Ribbon Communications Inc.
Q2 2008 Earnings Call Transcript

Published: 12 Aug 2008

[Operator:]

Welcome to the Sonus Networks second quarter fiscal 2008 financial results conference call. (Operator Instructions) I’d now like to turn the conference over to Karen Cellupica from Investor Relations.

[Karen Cellupica:]

With me on the call this afternoon are Richard Nottenburg, President and Chief Executive Officer, and Rick Gaynor, Chief Financial Officer. After the market closed, we issued a press release announcing our results for the second quarter 2008. The text of this release, along with the accompanying income statement, balance sheet and operating statistics, as well as the reconciliation of the most directly comparable GAAP financial measures to any non-GAAP financial measures used during this call and for certain prior periods, are available on the Investor Relations section of our website. Before Richard offers his opening remarks, I would like to remind you that during this call we will make projections or forward-looking statements regarding items such as future market opportunities and the company’s financial performance. These projections or statements are just predictions and involve risks and uncertainties such that actual events or financial results may differ materially from those we have forecasted. As a result, we can make no assurances that any projections of future events or financial performance will be achieved. For a discussion of important risk factors that could cause actual events or financial results to vary from these forward-looking statements, please refer to the risk factors section of our quarterly report on Form 10-Q for the period ended June 30, 2008. Any forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date. While we may elect to update forward-looking statements at some point, we specifically disclaim any obligation to do so unless required by law. During this call, we will be referring to non-GAAP financial metrics. These non-GAAP metrics are not prepared in accordance with the generally accepted accounting principles. For important commentary on why the management team considers non-GAAP information a useful view of the company’s financial results, please consult our filings with the SEC. I would now like to turn the call over to Richard Nottenburg.

[Richard Nottenburg:]

. It is a pleasure being with you today. With me here is Rick Gaynor, our Chief Financial Officer, and also Vikram Saksena, our Chief Technology Officer. We are here to review results for the second quarter, the first half of 2008, and to provide some perspectives on the business. We emphasize the change of format of this call from prior earnings conference calls. I will first give you an overview of the second quarter and some of my initial impressions from my first seven weeks as CEO before handing the call to Rick for an in-depth financial look at the quarter. I will then continue the call with additional color for our outlook for the back end of this year and a few thoughts on my approach to leading this company. One small item - I have decided to dispense with the slide deck. Let me begin saying that I am excited to be here and I am proud of the Sonus team for delivering revenue in the high end of our original Q2 outlook and earnings that exceeded expectations. Key takeaways from the second quarter include revenue was $87.9 million for the quarter, up 16% compared with the same period a year ago; non-GAAP operating income was $12.9 million for the quarter, up just over 300% year-on-year. Our book-to-bill ratio was greater than 1 for the first half of 2008, compared to a ratio that was less than 1 for the first half of 2007. Design wins announced include COLT, Tata Communications, Bahamas Telecom, Convergia and PTV Telecom. I know that many of you are interested in my initial impressions of the company, the markets we serve, the competitive landscape, and the customer environment. Many of you are also interested in my approach to leading the business and how I intend to position the company for the future. When I joined Sonus Networks in mid-June, I stated that my first 100 days would be spent listening and learning about Sonus. Over the past two months, I’ve had the opportunity to review the company’s operations, its assets, engage with our employees and spend time with many of our largest customers, prospects and our largest investors. I appreciate these inputs and will integrate some of them as we move forward. In addition, I know that many of you have questions about our relationship with our largest investor, Legatum. Sonus has engaged with Legatum and is having constructive dialog. I will continue to engage with all shareholders and believe the best way to create value is to focus on the business. What I have observed during my first seven weeks as CEO is that Sonus has many great assets, including smart and talented people, great customers, the best scaleable carrier rate IP architecture for intelligent session control in the industry, well-engineered products that work, sought after thought leadership, and high value beachfront property within the networks of many of the largest global operators. There are many positives at Sonus, and there is much work to be done. Seven of my priorities during the next 12 months will be to one, strengthen the single leadership team and build a winning culture; two, provide clarity around vision and strategy; three, focus on execution, increase organizational efficiency, speed and agility; four, build more predictability into the business; five, expand the number of Tier 1 anchor tenants in our customer base; six, drive innovation through profitable growth; seven, focus on prophecies that drive quality and customer satisfaction. I have observed Sonus for a number of years, and I am really excited to be part of this next chapter. I will have more to say about the business and market in a moment, but now I would like to turn the call over to our CFO, Rick Gaynor.

