoint and H3C, offset in part of the seasonally soft Q1 and the rest of SCN.

Although, this is a period of integration investments, we expected that the first quarter operating profit non-GAAP will be positive, marking the fourth consecutive quarter.

Secondly, there are four financial aspects to the acquisition that I want to address. First; the ERP [tail]: Following the initial ERP payments of $94 million, which will occur in our next fiscal quarter. There is a fixed obligation invest over three years in the closing. The annual vesting is estimated at $39 million, $30 million and $17 million for fiscal years 2008, 2009 and 2010 respectively.

The impact in our first quarter will be about $10 million, which is $4 million to $5 million more than the embedded run-rate. We will not be adjusting for these amounts till our operating profit and non-GAAP guidance reflects this cost.

Secondly, Purchase Accounting will have an impact to gross margin of about $6 million in each of the next two quarters, due to the required fair market value mark-up of the acquired finished goods inventory, and we will be incurring additional amortization charges of $18 million per quarter. This means that the total amortization for the next quarter will be about $25 million. These costs are excluded from the operating profit non-GAAP.

Third, financing, we closed the acquisition in financing from the 29 of March, 2007. H3C results were for the quarter ending 3/31, there was only one day of interest in the reported fourth quarter results. Full quarter effects will be seen in the next quarter. I expect the interest charge to be about $9 million in the quarter.

And fourth and finally, the Huawei minority interest. The minority interest charge ceases for the acquisition of a 100% of H3C. For reference, in Q3 which was unaffected by acquisition cost and accounting, the minority interest $15 million and this goes away.

Let me now turn the call back to Edgar Masri for comments on fiscal 2008 before opening the call up for questions and answers. Edgar?

Edgar Masri

Thanks, Don. Before I open the call for questions and answers, let me share a few comments about two key areas of focus for us in FY '08. Our first goal is to complete the sales and marketing integration across all regions in the first half of the year.

We believe that this will enable us to run a more efficient and effective organization. It will also allow us to take a more holistic view of the company. Ultimately, we will look at 3Com as one company with an enterprise business, SMB business and a TippingPoint business.

Our second objective is to show profitable revenue growth. For the full year, we expect each of the three major business units to grow on a year-over-year basis. We believe H3C will return to growth in FY '08, beginning with a modest increase in its quarter ending June 30, 2007. Revenue is expected to be in the range of $180 million to $185 million.

On the expense side, we intend to invest in our service, support and supply chain infrastructure during the first half of the fiscal year, which we believe will translate into cost savings in the second half of the year.

In FY '07, our emphasis on focus and execution yielded positive results and helped us stabilize the business, particularly in the SCN segment. I believe we are now at a point, where we have an opportunity to grow and improve our non-GAAP operating profitability.

With that, I will open this call out to your questions. Thank you.

Question-and-Answer Session


(Operator Instructions). And we will go first to Matt Shimao with Bear Stearns.

Matt Shimao - Bear Stearns

Hi guys. First of all, welcome to 3Com Jay and best of luck Don. Thank you.

Edgar Masri

Thank you.

Don Halsted

Thank you, Matt.

Matt Shimao - Bear Stearns

So, I wanted to just ask a fundamental question on the H3C business related to the $90 million or so of EARP bonus going forward over the next three years. I think you indicated in the past that these bonuses are not expected to degrade the H3C earnings power. So, are you basically indicating that you expect, on average over the next two years roughly a $100 million per year of H3C profits?

Don Halsted

Matt, this is Don. I am not going to get into guidance on the process over the next couple of years. The comments that we've made before is that the vesting of the tail of the EARP is basically within a range of what we have for operations. As I indicated in the guidance I did get for next quarter. The total of the charge will be above what's in the run rate by about $4 million or $5 million. But my overall comment stands, that I am not going to use that to leverage into a three year projection.

Matt Shimao - Bear Stearns

Okay. Thank you very much.


Thank you. We will take our next question from Manuel Recarey with Kaufman Brothers.

Manuel Recarey - Kaufman Brothers

Thanks. You spoke about the strength in networking especially in North America and EMEA, can you give a little bit more color on what was driving that? Was it enterprise spending or is it better execution on 3Coms' part?

Edgar Masri

Yes, thank you Manny this Edgar. Let me separate your question, you have two questions North America and EMEA. In North America, and I spend a lot of time of the team there. We have a great team, they have done a great job. It is primarily because over the past year, we introduced some leading Edge Switching products. The 5,500 is the world leading class product, and this has helped us sell a lot of secured converged networking.

Second, we got a security product with the X-family, that came out that quarter and it was well accepted in all channels in the US. And overall, we have a team that has been building up strength and we're adding selectively direct touch people throughout the region. That's what led to North America's strength.

I think, well, I don't have the data yet for Q2, I think we are gaining share in North America. But definitely, I'm pleased with this growth because it seems to buck the trend of our competitors who have had more anemic growth or even decline in North America.

On EMEA, what we have been focusing on and the team there has done a phenomenal job, again to focus on contribution margin. We had a region that had suffered from the loss of a General Manager a several quarters ago due to sadly death. But the new leadership there is very, very focused on contribution margin, and we would like to now see it turn like North America into growth.

Manuel Recarey - Kaufman Brothers


Edgar Masri

Thank you, Manny.

Manuel Recarey - Kaufman Brothers



Thank you. We'll take our next question from Long Jiang with UBS

Long Jiang - UBS

Yes, hi. Good afternoon. My question is related to the tradition of the 3Com business. If I did my math correctly, looks like operating margin for the tradition of 3Com was negative 11%, excluding options. So, I think that they had shown some pretty solid year-over-year improvement. My question is, do you have a target in terms of when do you plan to breakeven on the traditional 3Com business with or without TippingPoint consolidation?

Don Halsted

Hello Long, this is Don. One of the comments I made at the beginning of the presentation is we are going to be increasingly looking on an ongoing basis, on a consolidated business. And the reason for that is twofold. Inside the numbers that you quoted, and that sounds about right, I don't have that exact math in front of me. But inside of that you have a couple of phenomenons. The first is that a 100% of the corporate expense is in the SCN side of the ledger. Secondly, we have a significant portion of the sales in SCN, which are a resale of the products from H3C that drives the revenue eliminations. So, in fact increasingly, the way to look at the business, is to look at the business on a consolidated basis. So, while we do have objectives of continually improving the results in the SCN segment, you are going to see it's increasingly looking at a see through basis because that's the most comparable to the competition and our competitors.

Long Jiang - UBS

Perhaps with a follow-up question, for TippingPoint I know you are going to break it out in the future. Can you talk about TippingPoint's operating contribution to the operating income?

Don Halsted

Unfortunately, at this time, we cannot talk about that and that really is governed by some of the SEC regulations. We started in the last quarter to give some revenue breakups and we were able to do that to give you a sizing of the revenue, but that's likely going to have to wait for the S1.

Long Jiang - UBS

Okay. Thanks.


Thank you. We'll take our next question from Mark Sue with RBC Capital Markets.

Jenifer Tenenbaum - RBC Capital Markets

Hi guys, this is actually Jenifer dialing in for Mark. Just to follow-up on Manny's question on North American enterprise, can you talk a little bit about who you are gaining share from and which verticals are strong or which way you're facing strength or weakness from? And then secondly, can you also talk about the environment in China? We actually met with Cisco last week and they said that they were struggling a bit there, so we wanted to know your thoughts?

Edgar Masri

Yeah, thank you, Jenifer. North America, again in another month and a half, the analyst will show market share. But as you all know, we have been very successful in the vertical market and this is a very good period, it starts around May and it goes all the way in to August, September. We have one major competitor, so we typically run into that competitor most often. But what has been helping us, is our OSN plan, our ability to complement our solution with voice. I mentioned earlier security, but more and more video.

And I have been very, very impressed by how creative the team in North America has been able to leverage the video opportunity. The tragic situation in Virginia Tech actually got the whole education and university segment to focus a lot on video surveillance, and that actually played well into our ability to show a set of converged solutions through primarily partnerships in that space.

Your next question was about China and the enterprise business. We have been very successful in this business, as you know and we have a very, very healthy market share, and it's the one that has grown by almost three folds in just two and a half years. The opportunity is still there, we have had obviously to deal with the uncertainty during the acquisition part of H3C and some of the distraction around the integration. But overall, I continue to be very optimistic about the China business. It tends obviously to deal with macroeconomic levels. But right now China seems to show growth and we're counting on growing at least the same level as the market.

Jenifer Tenenbaum - RBC Capital Markets

And just lastly, one more question, can you also talk about which countries in EMEA seem to be performing particularly well for you?

Edgar Masri

We have seen great success in the U.K and we intend to add to our sales force there. One thing that the team there has done phenomenally well, is within a period of one year, if you were to sort of zero in on EMEA, we've reduced our expenses and costs by almost a half and yet increase our contribution margin in dollar. Another country that is very promising for us is Russia, and we feel that this is also at the macro level a very promising country and we have a great sales team there on both sides and we intend to continue pushing forward in that region.