[Richard J. Gaynor:]

I am pleased to report that we delivered solid Q2 financial results. Revenue was in line with outlook, and we significantly outperformed expectations on gross margin and operating income. Before I continue, I’d like to extend my appreciation to the Sonus team whose steadfast focus enabled us to achieve these strong results. Please note that throughout my discussion, I will reference both GAAP and non-GAAP financial information. There is a reconciliation of GAAP and non-GAAP information in the Investor Relations section of our website. As I do each quarter, I’d like to remind investors that, for a variety of reasons, our business is inherently uneven and we suggest that you consider our performance over a longer time horizon, as our sales will fluctuate from quarter to quarter. Let me now recap our results. Revenue for the second quarter was $87.9 million, up 18.7% from $74 million in Q1 2008, and up 16.4% from $75.5 million in Q2 2007. Product revenue was $62.4 million or 71% of total revenue, up from $51 million in Q1 and up from $52.2 million in Q2 2007. Service revenue was $25.5 million or 29% of total revenue, up from $23 million in Q1 and up from $23.3 million in Q2 of last year. Now looking at our revenue geographically, domestic revenue accounted for 80% of [inaudible] revenue versus 83% in Q1 and 75% in Q2 2007. AT&T and KDDI both contributed greater than 10% of total revenue in the second quarter. Our top five customers represented approximately 69% of revenue in Q2 versus 58% in Q1 and 65% in Q2 of last year. We reported revenue from 82 customers in the second quarter compared to 85 in the first quarter and 70 in Q2 2007. Please note that the timing of deployment schedules will cause shifts in the number of customers contributing to our revenue each quarter. We are very pleased with our efforts to broaden our customer base in the past year. As Rich mentioned earlier, we had many new customer announcements since our last call, including Bahamas Telecom, Convergia, Tata Communications, and PTV Telecom. Please note, however, that with new customers it may take several quarters post announcement before we recognize revenue. Our book-to-bill in Q2 was greater than 1. This was the best Q2 bookings performance in the company’s history. Bookings were strong across all solutions and in all geographies over the same period in 2007. Before I begin discussing our gross margins and operating expenses, I would like to point out that these are nonGAAP numbers that exclude stock-based compensation and related expenses, amortization of intangible assets related to Zynetix and Atreus acquisitions, an impairment charge related to Zynetix intangible assets and goodwill in 2008, and stock option review costs in 2007. Again, I would like to remind you that additional information regarding our non-GAAP financial measures, including GAAP to non-GAAP reconciliations, are available in the Investor Relations section of our corporate website and I would encourage you to visit this site. Non-GAAP gross margins for the second quarter were 67.1% of revenue compared to 64.2% in Q1 and 57.8% in Q2 2007. Product gross margin for the second quarter was 71.3% compared to 67.5% in Q1 and 55.3% in Q2 2007. Service gross margins were 56.8% compared to 56.9% in Q1 and 63.4% in Q2 of last year. Recently, we’ve seen margins at or above the high end of our target range due to very favorable customer and product mix as some of our larger customers have continued their network expansion plans. However, we believe that gross margins with our current product set and items currently in deferred revenue will be in our target range of 58% to 62%. As Rich will discuss later, this is particularly true if some of the CapEx planned by our customers is postponed because of macro economic conditions. As for non-GAAP operating expenses, Q2 R&D expenses were slightly below our expectations, coming in at $17 million compared to $16.9 million in Q1 and $15.9 million compared for Q2 2007. While we saw an increase in head count and other people-related costs, some of which reflects the addition of the former Atreus R&D team, we have offsets in other miscellaneous costs within the function. While we are committed to supporting our customer-based R&D projects, on a go forward basis we will ensure that our R&D investments will generate acceptable return on investment and support Rich’s objective of continuous improvement in our gross profit to R&D spend ratio. Like many metrics, due to the quarterly unevenness of our business, our gross profit to R&D spend ratio is far more meaningful on a trailing 12 month basis. This ratio for Q2 on the trailing 12 months was 3.2 versus 3.1 in Q1, again on a trailing 12 month basis. This is an important metric we are using internally to ensure that our R&D investments deliver appropriate returns. Also in line with our plan, sales and marketing expenses increased to $18.2 million in Q2 compared to $17.1 million in Q1 and $15.4 million in Q2 2007. The increase in sales and marketing expense was primarily associated with an increase in head count and other employee-related costs in support of our global expansion efforts and separation costs for a former executive. G&A expense was higher than anticipated at $10.8 million in Q2 2008 compared to $9.1 million in Q1 and $9.2 million for Q2 2007. The increase in G&A expenses in Q2 was primarily due to increased legal and other professional fees associated with ongoing litigation. Total non-GAAP operating expenses for the second quarter were $46.1 million, up from $43 million in Q1 and $40.5 million for Q2 of last year. Non-GAAP operating expenses in Q2 were at the low end of our expected range of $46 to $48 million. Rich has indicated that driving improved productivity and efficiency will be one of our highest priorities. This will require a judicious investment that will increase operating expenses moderately in the short term. However, we believe this is necessary to position the company for accelerated earnings growth as we enter 2009. Q2 non-GAAP operating income was $12.9 million or 14.7% of revenue, compared to $4.5 million or 6.1% of revenue in Q1 and $3.2 million or 4.2% of revenue in Q2 2007. Due to our strong revenue and higher than expected gross margin performance, we delivered operating income significantly higher than guidance for the quarter. Our non-GAAP effective tax rate is 52% for Q2. Our tax rate reflects non-deductible items, including new items in the second quarter against earnings expectations by tax jurisdiction. Please note that we had a significant historical net operating loss position of $110 million at year end and our actual cash payments for taxes are much lower than the financial statement provisions. In summary, Q2 non-GAAP net income was $7.8 million or $0.03 per diluted share compared to $5.2 million or $0.02 per diluted share in Q1 and $5 million or $0.02 per diluted share in Q2 2007. Now let’s turn to our GAAP results. Our Q2 gross profit of $58.1 million included $619,000 of stock-based compensation and $262,000 of intangible amortization. We had operating expenses of $54.2 million in Q2 which included stock-based compensation of $4.4 million, intangible amortization of $132,000, and an impairment charge of $3.6 million. In Q2, in connection with our quarterly review process, we determined that certain impairment indicators existed related to our acquisition of Zynetix in April, 2007, and as a result we recorded non-cash impairment charges of $3.6 million. Q2 GAAP operating income was $3.9 million, compared to an operating loss of $3.3 million in Q1 and an operating loss of $15.4 million in Q2 2007. Q2 interest income net of interest expense was $3.2 million compared to $3.9 million in Q1 and $4.4 million in Q2 2007. The interest income decline was primarily due to the lower interest rate environment. The GAAP effective tax rate was 98% for the second quarter and 92% for the first half of the year. We review our annual tax rate each quarter and make adjustments as required. Our tax rate is negatively impacted by non-deductible items, including new items in the second quarter, against earnings expectation by tax jurisdiction. These non-deductible items include such things as certain stock-based compensation expense, amortization of intangible assets, and the Q2 impairment charges for Zynetix. Our tax rate has also been negatively impacted by the current year’s exclusion of the R&D tax credit, which expired in December, 2007 and has yet to be renewed by Congress. Again, I remind you that we had a significant NOL position of $110 million year-end, and our actual cash payments for taxes are much lower than the financial statement provisions. In Q2, our diluted share count was approximately 274 million shares. Now turning to the balance sheet, overall Sonus ended the quarter with total cash, cash equivalence, marketable securities and long term investments of $397.8 million compared to $407.6 million in Q1. The decline in our cash balance was primarily driven by the acquisition of Atreus Systems for approximately $5 million, CapEx of $2.7 million and a modest operating cash burn of $2.7 million. Accounts receivable were $79.4 million, up from $66.9 million in Q1 and up from $72.4 million in Q2 2007. DSO on a straight single point was 81 days in the second quarter, which was consistent with Q1. Total deferred revenue was $94.6 million, a decrease from the $107.9 million reported in Q1 and an increase from the $86.6 million in Q2 2007. Of total deferred revenue, $38.1 million was deferred product revenue and $56.5 million was deferred service revenue. The deferred service revenue relates primarily to maintenance contracts. The current portion of deferred revenue was $74.7 million and the long term portion was $19.9 million. I am very pleased to report that we continued to make solid progress with BT. As we had expected, BT AGCF is now appearing in our deferred revenue balance for the first time, and we anticipate that it will continue to ramp as the project advances and deployment commences. We ended the second quarter with $48.4 million of total inventory, essentially flat from the $48 million we reported at the end of Q1 and down from the $49.5 million in Q2 last year; $35.8 million of our inventory balance is unearned inventory, which reflects product shift to customers but not yet reflected in our revenue results. Accounts payable came in at 38 days versus 34 days in Q1. CapEx during the quarter was $2.7 million compared to $1.7 million in Q1 and $5.5 million for Q2 2007. Depreciation was $3.1 million in the quarter, down from $3.3 million in both Q1 2008 and Q2 2007. Looking at our head count, we ended the quarter with 1,039 employees compared to 955 employees at the end of Q1. The increase was primarily due to the addition of 50 employees from the Atreus acquisition and increases in our sales and services groups as part of our global expansion initiative. Now turning to the second half of 2008, as Rich will discuss momentarily, we are not in a position to reaffirm our previous outlook for the second half or provide revised estimates. However, I will offer the following

[Richard Nottenburg:]

During the second quarter we continued to see solid order activity in North America, with an uptick year-on-year. AT&T, our largest customer, continues to expand their network and the order activity in part reflected the IP voice traffic and the deployment of new IP services. In addition, we were pleased that Sonus deployments in the quarter continued to drive network efficiency and lower the total cost of network ownership for our largest customer. We are making good progress in EMEA. Investments made in the region drove a substantial increase in first half bookings year-on-year. Work with BT on the [inaudible] contract win in the fourth quarter of 2007 continues and I am pleased that we are meeting milestones and excited to be working with BT on their 21CM program. During the quarter we announced COLT, one of the largest Pan-European operators as a customer. COLT is deploying an end-to-end Sonus Network solution for IP telephony to enterprise customers across 13 countries and Europe. We were successful in winning this business because of our underlying technology and the flexibility, scalability and robustness of our platform, which allows COLT to develop new services faster. The solution uses our core trunking and access technology as well as our Network Border Switch, which COLT confirmed as the best session border control technology. In the second quarter we saw the first cable customer for Sonus in Spain. PTV Telecom is an integrated voice, data and local television programming provider, and it selected Sonus to upgrade its next generation network with a full suite of Sonus solutions. During the first half of 2008 we continued to grow our market share in the session border controller space with our Network Border Switch. Our holistic approach to network design and the decision to build our Network Border Switch solution as part of our GSX platform enables us to capture market share as many of our customers use the NBS as a versatile hybrid network element. Our strategy is to continue to leverage the NBS as an integrated component of the Sonus solutions set while expanding our overall network footprint. Earlier in 2008 we launched our first solution dedicated to the wireless market. This quarter Sonus completed and released 1.1 of our mobile solution. The latest release features full support for 2G and 3G radio protocols and work is under way to support EVDO by year end. In June we announced our voice over WiMAX solution. By building on Sonus' proven track record in delivering voice over broadband, we now offer WiMAX operators a complete voice network solution that allows them to quickly and properly roll out carrier class voice services over an allIP network. If I step back and look at what is driving some of the bookings improvement year-on-year, I see a company that has moved well beyond the delivery of a single network element or a card to expand capacity. This year represents a significant shift in the type of business that Sonus is winning, a shift from the organic growth in the existing GSX footprint to define the next generation networks for some of the world’s largest and most influential network operators and carriers. We are seeing an increase in what I term network design wins or complete network transformational projects that involve our whole portfolio of trunking, access and session border control solutions as well as revenue generating services. Recent customer wins at COLT, Tata Communications and Convergia are representative of this change. In some of these opportunities, we are doing complete PSTN replacements. This change puts us in a very different position in the layer 4 to layer 7 IP communications space. The companies that will be successful are those who can partner with operators to deliver IP telephony messaging today and those who are able to future proof their customers' network infrastructure for the demands of video and multiplay subscriber services. In addition, with the acquisition of Atreus Systems in Q2, Sonus now offers an end-to-end migration solution that accelerates