We've had selected wins in France and Spain at the enterprise level which are encouraging but I would term them right now as an anecdotal.

Jenifer Tenenbaum - RBC Capital Markets

Okay, thank you very much and good luck.

Edgar Masri

Thank you, Jenifer.


(Operator Instructions). And we will take a follow up from Matt Shimao with Bear Stearns.

Matt Shimao - Bear Stearns

Thank you. So, Edgar, I wanted to follow-up on a comment you made. I think you said at the end that you plan to invest in your service support and supply chain infrastructure in the first half of the year. Can you characterize the level of investments? And then I think you said that will translate into cost savings. So, can you explain that a little bit more what you mean by that? Thank you.

Edgar Masri

Sure. Thank you, Matt. I will turn that to Don for most of it. At a very high level, enterprise networking is about customer intimacy, about service and support. We've been relying on an outsourcing model for the past couple of years, and we intend to take matters in our own hand, which I believe, will be in the best interest of our customers, and ultimately will give the best results for us.

That's what we are undergoing and you can imagine, therefore, that there is a period of transition, where the costs are ramping up in one level, while they are ramping down on the other. So there is going to be an overlap, and soon this overlap will take us till October, November timeframe. Beyond that, we are going to quickly start seeing the benefits of the ramp down on the outsourced offering.

On supply chain, we believe by working very closely between the H3C and 3Com team, we can leverage better component pricing and better overall designs for manufacturing. This has enough start costs that will end up yielding results beyond that. I am going to turn to Don to be more specific to your question.

Don Halsted

Okay. Hello, Matt.

Matt Shimao - Bear Stearns


Don Halsted

We are going to be investing principally in the next two quarters in the service structure. From an overall cost standpoint on the SCN side of the ledger, it's likely to run 1%, 2% impacting margin, and then you start to get return on that in the third and the fourth fiscal quarters. So, it’s going to be a fairly short turnaround, and part of that when you are changing an outsourcing model, you actually end up with some duplicate carrying costs during the time.

There was a little bit of that cost actually already reflected in the [actions] we had in the fourth quarter, and that was part of the contribution to the margin explanation in my comments.

Matt Shimao - Bear Stearns

Great. If I could ask another question, now, roughly how much of H3C sales right now are due to security, video surveillance and storage, and what kind of growth are you expecting in this category over the next year or two?

Edgar Masri

We don't break down this number, but it's still small, I would say, but growing very nicely. And one thing that is very, very exciting about it is, it actually supports one of the highest, if not the highest margin within the H3C portfolio. We are starting to introduce those products in APR outside China. And while it's early to tell, I expect it to have the same success as it has had in China over the past couple of quarters.

Matt Shimao - Bear Stearns

And with the SCN business up overall, I guess, you guys are indicating Q1 could be little weak seasonally, but are you pretty secure now that SCN is back on a steady consistent revenue growth track when we look at the year-over-year?

Edgar Masri

I am quite confident. As I told you North America and Latin America, two regions are humming and EMEA is starting to now add direct selected people because they feel that the profitability level now could justify an increase in sales force.

Matt Shimao - Bear Stearns

Great. Thank you.

Don Halsted

And Matt, just to add one point to that, in the last quarter in the SCN, if you look at the operating expenses, they were down about $2 million. And what that really means is the vast majority of that significant reduction happened earlier in the year and we've now be going through the stabilization period, and that's the reason or one of the reasons for the confidence in Edgar's comments.

Matt Shimao - Bear Stearns

Great. Thanks a lot.

Edgar Masri

Thank you, Matt.


Thank you. And at this time it appears there are not further questions. I would like to turn program back over to Edgar Masri for any additional or closing comments.

Edgar Masri

Thank you. Well, I appreciate everybody's listening on this call, and look forward to talking to you in the next quarter. Thank you.


That does conclude today's conference. You may disconnect your lines at anytime.


Tech-Stock Prospector seeks out promising small- and large-cap technology stocks offering a combination of growth and value. The research service is made up of Daily Online Updates at TechStockProspector.com, Action Alert e-mails and a 12-page monthly newsletter.

Editor Robert DeFrancesco, formerly senior writer at Louis Rukeyser's Wall Street, has covered the tech market for 15 years. He uses both fundamental and technical analysis to put together two long-term model portfolios. Tech-Stock Prospector also offers Trading Ideas and maintains a Watch List of potential additions to the portfolios.

To sponsor a Seeking Alpha transcript click here.

Copyright policy: All transcripts on this site are the copyright of 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.


If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!