a carrier's time to market and, more importantly, their time to profit. I will now talk about our outlook, the market, the competitive landscape, and my approach to leading the company. At the beginning of the year, Sonus set an outlook of 20% revenue growth for the calendar year 2008, with much of that growth anticipated to take place in the second half. We see many positives, including a good start on bookings, which has helped us build backlog. We also see positive progress around expanding our customer set and the breadth of the solutions we are selling. We expect global CapEx spending by carriers in general will be flat to slightly up in 2008, and there will be a continuation of a shift to next-generation products that enable the transition from circuit to all-IP networks. Like others, we are sensitive to the postponement of CapEx by our customers, and we see downward pressure from our prior outlook on revenue for the third quarter and for the full year. Revenue in the first half of 2008 grew approximately 10.5% when compared with the same period in 2007. Our current outlook is that revenue growth in the second half of 2008, compared with the same period in 2007, is not expected to exceed the 10.5% growth we experienced in the first half of 2008. That being said, we believe that this business can be run more efficiently at a lower expense structure. In the third quarter I will continue by deep dive on OpEx and will give you a view on our next earnings call. But our outlook for OpEx in the third quarter will not be less than the level reported in the second quarter. I would also like to comment on the competitive landscape and the customer environment. There are approximately 20 customers that drive the bulk of CapEx spending globally. These carriers are large enough to drive [inaudible] solutions around next-generation all-IP networks, but we operate in an environment with large, infrastructure companies who provide legacy products. Therefore, we are going to continue to use 58% to 62% as our long-term gross margin model for the foreseeable future. Also, we have seen a large number - we have seen a number of large companies go in and out of this space. The increase in purchasing power of global operators resulting from industry consolidation, together with the commoditization of certain network elements outside of our market, has put certain financial pressure on some of the large infrastructure suppliers. Given our portfolio of IP products serving the layer 4 through layer 7 communications space and our singular focus on this market, we should be able to grow our revenues faster than the market over the next few years, provided, however, we continue to expand and diversify our set of Tier 1 customers and we capture meaningful market share with our portfolio of access products. This is one of the priorities I stated in my opening remarks. In addition to the priorities I set out upfront, I will be focusing on the five following areas

[Karen Cellupica:]

We will no open for Q&A.

[Operator:]

(Operator Instructions) Your first question comes from Paul Silverstein - Credit Suisse.

[Paul Silverstein:]

Richard, can you tell us how broad, when you all talk about weakness in the second half of the year relative to the global CapEx outlook, how broad is this? Is this focused, as one would expect, on your - where the revenues are coming, your top five or so? Is this much broader than that? Any insight you could give us would be appreciated.

[Richard Nottenburg:]

Yes, first of all I think that clearly the softness in the second half of the year is external rather than any internal execution issue. I think though that the bookings strength is also noteworthy. We did quite well in the first half of the year compared with the first half of last year. But I think that, if you look at the landscape, I think that if you look at some of the customers across the landscape, I think there's some softness. I think they potentially give you some pushouts and we don’t have the visibility that I think we'd like to have with regard to that.

[Paul Silverstein:]

Well, Rich, that being said, is there anything specific from AT&T or any of your other major customers at this time that leads to the concern that's reflected in the numbers or is this just you being prudent and cautious given the overall environment or is it a combination?

[Richard Nottenburg:]

Well, first of all, it's not due to anything specific from any specific customers, number one. I think it's just basically looking at the landscape, looking at the backdrop of the year and just basically saying to yourself looking the at the things that I see among some of my colleagues in the industry.

[Operator:]

Your next question comes from Edward Jackson - Cantor Fitzgerald.

[Edward Jackson:]

When you, again, look at the back half, did you just make a comment you see the back half having revenue growth on a year-over-year basis - this is the back six months - of 10.5%?

[Richard Nottenburg:]

Yes, I think that's exactly what we said. We said not to exceed the growth rate you saw in the first half of the year, so just for clarity we were into approximately 10.5% growth in the first half of this year over the first half of last year, and what we're really saying is we expect the second half of this year to grow - not to exceed that rate from the second half of last year.

[Edward Jackson:]

When you look at the growth prospects for the back half of the year and look in some of the prior commentary that you've made I'm just speaking to the last call and you had talked about a pickup in business within Europe. You talk about how the Japanese spending was coming back in line. Has there been a fair amount of slowdown just on a global perspective or are there any particular geographic regions where you're seeing things a little [inaudible] than others? Is this mainly a North American phenomena? Just any color you can provide on that front.

[Richard Nottenburg:]

I don't really have a lot of, what I call specific color on that, just to say that. I don't think that the business environment is as robust as it was earlier in the year.

[Edward Jackson:]

And did you say that CapEx and operating cash flow, CapEx was $2.7 million and operating cash flow was negative 27?

[Richard J. Gaynor:]

Correct.

[Operator:]

Your next question comes from George C. Notter - Jefferies & Co.

[George C. Notter:]

Richard, you've been here for seven weeks, as you said. any thoughts about the balance sheet here? There's obviously a lot of cash. You did grow cash a little bit here this quarter in total. What do you think about the capital structure of the company in this low interest rate environment? Is there a way to pursue a buyback program or maybe you could optimize the balance sheet a little bit? Conversely, would you look at M&A to try to grow the company through inorganic means? What's the thought there?

[Richard Nottenburg:]

I've been here seven weeks, and certainly I don't have any, I'm not going to basically give you any, I'm not going to make some big statement here about the balance sheet. But let's just think about a couple of things I think that are important in terms of the questions that I'd be asking. I think first of all we have to think about how much cash we need to have so that our customers feel comfortable. We do business with some very, very big customers, and I think that's the first thing you have to assess. How much cash do we need to have on hand so that large customers feel comfortable? I think a couple of the other things you have to consider are what is the replacement cost of that cash? How much would it cost to go back and get cash? I think another thing is, and I haven't seen and I have to get a feeling for. what are the cash generating capabilities of the business? What are the cash from operations going to be here over the next 24 months? And I don't have that visibility right now. But that being said, I think obviously the Board every quarter, obviously the Board's going to look at the capital structure and ask the right questions. But I think I'm not in a position right now to say much more than that.

[George C. Notter:]

Any thoughts on M&A?

[Richard Nottenburg:]

On M&A? Well, I'm really focused right now operationally and I'm focused on execution. Any M&A activity would obvious, for me would tend to be, right now, be very opportunistic. And my real focus is on the business, on execution, strengthening the team, and doing the right things that getting the company ready for 2009.

[Operator:]

Your next question comes from Steven O'Brien - JPMorgan.

[Steven O'Brien:]

Regarding, going back, just a point of clarification on the 2H revenue guidance. You're using the word growth, so does that imply a band of zero to up to 10.5% growth you know, versus 2H 'O7? And then a second question, really my question is on the margin side of the business, the full year margin guidance implies a pretty substantial drop in the gross margin in the back half of the year, below normalized 58% to 62% percent level. Can you give us any more color on what are the puts and takes within that and if we should be reading through that that the gross margin does fall below the historic range?

[Richard J. Gaynor:]

Let me answer the growth question first. I think what we are indicating is that the growth rate in the second half over the second half of last year will be in line with the growth we say in the first half of the year versus the first half of last year. And the way we positioned it is we don't really expect it to exceed that rate, which was approximately the 10.5% rate, so I think that's your goalpost there. We have intentionally not given a lower end to that range because of the limited visibility we have. In terms of the gross margin question, I'm not giving the 58% to 62% on an annual basis, so you don't have to think about taking the first half and weighing it against the second half. We're looking at the 58% to 62% as our target range for the second half of the year.

[Steven O'Brien:]

Richard, you've come aboard and looked at the operating margin structure. Is it a function of reducing the cost for adding a new customer or cost for pursuing a new network opportunity that is an area for finding operating leverage going forward or what other factors have you identified as a way to target that mid-teens operating margin?

[Richard Nottenburg:]

First of all, I haven't had that much time here to really get into that level of thought process. What I can say is that as far as we did say that we would do a deep dive on OpEx and we're certainly looking at that. We looking at that putting [inaudible] and there's some things obviously in our expense structure that I think that we can improve on. I think being said, I think you raise some important questions about what is the cost to acquire a new customer and what does it cost for a very large customer? I certainly don't have any data right now to share with you on that, but that's something I'll be looking at as we go forward.

[Operator:]

Your next question comes from Brian Coyne - Friedman, Billings, Ramsey.

[Brian Coyne:]

First of all, I don't seem to have great historic numbers for your deferred product revenues, but I was wondering if you might be able to shed a little bit more light on how that's changing. That's first. And then second, again, I know probably not a deep area for discussion but what kind of an update on perhaps some of the sticking points might you have for in your discussions with your largest shareholder?

[Richard J. Gaynor:]

In terms of deferred revenue for product, the number we have here I can share with you now is $38.1 million for Q2. That number is down from $47.3 million in Q1 '08 and down modestly from the $44.1 million in Q4 '07.

[Richard Nottenburg:]

I think with regard to Legatum, I think I was pretty clear in the script. I think that what we said was that we have dialogue and I believe we have constructive discussion. And that's about the extent of my comment right now. When we have more things to add, we'll give you more information as we have something more to say.

[Operator:]

Your next question comes from Tim Savageaux - Merriman Curhan Ford & Co.

[Tim Savageaux:]

Did you specifically say your second half outlook is not driven by changes at AT&T or how did you respond to that question?

[Richard J. Gaynor:]

The way we responded to that question was we said that the second half outlook is driven by external factors and not by internal company execution.

[Tim Savageaux:]

On to that, looking at your guidance range, though, it looks like you continue to expect some sequential growth, just not the hockey stick that was implied in the previous forecasted guidance. Is that fair to say?

[Richard J. Gaynor:]

That’s fair to say. If you do the math, the second half of the year is typically stronger for us over the last several years, and if growth rate in the second half of this year over second half of last year is in line with global retail enterprise in the first half, that would mean that it is stronger in the second half than the first half if one uses the upper limit of the 10.5% expectation, given that we're not saying - and we have a lower limit on that number; I'm just giving you an upper goalpost, if you will.

[Tim Savageaux:]

You did see a bit of a bounce back in Japan with KDDI back on the 10% customer list, I believe for the first time in awhile. Do you expect that to continue to strengthen? Can you give us some sense of developments in Japan from an orders standpoint or whatever color you might be able to provide?

[Richard J. Gaynor:]

KDDI is a 10% customer in the second quarter. We did recognize that that was likely to happen because we scored a piece of that out of deferred revenue. So our relationship with KDDI is an ongoing relationship. Unfortunately, due to the vagaries of rev rec under 97-2, you sometimes get a scoring of revenue even though you have activity in every quarter. So we did see a spike in revenue for KDDI in the second quarter related to scoring some revenue out of deferred, however our relationship is ongoing, but I would not expect it to be a 10% customer every quarter.

[Richard Nottenburg:]

First of all, I haven't been over to Japan yet nor have I been over to Asia-Pac, at least for Sonus. And I think there's a lot of exciting activity going on in the region, and I plan on getting over there as quickly as possible. We've got a couple of good customers over there, including KDDI and J

[Operator:]

Your next question comes from Edward Jackson - Cantor Fitzgerald.

[Edward Jackson:]

Did you say in the third quarter that you expect operating expenses to be relatively flat with the second quarter?

[Richard J. Gaynor:]

No, we didn't say that. We actually said we expect them to be moderately higher in the second half of the year.

[Operator:]

Your last question comes from Paul Silverstein - Credit Suisse.

[Paul Silverstein:]

Rick, I don't mean to pin you down, but I know from historical experience one person's moderately is another's modest is another's extreme, so can you give us a little bit more insight when you [say] moderate if we're talking about just some type of bound.

[Richard J. Gaynor:]

Paul, what I'd like to be is precise but I'm afraid I can't. And let me give you some reasons why we can't. Rich is still relatively new to the company. His plans are still in development and as we indicated earlier, we've taken certain actions right now to position ourselves for 2009. Not all of those actions have been completely worked out. In addition, a wild card we seem to have here is litigation fees, and those have been relatively volatile and somewhat hard for us to predict over the last couple of quarters, and we expect that to continue in Q3 as well. So with that, we're saying moderately up, so I'll have to allow you to make your own estimate on what moderately means, but it's not going to be, let's say, less than a million, in our expectation.

[Paul Silverstein:]

It will be more than a million?

[Richard J. Gaynor:]

I would expect it to be more than a million.

[Paul Silverstein:]

The G&A was up $1.8 million sequentially, $1.7 million sequentially. You mentioned the litigation expense aspect. I understand it's hard to predict. Should we expect that to hit again in Q3 or should we expect G&A to come back down?

[Richard J. Gaynor:]

No, in terms of general OpEx G&A is an area where we still expect to see litigation fees in the third quarter.

[Paul Silverstein:]

With respect to BT in terms of the impact on your balance sheet, you mentioned it was in deferred revenue. I assume if it's in deferred revenue we're also seeing it in cash. Would that be correct?

[Richard J. Gaynor:]

That would be correct.

[Paul Silverstein:]

You had KDDI come out of deferred revenue and hit the income statement. You had BT go in. I also assume that it's still early days, and the impact of BT was clearly not that great in the grand scheme of things. As you go forward this coming quarter and each quarter thereafter we should expect that impact to become larger and larger. Is that a fair assumption?

[Richard J. Gaynor:]

Yes, it's fair to say that we'll expect to see it increase in deferred revenue. It won't be a linear growth. It will be following the project plan to some degree. But yeah, it's not a huge number in the first quarter, in which we start moving deferred revenue, but it is starting to become more material as we go forward.

[Paul Silverstein:]

You mentioned in the prepared remarks you had your best quarter of bookings in the history of the company. I understand Rich is also being prudent or conservative in terms of the outlook with respect to CapEx. But there seems to be a little bit of a disconnect in terms of the growth you're talking about, great order book, great book to bill, growth not so good in terms of the actual income statement. Is this just a timing issue? Where's the disconnect?

[Richard Nottenburg:]

I appreciate the question and, I understand why you're asking it. Look, we had very good bookings the first half of this year versus the first half of last year, and we built some backlog. Frankly right now I don't know what the bookings are going to look like in the second half of this year, and I'll be honest with you, I feel on the outside right now that we have less visibility. So I understand the disconnect, but at the same time it's really - it's driven by external visibility.

[Richard J. Gaynor:]

Paul, I want to come back with a clarification. While we did start invoicing earlier in the year, we didn't receive our first cash inflow from BT until Q3.

[Karen Cellupica:]

This completes this afternoon's financial results conference call. We would like to thank you again for joining us, and we appreciate your interest in Sonus Networks.